While crisis-related attention has mostly befallen Latvia and emerging Europe of late, there’s more reason than ever to cast one’s eyes to the South of Europe – towards Spain to be specific.
Aside from horrific unemployment figures, falling house prices and a public sector deficit that threatens to push public debt above 60 per cent by next year, there are also some highly toxic assets on the balance sheets of the country’s banks, a fact clearly worrying credit rating agency Moody’s if you consider its multi-streamed downgrade of the Spanish banking industry last week.
Nevertheless, it does seem like Moody’s may also be counting on some semblance of a rescue:
However, Moody’s also noted that a significant government capital injection – which apparently has been discussed for some time now by the Spanish government and the banking sector — could prompt subsequent upgrades of some BFSRs.
Moody’s was clearly referencing reports like this one, featured in the FT earlier this month, suggesting that a bank bailout in the region of €90bn may be imminently due. The bank bailout itself coming in expectation of:
“In anticipation of possible problems, we thought it was a good moment to go ahead with a restructuring,” Ms Salgado told the Financial Times.
Would that be in anticipation of problems like ratings downgrades?
Unfortunately for Spain, due to ongoing political quibbling on the matter of the bailout, it was Moody’s that acted first.
On Friday, nevertheless, the Spanish government approved the bailout, details of which are as follows:
June 26 (Bloomberg) — Spain approved the creation of a 9 billion-euro ($12.7 billion) fund that will finance banking takeovers should they become necessary as the recession drives up bad loans and weighs on earnings. The creation of the fund was approved in a decree taking effect June 29 that will go to parliament for ratification, Finance Minister Elena Salgado told reporters today in Madrid. The fund will be able to take on debt equivalent to as much as three times its start-up amount this year and could grow to reach 99 billion euros, she said. “It’s very much the right time to bring about a process of orderly restructuring of the financial system of our country,” Salgado said. While banks considered to be of “systemic” importance have “absolutely no problem,” some lenders may have difficulties if the economic crisis endures.
And while it’s nice that Moody’s will consider reinstating the banks’ ratings upon a bailout, they fail to mention one potential caveat: the impact of the bailout on Spain’s own sovereign rating.
This, though, has not gone unnoticed by the CDS market.
As can be seen below the cost of insuring against a potential default on Spain’s sovereign debt has been creeping higher ever since talk of a bailout began:
But you will also notice that it tightened recently too. That would be on the day of the ECB’s €422bn liquidity injection.
The bailout itself, according to details of the draft document reported earlier on Friday, focuses on purchases of securities called “cuotas participativas”, or preferred shares. This would see the Bank of Spain remain as a partial owner of these lenders during a transition period. The main message being that consolidation and sector restructuring are inevitable.
And from Bloomberg on Thursday:
The fund will also be able to take over the management and restructuring of troubled lenders that have to be seized by the Bank of Spain, the draft said. It will be run by a board made up of five people proposed by the central bank and three representing the industry-financed deposit-guarantee funds.
Why now?
Well, the main problem for Spain, of course, lies with its securitisation process and dependence not only on covered bonds, but on a particular structure of covered bonds known as multi-cedulas. These in effect are similar to CDOs, the main difference being that the liability remains on the balance sheets of the issuer banks.
But you thought the Spanish were extra vigilant about mortgage lending?
While loan to value (LTV) rates may have been stricter than in the US or Britain, averaging no more than 80 per cent for residential and 60 per cent for commercial property loans, there were unique risks in the Spanish structure. The multi-cedulas allowed a much greater number of small regional banks into the market, with the liability remaining on their balance sheets. In fact, any Spanish bank or savings institution had the right to issue these securities, which is why they became so numerous.
This was originally seen as good diversification, both geographically and demographically speaking. Of course, what people may not have accounted for in these structures was the capability of smaller banks to manage those liabilities under dire economic circumstances.
What’s more, many of these loans were issued on floating rather than fixed-rate agreements, a risk in a rising interest-rate environment. Further still, they were issued on the basis that if property values fell below critical ratios the same amount of ‘underfund’ would have to be deposited in cash with the Banco de España by the issuer banks. To cover that risk, multi cedulas came packaged with liquidity cushions, so investors would always be paid while banks scraped together new mortgage securities (cedulas) to make up the shortfalls. This in itself would not be pressing as, like with all other cedulas — both traditional hipotecaria cedulas and territorales cedulas (the vanilla non-structured types) — the multi-cedulas were also over-collateralised to the equivalent of a LTV of 125 per cent.
Here is a graphic explaining that process from an excellent introductory guide to the European covered bond market by Jonathan Golin:
As Barclays Capital explains in a recent note:
The issuer then has up to three months to restore the overcollateralisation through adding new eligible loans, buying CH from the market, or by redeeming a sufficient level of outstanding CH to re-establish a minimum mandatory level of over-collateralisation. Meanwhile, the bank would have to cover any deficit through depositing cash or government bonds with the Banco de España within 10 days47.
Which creates quite a need for short-term cash in the event of major defaults, and the depletion of liquidity cushions, a point referenced to by Moody’s as currently a major concern. For some more understanding of the structure here is another graphic from Jonathan Golin:
So, the practice of pooling these cedulas together to make giant multi-cedulas forges problems not due to the seignorage of the underlying mortgages irrespective of quality a la CDOs, but rather due to the distribution of liabilities across the variety and size of institutions taking part, and their respective strength.
Here, for example, is how Barclays estimates the current issuer breakdown for all cedulas to look:
In total, Barclays estimates there are up to 139 jumbo covered bonds of all structures (vanilla and structured) still outstanding in the market from 20 different issuers, and collectively worth some €251bn. In terms of volume, that is the largest market of its kind. Meanwhile, within the multi-cedula market Barclays esimates up to 26 different savings banks take part.
While there are obvious diversification benefits in pooling mortgages into jumbo multi-cedula issues, the market appears unconvinced. CDS prices on jumbo multi-cedula issues (even post ECB covered bond purchase announcement) have traded on average about 40-80 bp wider than comparable plain-vanilla securities. The differential widens the longer the remaining term-to-maturity is.
And this may have a lot to do with the practice of letting weaker lenders into the pool. As Barclays explain:
In our view, this development is largely attributable to the fact that up to 26 different savings banks participate in selected Multi-Cédulas issues. On most occasions, these are smaller-sized entities with a strong regional focus on retail banking services. Yet, irrespective of the fact that investments in Multi-Cédulas Hipotecarias are far less exposed to potential risks regarding the geographical concentration of the collateral pool (as a result of the diversification across different CH issuers) — and furthermore benefit from an additional protection provided by a liquidity facility, which helps to bridge any possible delays in payments due to an issuer default, investors have remained rather distant in recent months.
The chief concern being, how will small savings banks be able to cover their share of losses when non-performing loans are accelerating like this? :
And if interest rates do eventually begin to rise on the return of inflation fears, that statistic could very well accelerate due to the practice of most issues being based on floating-rate agreements. Meanwhile, Barclays confirms loan-loss provisions previously put in place are likely already being eroded:
The rapid deterioration of most banks’ loan portfolios, which started to be more visible in 2008, has severely reduced the general loan-loss provisions that protected these banks from losses so far. While initially the asset quality deterioration stemmed mostly from exposure to the commercial real estate sector, other asset classes are now also increasingly affected by the magnitude and breadth of the recession, thus having an impact on the much broader banking system.” With savings banks participating in virtually all of the outstanding 45 Multi-Cédulas, this market segment appears to be particularly prone to potential further rating actions which, in our view, look increasingly likely.
What’s worse, small lenders have already begun to fail.
In March, liquidity problems saw the government take over regional savings bank Caja Castilla La Mancha. Even some larger ones are opting to skip out on interest payments. And while the government will be able to handle the failures of a few small savings bank, the concern really is how much stress will their failure put on larger institutions that are also part of the jumbo multi-cedula programmes?
For the time being the analysts are optimistic at least on the larger lender front:
NPLs are set to further increase, causing the coverage ratio of savings and commercial banks to deteriorate, at the same time affecting the institutions’ annual profits. Some of the major lenders appear to be relatively well prepared, but we believe that the future development of (some of) the smaller, regionally active savings banks should be closely monitored.
The key point to take away from the above is, that Spain’s weak link is the mass involvement of its small institutions in the mass mortgage securitisation process. What’s more, their inclusion in multi-cedula structures is what threatens to spread that risk into healthier and stronger institutions. This is clearly why Spain’s ministers have been so keen to stress that consolidation of the industry will be inevitable.
In total, data from the Spanish Mortgage Association estimates Spanish savings banks and cooperatives (loosely identified as the smaller lenders) accounted for more than €650bn worth of off-balance sheet mortgage loans in April — be that within vanilla or structured issues.
It’s also worth pointing out that if new mortgages are not extended due to the credit crunch, the float available to top up underperforming multi-cedulas will increasingly be limited too.
Clearly, the bailout comes just in the nick of time.
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Update:
On the issue of covered bonds and the ECB’s one year tender this week, Barclays interestingly notes the following:
On a related note, we observe that the extension of the ECB’s tender to one year (July 2010) has caused banks to literally buy whatever covered bond they can find within this maturity bracket. In principle, banks are in a position to generate relatively risk-poor profits as by means of the tender, the ECB enables them to refund themselves (in virtually unlimited size) at a rate of close to 1%. Thus, any investment in a covered bond with a yield of more than the respective EUR GC Repo rate (Figure 5) generates profits for its holder. Therefore, since setting up the tender roughly a week ago, demand for the respective covered bonds sharply increased.
Related links:
Spanish banking pain, Caja Madrid RMBS edition – FT Alphaville
Why the ECB is a good bank with rubbish assets - FT Alphaville
Los covered bonds, por favor – FT Alphaville
