Fitch says Spanish covered bonds unaffected by residual claims

Covered bonds

Covered bonds ratings on stand-alone cedulas hipotecarias (CH, Spanish mortgage-covered bonds) and the structured finance ratings on multi-issuer cedulas hipotecarias (MICH) would not be affected by legislative changes that undermined the residual unsecured claim against the insolvency estate of a CH issuer upon default, Fitch Ratings said today in a press release.

Spanish newspaper Expansion reported on 4 April that the EU might consider subordinating cedulas holders to unsecured depositors (specifically those with deposits not covered by guarantee schemes). The ratings agency explained it did not suggest that the EU is questioning the framework that results in the legal, valid, binding and enforceable encumbrance of assets.

“Our rating criteria for covered bonds disregards any potential unsecured recourse to the insolvency estate of a defaulted issuer. In very simple terms, we check whether the stressed value of the mortgage cover pools securing CH allows us to rate the bonds above the issuing bank’s rating, and we do not give any credit to further recoveries.”

Under the current regime, covered bond investors in Spain have an additional unsecured claim on a bankrupt institution, which ranks pari passu with unsecured creditors (which include no-guaranteed depositors), and is used if the proceeds from the cover pool are insufficient to repay their debt in full. “If covered bond investors became subordinated in this additional unsecured claim, it would have no ratings implications because the additional claim is given no credit in our analysis.”

Fitch stated that “we are confident that the legal framework protecting CH is not at risk. We do not expect changes to the laws that allow for the encumbrance of assets as this would go against the essence of the legal framework. Spanish law clearly identifies CH investors as special privileged creditors secured by the entire mortgage book of a bank.”

Furthermore, recent legislative developments in Spain have aimed to clarify the restructuring process of troubled banks (although they do not specifically address covered bonds).

In a separate note, the agency also told investors that progress in reforming the Spanish banking sector is good, “but there are a number of remaining issues that will influence the success, or failure, of the exercise.”

“With a five-year timeline for restructuring the recently recapitalised banks, work remains. We are negative on the overall outlook for the Spanish banking sector,” the agency remarked, though.

Banks that received state aid have to substantially reduce their businesses to bolster their solvency, liquidity and long-term viability. After transferring selected assets to Spain’s bad bank, SAREB, thousands of branches are being closed and staff made redundant so these banks can focus on retail and SME lending in their core regions.

“Some of the sector’s capital needs will be covered by bailing-in subordinated debt and preference share investors. We estimate around EUR13bn of capital will be generated through these measures, although in some cases investors may be given shares or other debt in return. The subordinated liability exercises have been delayed slightly, complicated by potential mis-selling to retail investors. We estimate that up to 20% of outstanding hybrid instruments could be affected by conduct allegations, with this percentage varying from bank to bank. This will result in additional capital having to be injected.”

“We are pessimistic about asset quality and our ratings incorporate an assumption that non-performing loans will increase this year as problems spread to SME loans and residential mortgages that have so far held up relatively well,” Fitch added. “Loan provisions are likely to remain high in 2013, although probably not at 2012 levels when provisions were frontloaded as part of the banking reforms. But with SAREB actively managing down a substantial real-estate portfolio over the next 15 years, there could be knock-on effects for the asset quality of non-recapitalised banks.”

“The sector’s restructuring efforts are likely to fuel the higher level of consolidation seen since the reforms started last year. We expect the M&A trend to continue for the rest of 2013. Together with the mandatory downsizing of recapitalised banks and cost optimisation by healthier banks, this should take further excess capacity out of the system and in time, contribute to sustained profitability.”

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