Spain’s draft covered bond law could be amended in the wake of criticism of reduced OC for existing cédulas, according to market participants, while an insider said a postponement of the July 2022 deadline is necessary, with an issuer warning the market could otherwise be impaired.

The Spanish government published the draft law on 25 June, preparing to bring the country’s covered bond framework into line with the EU covered bond directive and related regulation.

Concerns centre around the reduction to zero percent of the overcollateralisation (OC) requirement for cédulas hipotecarias from the current 25% minimum requirement and much higher levels that have resulted from the covered bonds being secured on the total mortgage portfolio of issuers.

Moody’s, for example, had indicated in an initial sector comment on 30 June that, in spite of the reduced OC requirement, the draft law would be overall credit positive for Spanish covered bonds, but on 14 July the rating agency published a more in-depth and cautionary assessment.

“If issuers choose to materially reduce their covered bonds’ OC in response to the law’s low minimum standard, it will hurt the bonds’ credit quality and potentially outweigh the draft law’s other positive provisions,” it said.

Although market participants agree that the features being introduced to bring the Spanish product into line with the directive are in general appropriate and positive, the reduction in OC levels for holders of existing cédulas in particular can be considered a bitter pill for investors to swallow, in the words of DZ covered bond analyst Jörg Homey. Cognisant that the update to Spain’s framework could entail such a development, some market participants had previously discussed grandfathering or exchanges as alternative ways forward, but this route was not taken, noted Homey.

“We are very critical of the abandonment of the cover principle for the cédulas hipotecarias together with the reduction of the OC in conjunction with the investor-unfriendly conversion of the old cédulas to the new rule,” he said. “The improvements in the special public supervision of the cédulas and the introduction of a liquidity reserve are undoubtedly positive. However, in our opinion they do not outweigh the disadvantages.”

Other market participants inside and outside Spain disagree. Among them, Gregorio Arranz, secretary general, Spanish Mortgage Association (AHE), said that, overall, the draft legislation is positive and aligned with the AHE’s stance, albeit with room for improvement in some respects.

“The draft contains many improvements relative to the current legislation, fairly adopting all the mandatory covered bond directive provisions, and incorporating other positive elements, such as a dedicated insolvency administrator,” said Arranz, speaking in a personal capacity and not necessarily expressing the views of AHE members.

“All these changes are very positive and clearly outweigh the change in the OC ratio.”

However, Arranz acknowledges that the OC situation is the main weakness of the draft law.

“My idea is that the Treasury officials are now keen to change this,” he told The CBR.

Indeed, both sides of the debate have noted that the law is yet to be finalised – a consultation ended on 16 July – and it has also been suggested the Bank of Spain could specify a higher minimum OC level in associated regulations.

A 5% level would be necessary for cédulas to achieve the European Covered Bond (Premium) label, although issuers could also achieve this individually on a contractual basis even if the zero percent of the draft remains, as Moody’s, DZ’s Homey and others less sceptical of the draft law have noted.

“Generally, we would expect issuers not only to provide sufficient collateral to maintain their rating levels as far as possible,” said Ted Packmohr, head of financials and covered bond research at Commerzbank, “but also enough to not unsettle their investors.”

Noting the impact of the 180 day liquidity requirement and introduction of soft bullets, Fitch highlighted that there would be a trade-off between such measures and lower OC.

“A maturity extension of at least 12 months complemented by sufficient liquidity protection for three months’ worth of interest payments would improve the payment continuity for cédulas,” it said, “increasing the rating uplift potential over the bank’s IDR (issuer default rating) by two rating categories as per our covered bonds ratings criteria.

“However, any future uplift depends on sufficient OC protection for stresses on the cover pool assets and cashflows.”

Even if overcollateralisation and other outstanding issues are settled in a manner satisfactory for most market participants, Spanish issuers are expected to face an uphill struggle to be practically ready for the 1 July 2022 implementation deadline.

“From an issuer perspective, that’s the main challenge,” said Miguel García de Eulate, head of treasury and capital markets at Caja Rural de Navarra. “We will need to do a lot of work internally, because the new law will require us to work with the Bank of Spain, our IT provider, our legal advisors and probably the new cover pool monitor to change our systems.

“Legally, I expect every issuer to be compliant by the deadline,” he added, “but perhaps not sufficiently confident from an operational perspective for new issuance. The cédulas market would then be kind of impaired.”

Although the introduction of a dedicated cover pool monitor has been widely welcomed as a positive step, there appears to be little consensus over how this role will be fulfilled. According to Moody’s, the monitor can be an external or internal party related to the issuer, subject to central bank approval.

“The draft law sets tight conditions for issuers’ appointment of external cover pool monitors,” said the rating agency. “For example, external entities cannot provide any service to the issuer representing more than 30% of its revenue or perform any annual account audit in the three years before the appointment.

“The tight conditions for external monitors could encourage issuers to appoint internal monitors. Conflict of interest risks will be greater with internal monitors than external monitors, even with the Bank of Spain’s checks on independence.”

A representative of one Spanish securitisation company (gestora) said that to his understanding, the cover pool monitor role “will end up in the hands of the issuers themselves”.

García de Eulate currently expects to appoint an external monitor, and said issuers could find the associated data burden a challenge.

“To my knowledge, not all Spanish issuers give the rating agencies cover pool information loan-by-loan,” he said. “But with the new law, issuers will have to send this information to the cover pool monitor to be analysed and assessed.

Arranz at the AHE reckons the new law may end up being approved not long before next July, which would leave issuers little time for such preparations.

“For me, it is rather evident that an extension of the deadline is completely necessary,” he said, and some other market participants echoed this.

Any ill effects of the timing and ultimate shape of the new cédulas law are expected to be mitigated by a variety of factors that have otherwise taken the Spanish instrument out of the limelight. No new Spanish euro benchmark covered bonds have hit the market since February 2020, while Spain’s property market has been relatively stable and its banks are in better shape than during previous crises.

“There are clearly challenges, but I would say it is not the worst timing, in the sense that there is not so much market activity,” said García de Eulate. “This needed to be done at some point, and if it’s now, OK, let’s do it.”

Photo: ​Nadia Calviño, Spain’s first deputy prime minister and minister of economic affairs and digital transformation; Source: Ministerio de Asuntos Económicos y Transformación Digital