The amount of collateral supporting cédulas hipotecarias would drop as a result of Spanish issuers transferring mortgages to a proposed bad bank, said Fitch and other analysts, but benefits such as reduced funding pressure and a lower probability of default could offset this impact.

Spain’s government at the end of August approved the creation of an Asset Management Company (AMC) to acquire bad loans from Spanish banks, a condition of a rescue package of up to Eu100bn for the country’s banking system.

Fitch on Friday said that swapping mortgages for government guaranteed debt issued by the AMC, with the price yet to be determined, will cause collateral to drop given that in Spain the whole of a bank’s mortgage portfolio secures covered bonds.

The government guaranteed bonds are of higher credit quality than the troubled mortgage assets transferred, but will in principle not be available as cover pool assets to the covered bond investors, according to Fitch.

It said that the exact format of the guaranteed bonds is still being designed, but that it expects them to be used as eligible collateral for ECB repo transactions, and will contact affected banks to determine if they intend to amortise existing retained covered bonds with the funds obtained via the repo transactions.

The rating agency flagged the possibility of an extreme case materialising where the amount of mortgages transferred is so large that the volume of eligible mortgage cover assets dips below the legal minimum of 125% of the covered bond liabilities, but said that it expects banking authorities to develop a solution that protects covered bondholders.

“The resulting drop in the coverage will be partly offset by the lower risk of the remaining cover pool,” added Fitch.

RBS analysts referred to a twofold impact on cédulas hipotecarias stemming from a transfer of mortgages to AMC, which, as Fitch said, will reduce the amount of available assets for covered bond investors in case of issuer insolvency.

“A cédulas hipotecaris investor is probably still better off holding the bad assets himself,” said the RBS analysts, “than the bank selling them to the bad bank and receiving cash or government debt in return (as the CH investor will not get priority access to the those assets).”

A positive impact, however, stems from a reduction in the probability of default as a result of a bank selling bad assets at a price slightly higher than the market price private investors would be willing to pay, said the analysts.

Fritz Engelhard, German head of strategy at Barclays, noted that Bankia is the institution with the largest amount to be transferred to the AMC, with a mortgage book of around Eu110bn at the end of 2011, comprising roughly Eu70bn of residential and Eu40bn of commercial, mostly developer and land, financings. A total of around Eu75bn of this has been eligible for around Eu55bn of covered bond funding, he said.

“Assuming that roughly Eu60bn of the residential book and Eu15bn of the commercial book contribute to the eligible pool,” added Engelhard, “a complete transfer of the commercial book could indeed lead to some pressure on maintaining the legal OC ratio.”

However, he said that Bankia might keep Eu10bn-Eu15bn of the commercial loans on its balance sheet, limiting the drag on eligible assets, and that the reduction in funding pressure could allow the bank to retire some of its (retained) covered bonds.

“So even in the extreme case of Bankia, the maintenance of the legal OC ratio appears manageable, due to the ability of the bank to compensate the drop in cover assets by (a) substantially increasing the ratio of eligible assets and (b) also reduce liabilities,” said Engelhard.

“As eligible assets usually have also above average quality and as the transfer of assets to the AMC will substantially improve the overall quality of the bank’s mortgage book, I would rather think this process is fundamentally positive and not negative for covered bond investors.”

Fitch said that the vast majority of mortgages that will be transferred to the AMC are likely to be troubled developer loans. Because the rating agency assumes high default rates and low recovery rates for these loans (around a 70% default rate and a 20% recovery rate under a BBB rating scenario) the benefit to the cover pool is limited, said Fitch, but “not zero”.

For example, where 30% of a bank’s mortgage portfolio consists of developer loans a transfer could add 7% to 10% to the net present value estimation of the collateral pool.

Bernd Volk, head of covered bond research at Deutsche Bank, said that many Spanish banks are close to their cédulas issuance limit, but that ECB funding will likely decrease as other forms of funding increase, with BBVA for example issuing several senior unsecured bonds, and/or as their loan books decrease.

“This in turn leads to increasing eligible OC (as the volume of retained cédulas would decline or the preferential claim would collapse in case retained cédulas are no longer repo-ed at the ECB),” he said. “While a normalised funding profile would put pressure on net interest income, in our view, it would increase issuer credit quality.”

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