Spain’s government on Friday finally published a draft law to bring the country’s covered bond legislation into line with the EU Covered Bond Directive, and Moody’s said the proposals could enhance the Spanish framework, but also lower OC and be open to legal challenges.

Cédulas have been widely viewed as the covered bond product requiring the greatest changes to meet the requirements of the directive due to idiosyncrasies of the Spanish framework.

According to Moody’s, the law – which would govern all outstanding and future mortgage, public sector and export finance covered bonds – would be overall credit positive for Spanish issuance.

“The law would strengthen some legal protections for investors, reinforce regulatory supervision and include provisions to control risks in the pool of assets backing covered bonds (the cover pool),” the rating agency said.

Under the draft law, issuers are required to segregate cover pools so that they are not part of their insolvency estates, which Moody’s said strengthens protections for covered bondholders. A 180 day liquidity buffer would need to be maintained, and protections for derivatives counterparties improved by giving them recourse to both issuers and cover pools. Moody’s also highlighted enhanced supervision by the Bank of Spain and more stringent eligibility requirements for collateral, as well as the possibility of extendible maturities.

However, the rating agency noted that overcollateralisation (OC) requirements for current and future issuance will be lowered.

According to Moody’s, the legal OC level for all covered bonds will be lowered to zero, from 25% for mortgage covered bonds (cédulas hipotecarias), and from 42.9% for public sector covered bonds (cédulas territoriales) and export finance covered bonds (cédulas de internacionalización). Issuers seeking the most preferential treatment for their issuance (as European Covered Bonds (Premium) under the directive), such as lower risk weights, would have to commit to a minimum 5% OC level, the rating agency noted.

“Issuers can choose to maintain OC above the legal minimum, but this would be voluntary and would decline from Spain’s currently high levels,” said Moody’s.

A key difference of cédulas from other jurisdictions has been that covered bondholders have a priority claim against all the mortgages on an issuer’s balance sheet, rather than just a cover pool. This has further contributed to Spanish OC levels on average being the highest in Europe.

Moody’s analyst Miguel Lopez Patron told The CBR that as issuers select eligible mortgages to be segregated in their cover pools rather than having all mortgages backing cédulas, this will contribute to lower OC levels.

According to Moody’s, the draft law would in many respects directly implement the EU directive’s substantive provisions without providing further detail.

“Therefore, the draft law opens the door for further regulatory provisions,” it added, “and it is possible that the final law may include a higher legal OC requirement.”

Noting that the new law would supersede all existing Spanish covered bond laws, Moody’s highlighted that the law explicitly prohibits existing covered bondholders from exercising any rights to call for early redemption by virtue of a change in law.

“This raises the prospect of legal challenges by covered bondholders who may view the legal changes as detrimental to their interests, particularly regarding loss of OC levels,” the rating agency said.

Around €243bn of Spanish covered bonds are outstanding, according to Moody’s.

The draft law deals with bonos hipotecarios and bonos de internacionalización as well as cédulas.

Lopez said that, according to the draft law and related documents, the government considered separately amending each of the existing separate covered bond laws, but felt that a unified law would be better, and he agreed that the move is more “clear and efficient”.

A consultation on the draft is open until 16 July.

The publication of the Spanish draft comes less than two weeks ahead of the 8 July date by which EU member states were meant to have transposed the directive, with the vast majority of countries having failed to do so.