Sharp declines in Spanish housing prices since 2008 and a related erosion of protection against credit risk in cédulas hipotecarias cover pools are not being captured by LTVs reported by Spanish issuers, which are based on original appraisal values, said Moody’s yesterday (Wednesday).

Spain’s covered bond legislation does not require issuers to re-evaluate appraisal values for the purpose of qualifying assets as eligible collateral or to disclose any updated values, said the rating agency, and cédulas issuers typically report loan-to-value ratios (LTVs) based on original appraisal valuations. This means that the LTVs do not reflect house price fluctuations and understate credit risk in mortgage pools backing covered bonds, said Moody’s.

This is because the higher an adjusted LTV is at foreclosure, the higher the losses a covered bond’s protection will need to absorb because of lower proceeds on liquidation of properties, it said. It noted that in Spain borrowers are usually personably liable for all outstanding debt to a bank and therefore have no incentive to default if the mortgage loan is in negative equity.

José de Leon, senior vice president at Moody’s, told The Covered Bond Report that the rating agency decided to issue a report on the subject of LTV reporting in Spain to help investors who want to fine tune their analysis and investment decisions based on stressed rather than base scenarios in the event that issuer support disappears.

“One of the questions we have regularly received over the past two years is about how Spanish issuers report LTVs,” he said, “and another is how house price declines will affect eligible cover assets.”

And while eligible cover assets will not fluctuate, he said, this does not provide an accurate estimate of the protection available to mortgage covered bondholders.

“It’s not a credit problem from a rating perspective because we already stress for house price declines,” added de Leon, “but more of a transparency problem.”

LTVs reported by issuers in other covered bond jurisdictions typically reflect house price fluctuations, according to de Leon, with significant house price declines recently in Spain making LTV reporting practice there an important issue.

The topic of LTV valuation/reporting emerged as an issue in the lead up to Australian banks’ debuts in covered bonds, with investors’ preference for indexation having prompted issuers to make this a feature of their programmes despite this not necessarily having been planned from the outset.

Moody’s said that LTVs reported by Spanish covered bond issuers understate negative equity mortgages.

The rating agency estimates that, after adjusting reported LTVs for house price declines, more than 10% of the mortgages backing Spanish covered bonds are in negative equity with LTVs exceeding 100%. This is more than double the percentage the Spanish banks have reported, according to de Leon, with only 4% of mortgage loans in negative equity based on issuer reports.

As of June 2012 Spanish house prices had fallen around 23% on average since a peak in early 2008, and are at pre-2005 levels. A loan originated in early 2008 with an LTV of 80% would now have an LTV of nearly 95% if marked to market, according to Moody’s, assuming that scheduled repayments have decreased the loan balance by around 10%.

Residential mortgage loans up to an LTV of 80% can be included in Spanish cover pools, and commercial mortgages up to 60%.

Moody’s ran a sensitivity analysis on relevant cover pools, assuming no issuer support, to determine the extent to which house price declines have eroded protection beyond that indicated by an unadjusted LTV. This involved projecting expected losses stemming exclusively from credit risk at different borrower default rates and house price projections for a sample from the mortgage cover pools backing the covered bonds that Moody’s rates.

“Our study shows that adjusting LTVs is necessary to project the expected losses that credit risk causes,” said de Leon. “According to our central scenario, around 24% of mortgages would be in negative equity if prices were to fall another 20% in the next 18 months.”

Credit losses on cover pools would almost triple and overcollateralisation ratios would have to increase by 43% for investors to avoid suffering losses if an issuing bank cannot support its bonds, according to Moody’s, assuming the default rate simultaneously increases to 20% from a current estimate of 10% for mortgage assets. The rating agency noted that Spanish regulations require issuers to revalue property prices for the purpose of provisioning “doubtful” loans, but that covered bond issuers are not required to report these prices. In addition, it said that although recent laws require that independent audit firms revaluate the assets that a restructuring bank will transfer to third parties, these revaluations would not form the basis for issuers’ LTV reporting.

The rating agency’s analysis on the implications of cédulas issuers’ LTV reporting does not have any impact on covered bond ratings, said Moody’s, because these already reflect the effect of negative equity on the relevant loans.

Source: Moody’s