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Optimal Cédulas reform is possible, but tricky

By Bill Thornhill
21 May 2019

Spain has a limited amount of time to bring its Cédulas framework into line with the EU's Covered Bond Directive. A legal update is probably going to be less disruptive than a completely new law — but neither option is perfect.

Spanish authorities have roughly two years to bring the Cédulas framework into line with the Covered Bond Directive. Yet, because the Spanish regime is so different from the rest of Europe, there will be big ramifications however they decide to do it.

The biggest single problem is that, under the current regime, investors have a claim on the entire mortgage portfolio of the issuing bank. Amending the law would probably require a more definitive separation of the cover pool assets from the issuer’s balance sheet, which would dilute investors’ claim and would, according to ratings agency Moody's, be a negative for Cédulas credit.

But an updated law would also include a range of other compulsory modifications that are likely to be positive for investors, such as the inclusion of a liquidity buffer, the addition of derivatives in the cover pool and tighter supervision.

Cognisant of the diluted collateral claim, law makers could go a step further and adopt other arrangements, like committing to having a cover pool monitor and cover pool administrator that both adhere to comprehensive and tightly defined job descriptions.

Legislators could also ensure that cover pools are regularly valued and topped up. This would respond directly to rampant concerns, laid bare during the height of the financial crisis, that a considerable proportion of mortgage loans in Cédulas cover pools exceeded the value of properties that they were secured on.

Ireland experienced a similarly sharp fall in house prices to Spain, but the cover pools there were valued more regularly and borrowers were obliged to add collateral, or refrain from issuing. This meant that the legally defined overcollateralisation ratio was not exceeded and that investors had a much clearer view of the value of their cover pool compared to Spanish Cédulas.   

The biggest single advantage of amending the existing law is that all outstanding notes will automatically fall under the new regime in one fell swoop. Investors might complain that their collateral claim has been diluted, but if the law is correctly gauged, there would be more than enough offsetting positive factors to nullify the grumblers.

On the other hand, legislators could devise a completely new legal framework and grandfather in existing deals. The biggest single advantage to this is that the terms and conditions of the bonds that investors bought in good faith would not be changed while the debt is outstanding and on their books.

But that may not stop them from feeling hard done by and complaining. With a new law, issuers would have to transfer a substantial portion of the best mortgages to their new programmes. Moody’s believes that would lead to a material reduction in both the size and quality of existing cover pools.

Moreover, from an issuer’s perspective, running two programmes would present further complication and costs. More pointedly, having parallel regimes would not bring the harmonisation that the covered bond directive was essentially designed to deliver, but rather would fragment the market.

Fortune favours the bold, and Spain cannot afford to waste much more time deliberating over how to proceed. Even though a wholesale and fundamental revision is needed, amending the existing framework is likely to offer a more orderly transposition of the covered bond directive than adopting a new law.

By Bill Thornhill
21 May 2019