The cédulas market has recovered from a difficult start to the year and become too important to ignore. But fortunately issuers are increasingly learning to resist the temptations on offer from banks seeking league table position in the competitive market. And while the rating agencies may have disappointed in their reaction to legislative improvements, the credit quality of the product has improved.
In the first quarter of the year, the outlook for the cédulas market was not bright. Seven jumbo issues by the end of March resulted in fears of oversupply and the first three Spanish covered bonds to hit the market all widened in their first three days of trading, according to research by Dresdner Kleinwort Wasserstein (DrKW).
Parallels were soon drawn between the market's predicament and that of the Pfandbrief market in 2001 when a combination of declining credit quality and aggressive issuance techniques combined to undo much of the good work the German mortgage banking community had put in since 1995, when the jumbo market was launched.
Surely Spain, with aggressive banks such as Banco Popular, Banco Bilbao Vizcaya Argentaria (bbva) and Santander Central Hispano was heading in the same direction, claimed some observers. And for good measure the prospect of a bursting of Spain's housing bubble was brought up.
However, several factors pulled the market back from the brink ? if, indeed, it had ever really been in such a perilous position, and was not just suffering from the usual market bickering.
Critical condition or critical mass?
Ironically, one of the ingredients that was cited as an ingredient in the market's potential downfall is now seen as a key to the market's success, namely its size.
?The surprising thing about the Spanish cédulas market is that rather than scaring people away from the market due to oversupply, the larger the market has become, the more the big investors have taken it seriously,? says Ted Lord, global head of covered bonds at Barclays Capital in Frankfurt.
?I know of one central bank, for example, that was previously not interested in the cédulas market because it was regarded as too peripheral. Now they are buying very large sums because once the market crossed over the Eu80bn level they realised that it was now a very serious market.?
The growth of the market has been spectacular. In a research piece in early October, analysts at Commerzbank noted that the cédulas market has had a 66% annual average growth rate, and between 2001 and 2004 grew at rates above 100%.
Some 45 issues totalling Eu85.55bn are now outstanding, with Eu26.2bn of the total added this year. DrKW's analysts expect that, taking into account forecast issuance, this year's total supply could exceed Eu32bn.
Spain's share of the overall jumbo covered bond market is 14% outstandings, with a 29% share of jumbo issuancethis year.
Underpinning the market's ascent is, of course, the phenomenal growth of house prices in Spain and the accompanying expansion of the mortgage market. Spanish house prices have risen faster than those of any other OECD country over the past 23 years, and the market remains buoyant, surprising even those closely involved in the business.
?No one was really expecting so much growth in the Spanish mortgage market over the past few years,? says Luis Sánchez-Guerra, head of capital markets at Ahorro Corporación Financiera (ACF) in Madrid, which arranges the AyT issues. ?If you had talked to anyone three or four years ago and said that the market will grow at between 15% and 20% every year, they would have told you that was impossible. But that is what has happened.
?That is the reason why we are issuing more than we expected,? he adds. ?The mortgage market has seen strong demand and savings banks have been very active, and this is being transferred into the cédulas market.?
A second factor explaining the market's resilience to supply pressures has been the simple fact that after a busy first quarter, the flood of issuance receded. No new cédulas were issued in April and May, and this was not the result of any reluctance of investors to keep buying, but rather a simple administrative issue.
?In the run-up to March a lot of issuers are keen to tap the market for documentation reasons,? says Ricardo Gabilondo, at ABN Amro in Madrid. ?March 31 is the last day of the year when you can use your financial statements from 15 months previously. That is why in the first quarter, and mainly in March, there is a long pipeline of issuers wanting to tap the market. We often have to explain this to investors when they ask why there is so much supply.?
But perhaps the most important reason for the market's continued health is that issuers appear to have heeded the warnings of the ill fate that they might have suffered had they continued to behave in the same manner. Some of those that had been more aggressive in their approach to the market have adopted a more market-friendly attitude.
BBVA's change of heart
?At the beginning of the year, perhaps AyT, TDA and Caja Madrid were the only regular fair issuers,? says Carlos Stilianopoulos, head of capital markets at Caja Madrid, which arranges the Cédulas TDA issues as well as its own. ?That was good for neither us nor the market. But since then we have seen almost every single issuer come to the market in a more professional way and that really helps us all.?
ABN Amro's Gabilondo has also seen an improvement. ?Issuers are increasingly seeing this market as a strategic, important source of funding,? he says, ?and they therefore want to launch transactions that perform and that are really interesting for investors. This is also because competition from more countries will soon arrive, from Italy and Portugal, where they are working on new laws.?
The change of heart was best illustrated by BBVA.
In early March a Eu3bn seven year cédulas hipotecarias issue for the bank turned into a fiasco. Deutsche Bank, HSBC, JP Morgan and SG had been awarded the mandate on a retention basis at an all-in level of 9.5bp over Libor. But when they began marketing the issue at 8.5bp over ? already halving the normal fees for such an issue ? demand was thin on the ground. Only Eu600m of orders were placed at the marketing level, with most investors seeking a minimum 10bp spread.
The spread was duly revised to 10bp and by the end of the second day of bookbuilding around Eu1.8bn of orders had been placed. The deal was finally priced the Monday after launch, three days late, 1.5bp wider than the original marketing spread, and 0.5bp wider than the initial all-in level.
So when BBVA announced that it would be approaching the market with a Eu3bn 10 year issue for launch in early July, expectations for the deal were low. On top of BBVA's poor track record, its Banco de Crédito Local subsidiary had in late June only managed to sell a Eu1bn five year cédulas territoriales at full fees via BBVA, Calyon and HSBC.
However, BBVA silenced its critics by announcing fair price talk of 11bp over mid-swaps when opening the books on the Monday of its launch and achieving an oversubscribed deal by pricing on the Wednesday. Leads Barclays Capital, Deutsche Bank and SG, alongside BBVA, were able to build a book of Eu3.6bn, including some 95 accounts.
The deal also tightened slightly in the aftermarket by around 0.5bp in the days after launch.
Down to experience
José-Luis Dominguez de Posada, director of funding at BBVA, says that the bank changed its approach to the market partly in response to its experience with the first transaction of the year.
?Previously we had only launched fully underwritten cédulas issues,? he says, ?but on our first deal we saw that the retention system is too rigid in order to accommodate the time delay that we have, due to the necessity of getting CNMV approval. Even if everything goes smoothly you still need some seven to nine days between awarding the mandate and launching the transaction. We therefore needed to establish a flexible procedure to take into account the possible outcomes.?
What BBVA chose was a method that is a compromise between the pot system and retention deals, but is most certainly a move away from its previous stance. ?When we talk with the banks we ask them for a re-offer level, which we will then combine with the level of fees and commission, but we do not grant the mandate on the basis of the cheapest re-offer level we are quoted,? says Dominguez de Posada. ?We try to evaluate some qualitative aspects, too.
?Usually there are two ways of awarding a mandate: give it to a group of banks without allowing others the opportunity to make any suggestions; or give it to those that show the cheapest all-in cost. We are in between those two ways.?
Those involved in the transaction were delighted with the deal. ?BBVA did everything that they needed to ensure a successful transaction,? says Achim Linsenmaier, vice president in debt capital markets at Deutsche Bank in Frankfurt. ?Rather than just announcing a deal and executing it without preparation a few days later, they prepared the deal thoroughly, visiting accounts across Europe and followed the leads' advice on timing and execution.
?Everything then came together ? a good market environment, positive sentiment towards the transaction, fair pricing and clean execution. There were even some comments that the deal could have perhaps been priced marginally tighter. It shows that BBVA did the right thing and not opt for the tightest possible pricing, thereby ensuring a good secondary market performance.?
Another issuer that has impressed observers this year has been Banesto. The bank had once previously experimented with a pot structure, but with mixed results, and its previous deal, in February, had disappointed.
The underwritten Eu2bn seven year issue, led by Credit Suisse First Boston, Deutsche, DrKW and HSBC, was only 75% subscribed by the time of pricing. With an all-in of 11.25bp, a marketing level of 10bp over mid-swaps had been agreed, but little money was made on the transaction.
Banesto redeemed itself, however, when it returned to the market in early September with a Eu1.75bn 10 year deal launched via the pot system.
Led by ABN Amro, CDC Ixis, HVB and SG, the deal was increased from an initially targeted Eu1.5bn after Eu2.1bn of orders were placed. Banesto was able to price the deal at 11bp over mid-swaps, spot on price talk, and at the same time achieve a competitive funding level versus its peers.
And Banesto's conversion to the pot system could be lasting. ?The results that we have seen from using the pot structure have been very positive,? Miguel Sánchez, head of funding at Banesto, told EuroWeek at the time of the deal. ?So perhaps in the future ? taking into account the success of this deal ? we will consider following the pot system rather than retention.?
However, several bankers and issuers point out that rather than the syndication method, it is the issuer's attitude that is key to the success or failure of an issue. ?If the level is too tight, then a deal won't work whether it is underwritten or a pot deal,? says Deutsche's Linsenmaier. ?When an underwritten deal appears in the market, it often raises eyebrows, but if it is at a fair level then no one should care if it is underwritten or a 100% pot deal.?
And Pablo Llado, head of origination at Calyon in Madrid, says that issuers should look to the future when deciding on their approach. ?When the market is in good shape, then sometimes it is an advantage to give the mandate just based on price,? he says. ?But in the long run it hurts more than it helps.?
Competition at every level
While issuers have taken a lot of the blame for poorly executed issues, the banks that have led such transactions are also considered as accomplices. Some acknowledge from time to time that they have entered into transactions they know are unlikely to succeed because of the pressure to win mandates that they are under.
Issuers, however, are learning to discriminate between those seeking league table positions and those with expertise. ?It is a very competitive market,? says Dominguez de Posada at BBVA, ?and day by day it gets even more so. But we receive information about how the different transactions went and know which of the banks has a track record in successfully executing cédulas hipotecarias issues.?
Stilianapoulos at Caja Madrid is similarly discriminating. ?There are many banks only in this market for league table reasons,? he says, ?but we know who they are and which really are good at covered bonds.?
Sánchez-Guerra at ACF says that it is not surprising that competition for mandates is so strong. ?Covered bonds will become the biggest part of the fixed income market in the world,? he says, ?and some banks did not fully realise this and therefore did not get very involved in the market. But everyone now understands the importance of the covered bond market and has to have a part of it.?
Competition at a different level has been cited as a factor in another of the market's challenging deals this year.
When the fourth Cédulas TDA transaction hit the market in early June, it proved to be the toughest yet off the programme. The Eu1.5bn transaction, led by Caja Madrid, Calyon, DZ Bank and HSBC, was launched into an oversupplied five year market just as investors were pulling back from the maturity.
While the deal was oversubscribed by the time of pricing, it was priced towards the wide end of 4bp-6bp over mid-swaps guidance and was not the textbook success that most of the Cédulas TDA issues have been. ?This was a difficult transaction,? acknowledged Fernando Cuesta, head of funding at Caja Madrid, at the time. ?But at the end of the day we are happy with the overall performance. We were able to build a book of slightly more than Eu1.75bn.
?Our target was a re-offer level of 4bp-5bp over,? he added, ?but the book and the market implied a spread of 5bp. We priced it at 5.5bp over to ensure a good secondary market performance.?
Afterwards, one observer suggested that the underlying problem had not been the market, but a more aggressive approach from Caja Madrid. The charge, also laid at the door of ACF, was said to be explained by competition between the two programmes for business from the banks that participate in the pooled deals.
However, few market participants have given the accusation much credence and the arrangers of both programmes deny that their competition is anything but good for the health of the market. ?It is good for the savings banks and for investors, as it means that there is no monopoly on the structured deals,? says Stilianapoulos. ?They both have a choice.?
At ACF, Sánchez-Guerra takes a similar view. ?There is competition between ourselves and TDA for business from the savings banks, but that should not affect the investors,? he says. ?And so far TDA, like ourselves, have been doing a very good job in the market and have not taken an aggressive strategy towards issuance as have some others in this market.?
Indeed bankers even highlight the co-operation between the two as positive for the market, something that Stilianapoulos is aware of. ?We speak to the people at ACF quite often to co-ordinate our activities,? he says. ?We try not to do the same maturities at the same time, for example.?
ACF and Caja Madrid's programmes have this year been joined by a third joint issuance platform, one arranged by Spanish securitisation management company InterMoney. Two deals ? IM Cédulas 1 and 2 ? have so far been launched, and as this report was going to press a third was being prepared.
The first transaction, arranged for the Banco Popular group in January, was a Eu2bn 10 year issue led by Barclays, CDC Ixis, DrKW and HVB that suffered from the issuer's aggressive approach.
The programme has nevertheless introduced two interesting elements to the cédulas market.
The first is that IM Cédulas 2, arranged for an unconnected group of banks, was executed as a private placement. The Eu1.475bn 12 year transaction was led by CDC Ixis in June.
Carlos Perello, head of Spanish capital markets at CDC Ixis in Paris, says that further private placements could emerge from the cédulas market because of the advantages they hold for investors, and consequently for issuers in the levels that they can achieve. ?The investors are buy and hold accounts that are interested in the product,? he says, ?and with a private placement they have total power of negotiation on pricing with the issuer through us as lead manager. They also avoid mark to market issues, although we will quote a price for them.?
When taking bids for its third transaction, InterMoney was offered ideas for both public and private, but had not made a decision on which way to proceed by the time this report went to press.
What the development is unlikely to herald, though, is MTN-style deals from cédulas issuers. ?I don't expect that to happen and at the end of the day this is because of the CNMV,? says one market participant. ?Other jurisdictions use MTNs or other fast documentation routes, but we have to go via the CNMV. As this is such a time consuming business, taking just as long for a Eu50m deal as a Eu2bn deal, issuers prefer to maximise the amount they do in one shot.?
The second innovation provided by the IM Cédulas issuance has been the increasing replacement of subordinated loans by liquidity facilities in the structure of pooled cédulas.
The subordinated loans were introduced by ACF into the AyT Cédulas issues to provide a reserve fund required by the rating agencies to achieve triple-A ratings. The reserve fund's function is to cover any shortfall in cashflows that might arise from a delay in cédulas payments resulting from a bankruptcy of one of the savings banks issuing through the structure.
IM Cédulas 1 replaced this with a liquidity facility provided by the parent bank, Banco Popular Español, to its subsidiaries, and in IM Cédulas 2 the facility was provided by a third party, CDC Ixis. Perello at CDC Ixis says that the liquidity facility has several advantages over subordinated loans.
?Firstly, when the savings banks provide subordinated loans, they can all be used for defaults or lack of payments even if it is for one other institution,? he says. ?Savings banks do not mind about this too much, because they are quite close to each other, but a liquidity facility is cheaper and if they can avoid the above problem then they will.?
The subordinated loans are also costly from a capital point of view and are likely to become even more so under Basel II, says Perello. Furthermore, the proceeds raised using a subordinated loan are lower.
?If a bank issues Eu100m of cédulas and uses a subordinated loan,? says Perello, ?then they receive Eu100m minus the amount of the subordinated loan, which can be anything between 2.5% and 5% of the issue. They would therefore only receive Eu95m for a Eu100m deal.?
The Cédulas TDA programme is likely to make the switch to liquidity lines. Caja Madrid's Cuesta said that this was likely when preparing the latest TDA deal, which is due out in November.
ACF is still considering the merits of the new technique and will not be including it on the eighth AyT Cédulas deal. However, Sánchez-Guerra says that the issue's documentation would allow for a future substitution, provided it did not affect any of the deal's ratings.
Watching the OC
Cédulas issuers had hoped that their ratings would get a lift when Spain's new insolvency law came into force in September. Under the new law the privileged status of cédulas holders is strengthened and the bankruptcy administrator must allow payments to cédulas holders to continue.
But while all three of the rating agencies have welcomed the new law and said that it strengthens the credit quality of cédulas, their actions were muted. A two notch differential between senior unsecured ratings and cédulas hipotecarias remains at Moody's, as does its three notches for cédulas territoriales. Standard & Poor's has made no formal announcement since September, so its two notches for both products remain. Fitch left its three notch differentials unchanged, but removed its previous rule that only the cédulas of triple-A issuers would be rated triple-A.
Moody's highlighted the rating agencies' main problem with the law when it said that the legislation did not provide a high degree of certainty that in the event of an issuer's insolvency, cashflows from the collateral would match the funds necessary to ensure full and timely payment of debt service on the covered bonds, since it failed to include any matching requirements.
Many observers feel the rating agencies are being harsh, particularly on the issue of timeliness. ?The proceeds will go directly to the cédulas holders, according to the law,? says one, ?but if there is a default today then you might not have the proceeds in time to make a payment tomorrow. So even if the problems in terms of timing have been dramatically reduced, this extreme scenario has not been reduced to zero and remains a problem for the rating agencies.?
Perello at CDC Ixis, meanwhile, points out that what investors are really interested in is the massive over-collateralisation of most cédulas issues. ?Take AyT, for example,? he says. ?The level of over-collateralisation on their second issue was around 600% and in spite of the large amounts that they have issued, that has only fallen to around 500% for the eighth deal.
?That means that the amount of cédulas issued has not reduced over-collateralisation at a speed that is worrying for investors because the banks are issuing as they produce mortgages. And since the seventh deal the level of over-collateralisation has even increased slightly, from 468% to 493%, because their production of assets has been faster than their cédulas issuance.?
ACF is nevertheless introducing an added minimum over-collateralisation measure to the AyT Cédulas deals on top of the legally required standard, partly in response to a misunderstanding in some quarters regarding the difference between a cédulas issuer's total mortgage portfolio and its eligible mortgage portfolio.
Cédulas issuance is limited by law to 90% of a bank's eligible mortgage portfolio, resulting in minimum over-collateralisation of 11%.
However, because a bank's total mortgage portfolio is always larger than its eligible mortgage portfolio and cédulas hipotecarias are secured on all a bank's mortgages, the degree of over-collateralisation is always greater than the legal minimum.
For example, according to data from Standard & Poor's, on the seventh AyT transaction, while the ratio of eligible mortgages to total cédulas issuance ranged from 160% to 350%, the ratio of total mortgages to cédulas issuance varied from 250% to 850%.
Sánchez-Guerra says that because the total mortgage portfolio more accurately reflects the security investors enjoy, individual savings banks will be limited, for the AyT programme, to issuing cédulas up to 66.6% of their total mortgage portfolios. ?That will result in over-collateralisation of 50%, which should be enough to make everybody comfortable,? he says.
Savings banks breaching the rule will have to set aside enough funds to cover two coupon payments. Sánchez-Guerra says this should prevent any individual savings bank from acting in a manner detrimental to the interests of its peers.
A work in progress
But despite the unquestionable strengths that cédulas over-collateralisation brings, and the triple-A ratings that the joint issuers and other banks enjoy, the product continues to trade at a discount to covered bonds such as Pfandbriefe and obligations foncières.
At Caja Madrid, Stilianapoulos says that that this may simply be a question of investor education. ?Perhaps we need to explain the underlying risks better,? he says. ?In our opinion, cédulas are just as safe or safer than what else is available and we should be trading at the same level as French and German covered bonds.?
Gabilondo at ABN Amro says that it should be remembered how recently the market has developed, and also that cédulas suffer another disadvantage. ?The Spanish are not a big investor in this product,? he says. ?They tend to invest in their real estate rather than funds, so we do not have the fund investor base that other countries do. The contribution of Spanish investors to the cédulas market is therefore less than 10% of most issues, whereas in Germany there is huge local demand for Pfandbriefe.?
Meanwhile Lord at Barclays is confident that the situation will improve. ?Don't forget that spreads are still coming in,? he says. ?There was a time when you saw longer dated cédulas at spreads like 15bp over swaps, but you now see some in the low single-digits. This move will continue as more investors become familiar with the market.?