The Spanish Treasury has released a consultation paper on how Spain’s covered bond framework could be revised and, although Moody’s commented negatively on potential cuts to OC, other market participants said it should result in a stronger Spanish instrument, with the challenges of a transition period mitigated by its timing.

The Spanish Ministry of Economy and Competitiveness last Wednesday released a document on a public hearing “on the potential improvement of the regulatory framework of covered bonds”. The paper refers to a European Banking Authority report on covered bonds published in July and EU regulatory developments that could result in new standards being required for preferential treatment to be retained.

“Given the aforementioned international analysis, which will probably link risk weights to the fulfilling of certain criteria, it is advisable to revise the Spanish legal framework for covered bonds to see what improvements could potentially be introduced therein,” said the ministry.

It listed seven main areas for consideration (in the words of the document, including original emphasis):

- Possible reduction of the levels of asset encumbrance of issuing institutions, especially regarding «cédulas hipotecarias».

- Clarification of the rights of the covered bondholders in case of insolvency of the issuing institution by segregating the cover pool.

- Indexation of the value of the cover pool assets and, when needed, of their collateral.

- Redefinition of the eligible assets for each type of covered bonds.

- Additional liquidity management measures.

- Publication of more complete, transparent and homogeneous information by issuing institutions.

- Creation of the figure of the asset pool monitor to supervise the fulfilling by the issuer of their obligations.

“Given the potential impact of a reform of the legal framework of covered bonds, competent public authorities (the Spanish Treasury, the Bank of Spain and the Spanish Securities & Exchange Commission) deem it appropriate to conduct a public hearing as a means of gathering the opinion of any potential stakeholder,” it said.

Lorena Mullor, manager at the Spanish Mortgage Association (AHE), stressed that the Treasury’s initiative is at a very early stage, with no law proposal on the table, merely a public hearing – which she noted was unusual – so that stakeholders can address key issues. She noted that the industry will present its own views to the Treasury, given that most of the areas have been already examined.

Indeed market participants have been discussing possible reforms to Spain’s covered bond framework for several years given its significant differences from practices common elsewhere, and particularly since the onset of the financial when concerns about idiosyncrasies of the Spanish instrument came to the fore.

Unlike those of other jurisdictions, covered bonds in Spain are backed by all the mortgages of an issuing institution – hence the focus on asset encumbrance, which the EBA has also been considering – while in other areas – notably those listed by the ministry above – Spain’s framework is widely seen as having shortcomings.

Agustín Martín, head of European credit research, ABS and covered bonds at BBVA, said that Spanish covered bonds have been negatively affected by their shortcomings in terms of ratings and non-domestic demand for the product, and that changes therefore make sense.

“The only potentially controversial aspect from our point of view could be the likely revision of the OC requirements under the current framework,” he added.

Whereas cédulas hipotecarias have to comply with a 25% overcollateralisation (OC) requirement based on eligible mortgages (described as eligible OC), as mentioned above they are backed by all mortgages on the issuer’s balance sheet (total OC). Any change to the Spanish framework is expected to remove the latter security, so that overcollateralisation levels could fall sharply.

Moody’s today (Monday) highlighted that such a reduction in collateral would be a credit negative.

“If these changes take effect, covered bonds would be backed by much less collateral, instead of the issuer’s entire mortgage book,” it said. “As a result, overcollateralisation (collateralisation above the amount of covered bonds) risks dropping to 25% or less from current levels of more than 100%.”

The rating noted that other measures could improve the credit quality of the covered bonds, but said that the collateral reduction would make the overall package credit negative.

Martín questioned Moody’s coming out with such a judgment so soon after the release of the Ministry document.

“Taken as a whole, the changes proposed will from my point of view lead to a much more efficient and modern framework than the one we have as of today,” he said. “Everyone knew that the Spanish issuers have huge excess collateral, but in spite of the access to the whole mortgage portfolio rating agencies have not given any uplift on the back of that due to the structural deficiencies of the cédulas framework in terms of liquidity mitigants.”

Related to the potential change in OC levels, the question of how a transition from the prevailing framework to a new one should be managed is also considered challenging. Mullor at the AHE said that it is one of the most important issue and will not be easy to address. However, she said she is sure that regulators and issuers will be very careful with this question given the importance of the funding product for both investors and Spanish issuers.

The possibility that the transition would necessitate a change from the existing instrument to a new one with associated exchanges has been raised, but Martín said he does not envisage substantive documentation changes as a result of the framework update.

“We view the existing cédulas transactions will simply accede to the new governing law in a manner tantamount to a contractual programme change affecting all outstanding series, given this is the manner in which cédulas transactions are documented under Spanish law,” he said. “The odds are that there will be grandfathering.”

Mullor said that the industry will also have lots of time to prepare for the changes given that, with a Spanish general election scheduled for December 2015, any change to legislation will probably not happen until at least 2016. Martín, meanwhile, noted that cédulas redemptions dropping sharply around 2017 will also make the process more manageable.

Bernd Volk, head of covered bond research at Deutsche Bank, said that on balance he expects the outcome to be positive.

“While the comment from Moody’s is clearly negative, and indeed significantly less OC is negative, we argue that the excessive OC (i.e. a preferential claim on the whole mortgage book) in the current legislation has limited credibility anyway,” he said. “Moreover, a change of law reducing OC of currently outstanding bonds provides good political reasons to prevent harm to covered bonds outstanding at the time a new law would come into force.

“Moreover, the proposal includes numerous mitigants (LTV indexing, separate administrator) to improve the credit quality of Spanish cédulas.”

The ministry has requested responses to its paper by 24 November.