A new law introduced in Spain on Sunday that facilitates debt forgiveness of mortgage debt is credit negative for Spanish covered bonds, Moody’s said yesterday (Thursday), although the rating agency added the impact will depend on how widely borrowers opt for the legal mechanism.

Moody’s noted that the new law, a so-called second chance rule, allows any individual to ask for bankruptcy protection, with no restriction contemplated other than that they are acting in good faith, whereas individuals previously seldom declared themselves bankrupt as mortgage debt was not subject to debt forgiveness.

In most cases the only asset owned by individuals to pay their secured debt will be the residential property backing their mortgage, Moody’s said, noting the new rule allows the borrower to achieve debt forgiveness once the property backing the mortgage has been repossessed by the creditor.

“Such debt forgiveness is a clear weakening of the full recourse that existed previously for Spanish secured lending,” the rating agency said.

Moody’s said that its default assumptions for Spanish secured loans considered the previous full-recourse nature of Spain’s mortgages, although it assigned limited value to recoveries from a borrower’s future earnings and assets.

“The effect of this legal change will depend on how widely borrowers opt for this legal mechanism, which is not straightforward given legal formalities (i.e., court-requested documentation and information and securing legal advice),” it added.

The rating agency also noted that the law does not completely mitigate moral hazard and gives creditors the right to ask for revocation of debt forgiveness in the cases of fraud or a significant improvement of the borrower’s assets. However, lenders have little practical ability to monitor former borrowers, Moody’s added.