The bigger they come...
One of the biggest attractions to covered bonds is of course their safety value thanks to the high levels of over-collateralisation. However, following the sharp growth of the market, fuelled by rising property prices in markets such as the UK and most notably Spain, some fear that quality levels may be falling. Should covered bond investors be worried?
One question that Spanish covered bond issuers regularly have to deal with on roadshows is whether the level of house prices in the country is sustainable. This is an obvious question for anyone who believes the familiar idiom "the bigger they come, the harder they fall".
Spanish house prices have grown much more rapidly than other major European markets since 1990 and their rise continues to outpace those in other buoyant jurisdictions such as the UK, the Netherlands and Italy.
However, despite annual forecasts of a slowdown in house price growth and an accompanying fall in mortgage lending, the Spanish market keeps on running. In 2005 Spanish property prices rose 14%.
That the covered bond investor base has been able to swallow some Eu50bn of cédulas supply already this year, albeit with periods of indigestions, shows that investors are not fearful of a sudden crash in the Spanish property market. But they are said to be keeping a closer eye on the underlying market than in jurisdictions such as Germany, where Pfandbrief buyers can take some degree of comfort from the flat housing market, even if there are some signs of a pick-up.
"The spread levels of Spanish covered bonds have not tightened against their peers for two main reasons," says Jörg Huber, head of debt capital markets at LBBW in Stuttgart. "Firstly, the high level of supply, which is set to continue.
"Secondly, some investors are a bit worried about price developments in the Spanish real estate market. They feel secure with the triple-A ratings, but are monitoring the market carefully."
Extra vigilance has been necessary since the European Central Bank began raising rates in March. "In Spain, about 99% of mortgage interest rates are variable," wrote analysts at Barclays Capital the following month, "and as the ECB is widely expected to raise interest rates further, there is the danger of a slump in the housing market, which may reduce Spanish covered bond investors' returns."
Higher interest rates would both have a negative effect on borrowers' ability to service their mortgages and on real estate prices, noted analysts at LBBW. "Initially, individual defaults in the banks' portfolio do not represent a problem as long as property prices remain high and banks are able to collect the full outstanding amount of the loan in full when they sell the property," they wrote.
"However, rising interest rates at the same time increase pressure on real estate prices and so raise the risk for the banks from that side as well. We therefore believe that this is the biggest risk factor for Spanish cédulas, most of which have fixed coupons."
This last fact is important as cédulas holders do not have a preferential claim on the derivatives used for hedging purposes, although this is not a problem in the multi-cédulas issues.
A fall in Spanish house prices would increase the risks to cédulas holders in three ways, according to Barclays: headline risk; the risk of downgrades to issuers and potentially a related downgrade of cédulas; and a reduction in the volume of cédulas-eligible assets, which could push down the cédulas issuance threshold and pressure a bank's liquidity management.
The strength of cédulas
Analysts, however, say that there are several mitigating factors that should ensure the cédulas market remains resistant to any fundamental weaknesses, even if headline risks cannot be completely dealt with.
The first is strength of issuers. "The Spanish banking sector currently appears extremely robust and we believe it could stand up well to a deterioration in credit quality," said the LBBW analysts.
Indeed Spanish banks have enjoyed several upgrades this year, with Fitch, for example, upgrading Banco Santander Central Hispano and Banesto in May to AA.
The second cause for comfort is the high levels of over-collateralisation that cédulas benefit from and which is being increasingly recognised by the rating agencies, and Moody's in particular under its new covered bond methodology. Strong over-collateralisation was a key reason why the rating agency upgraded the cédulas of Banco Pastor by an unusually high three notches, from Aa3 to Aaa in July — although, as noted by analysts at HVB, this level will have to be monitored.
"For its Aaa rating, Moody's has relied on over-collateralisation above that required by law," they said. "Hence, in contrast to other covered bond issuers, eg Hamburger Sparkasse, a decline in over-collateralisation could lead to a deteriorating cédulas rating."
The very high levels of over-collateralisation, sometimes well over 500%, that were a notable feature of early cédulas issuance, as a result of cédulas-holders' claim over an issuer's total mortgage book, have fallen as banks have stepped up supply. The ratios at credits such as Banesto and Santander have fallen below 100%, according to analysts at Dresdner Kleinwort, and for some small savings banks are approaching the regulatory 11.1% limit.
But in their research in June the Dresdner Kleinwort analysts declared themselves comfortable with cédulas over-collateralisation levels. Their reasons included Fitch's view that multi-cédulas over-collateralisation levels of 25%-30% are usually sufficient to achieve a triple-A rating, and Moody's comfort with lower ratios, as indicated by its Aaa rating for Santander Consumer Finance, which was achieved with no commitment to over-collateralisation beyond the mandatory 11.1%.
Furthermore, most issuers are aware of potential concerns surrounding over-collateralisation levels. "Of course we have reduced the level from the highs of 2000 and 2001," says Fernando Cuesta, head of funding at Caja Madrid, "but in the years in which we have really developed the cédulas market, from 2003 to this year, we have been careful not to reduce over-collateralisation levels below those at which investors and the rating agencies feel comfortable.
"In our case the right level is probably somewhere between 150% and 200%, and even this year, when we have launched three transactions, we have remained within that range. And any issuer that has been using this instrument so far is going to maintain over-collateralisation at a level that both allows them access to cédulas funding and gives the market comfort."
Even more fundamental support for the cédulas market is seen as coming from the underlying state of the Spanish economy, even in the face of rising interest rates.
"There has been a big rise in house prices and it could be something of a bubble that we are seeing in areas such as Madrid or the coast," says Frank Will, senior strategist in Royal Bank of Scotland's frequent borrower group in London. "However, what would make any bubble burst is really high unemployment and very sharp increases in interest rates.
"The last time we had a similar problem in the UK we had mortgage rates of around 15% and now even with interest rates rising in the UK we are unlikely to see levels reaching anywhere near those of the last crisis. The same is true of Spain where we have relatively low interest rates and low unemployment rates, which we expect to continue."
Relaxed in the UK
The UK is the other major covered bond market where house prices are a regular talking point but, like Will at RBS, most market participants are quite relaxed about its prospects, particularly as it has grown less strongly than Spain and also has more comparable history on which analyses can be based.
"Despite the high past growth rates, we expect no substantial risks for the UK housing market which could trigger a sharp fall in prices," said analysts at LBBW in June.
However, for many observers, particularly those outside the UK and who have not been active in the country's large residential mortgage backed securities market, one aspect of the sector remains relatively opaque: that what is described by some market participants as non-conforming.
Moody's, along with some other market participants, breaks UK RMBS into two sectors: prime and non-conforming. "The non-conforming market refers to transactions originated by non-banking financial institutions without a high street presence offering various non-conforming mortgage products," said the rating agency in its 2005 review and 2006 outlook for UK RMBS. "These products generally do not conform to the standard mortgage products offered by the high street lenders because of (i) income verification (self-certified); (ii) credit history and (iii) occupancy status (buy-to-let)."
Such a classification is not particularly helpful, say some observers, given that one might assume that the separation of non-conforming mortgages from the prime category might suggest that they are of less than high quality. In fact, another category, sub-prime, also exists, meaning in the UK loans to borrowers with county court judgements (CCJs) against them, mortgage arrears problems, or who have been declared bankrupt.
One problem with judging just how buy-to-lets and self-certs should be classified is that they are quite new products and therefore lack significant historical data. In a study on the performance of UK residential mortgages originated in 1985-2003 published in March, Moody's drew no firm conclusions on the products.
It did, however, reflect negatively on them in a list of reasons why any downturn in house prices could be more severe than previous downturns. "There is an increasing range of products in the UK mortgage market that were not present at the time of the last recession," said the rating agency. "It is subject to debate how non-conforming, self-certified and buy-to-let loans would perform in a downturn."
Indeed it is. "You can argue that the loans to owner-occupiers are better," says Huber at LBBW, "but others say that with buy-to-lets you benefit from the cashflows that are being generated from the letting. You can argue it both ways."
Even some experienced covered bond investors admit they are stumped when it comes to the topic.
The issue is nevertheless an important one, particularly if one is an investor in Bradford & Bingley's covered bonds. In May this year the bank more than doubled the size of its cover pool to around £4.5bn, with almost all the increase accounted for by buy-to-let mortgages, which now account for 61.5% of the collateral, compared to 15.9% before the pool was increased.
B&B can point to research by the Council of Mortgage Lenders showing that buy-to-let collateral performs better than owner-occupieds in terms of arrears and losses. Furthermore, buy-to-lets are not granted to the first time buyers who typically take out high loan-to-value mortgages and are often the first to suffer in times of economic stress.
Half of Northern Rock's mortgages, meanwhile, are self-certs.
The focus on buy-to-lets and self-certs in the UK is perhaps unfair given that in Germany buy-to-let mortgages to borrowers who would qualify as prime for their own mortgage are not considered to be of an inferior quality to owner-occupied. On top of this, German issuers are not so forthcoming on the breakdown of their cover pools as UK issuers in this respect.
The situation regarding prime, non-conforming and sub-prime will be further complicated by the arrival of US issuers in the covered bond market, as the terms have yet different meanings there.
However, transparency in US issues should be enhanced by the use of FICO scores. This is a credit scoring system created by Fair Isaac & Co that has been developed over 50 years in the US.
"One thing that we expect to go down well with investors from US issuers is the unique nationwide credit scoring system that they have in place in the US," says Mauricio Noé, head of covered bonds at ABN Amro in London. "This is going to make it easier for issuers to sell covered bonds backed by more varied mortgage products, because as long as the collateral has a sufficiently high average FICO score, then it will guarantee the credit quality, whereas in Europe one country's prime is another country's sub-prime."