Saturday, March 1, 2008

In Spain, mortgage funding is different

Spain is different. The slogan, which the tourism industry used in the 1950s to celebrate the country’s identity and culture, is nowadays something of a joke. Among Spaniards, the old line is an expression of self-deprecation, of a sentiment of quirkiness and inferiority, which constitutes a fundamental part of the Spanish ethos. When it comes to funding mortgages, however, Spain is different in a good way.

Like so many other parts of the developed world, Spain has experienced a housing fever over the last ten years. Banks have thus been lending at a hectic pace. Because bank deposits do not provide reliable and sufficient liquidity to fund the mortgages, lenders everywhere have resorted to mortgage-backed securities (MBS) and mortgage bonds.

An investor in a “standard” MBS holds a claim on the issuer of the security, not on the mortgagee, even if he buys securities directly from the originator of the mortgages.

In Spain, however, at least one link in the chain of investors has a stake in the original loans. In order to securitize mortgages, Spanish banks first issue participations, which are shares in each of the mortgages included in a pool. A holder of participations receives a percentage of the interest and principal of the mortgages from the originator, who in turn receives the payments from the Janes and Joes (or Pacos and Dolores) who obtained the mortgage loans. The participation holder has thus a claim on both the originator and the mortgagee. More importantly, the originator retains a certain fraction —100 minus the percentage of the participation— of each and every mortgage created, turning originator and participation holder into co-creditors. In a second step, holders of the participations may form pools and then issue securities that represent stakes in those pools of participations.

This scheme provides a form of risk-sharing between originators and participation holders, which is conducive to higher lending standards. Originators are not off the hook when they sell the participations, because they keep a share of each mortgage. That makes them more careful when assessing the creditworthiness of mortgage applicants, and reduces the chance of overly loose credit standards. And participation holders have a stronger incentive to keep an eye on individual mortgagees than if they had a claim on the originating institution only. (Read this post at Calculated Risk about this subject.)

* * *

The second source of mortgage funding for originators is the so-called covered bond. This is a debt instrument issued by a credit institution and secured by a pool of mortgage loans or public debt or even MBS themselves. These bonds pay coupons and principal, just like any other bond. The investor has a claim on the issuer of the bond and, if the latter defaults, on the pool of loans (not on individual loans).

In most European countries, where covered bonds are popular, a set of cover assets is set aside for each bond issue. In Spain, however, all mortgages of the issuer constitute collateral for the bond. The risk of the bond depends thus on thousands of separate individual loans, with varying credit quality, not just sub-prime or fixed-rate 30-year loans.

The amount of outstanding bonds has experienced an astonishing growth in Spain, thanks in part to the participation of regional savings banks. That has some people fretting, because the business of each of those small institutions is too dependent on local economic conditions. But those banks, known as “cajas” o “caixes,” formed a coalition that has become the largest issuer of covered bonds in the country: AyT Cédulas Cajas. (The composition of the coalition varies by issue.) By pooling their mortgages into a single issue, the risk of the bond depends on dozens of local real estate markets, spread all over the country.

But perhaps the most important reason why the Spanish financial system is unlikely to suffer a meltdown is the virtual absence of Special Investment Vehicles (SIV) and conduits. These animals allow banks to move mortgage-backed securities off their balance sheets, thus obscuring the exposure of individual institutions and escaping capital requirements.

Not in Spain. The Bank of Spain, scarred by a financial crisis in the 1980s, demanded a long time ago that lenders post an 8% capital charge against SIV assets. The result: a relative absence of off-balance mortgage risk. Surely, Spanish banks have suffered losses, but much smaller than those of their European neighbors. That is remarkable considering the size of Spain’s mortgage-backed issues, only second to the UK’s. (Read this article in the Financial Times, Feb. 1) From here, then, my sincere bravo to the Bank of Spain.

* * *

Six months after the beginning of the credit crisis, back in August 2007, Spanish lenders show signs of liquidity stress. The market for covered bonds is practically inactive, and there is an obvious mismatch between the maturity of mortgages (20, 30 or 50 years) and the liquidity needs of originators.

But the policy of the European Central Bank (ECB) is proving very useful here: Europe’s banker has long allowed its members to use mortgage-backed bonds as collateral. So Spanish lenders are simply issuing covered bonds, keeping them instead of selling them to investors, and using them to borrow from the ECB at the weekly auctions: unprecedented, odd, but nothing to worry about.

The default rates of Spanish mortgagees are still near historical lows, even after months of rising mortgage payments. If the macroeconomic forecasts for the eurozone are roughly accurate, growth will slow down, inflation will subside, and the ECB will cut interest rates, providing relief to debtors. So when the liquidity crisis goes away, Spanish banks will be sitting on piles of solvent mortgage loans. There is no looming solvency crisis here.

UPDATE (3/6/08):
I found this graph of default rates on mortgage loans here.

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Anonymous said...

Hi Francisco,
I have been involved with property in Spain for the last 7 years and never had such an interesting overview of the Spanish mortgage. Thanks for the info, this will be very informative for my clients. Sean Clay.

Anonymous said...

Great post on the state of the Spanish Economy. Very Accurate!

Anonymous said...

Thanks for this article. I´m very happy again to understand a litle bit of economy. This is the confirmation, the technical confirmation, about these comments that some professionals of the education and the automotion, not in economics,discuse in Spain a few days ago. That was my opinion, in other way than the technical, to discuse in favour of not to worry about this comments about the litle banks. I´ll be here to continue learning!

Anonymous said...

Greetings from NY...I'm curious to hear (or read) your thoughts on the future of risk in the Spanish household credit market. It seems to me that default rates for mortgages are headed up the way they did in the 90's. I understand that interest rates and so on presently aren't anything like they were back then...nevertheless, things look bad. Most folks talk about how defaults are going to skyrocket in the real estate and construction industries, but what do you think is happening or set to happen among households? Thanks!

Charles Butler said...

Nice piece, Francisco.

I've been known to go off from time to time when too strict comparisons are made between anglo-saxon style real estate bubbles and the Iberian sort. The fact is that, because property has historically been the only investment thought trustworthy (and I know it is almost impossible to convey how deep seated this is to a person with no personal experience in that regard), there is bid probably not very far below market high's. And it's backed up by the known 56 bn in 500€ notes stuffed into mattresses and wall safes throughout the country. There is no question, though, that this argument has less validity in the Mediterranean areas that are most dependent on foreign sales.

Interestingly also, the manager of the local caja where I do my day-to-day banking pulled me aside about a year and a half ago and offered me what I thought were awfully good terms if I moved the bulk of my business there. They were onto the issue of shoring up reserves pretty early on.

Notable also was Santander's sale of its property portfolio, simultaneously adding to reserves with the 1 bn capital gain booked and probably providing themselves with more paper to turn in to the ECB. What hasn't happened yet, of course, is the bankruptcy of a large builder/promotor - extreme degrees of incestuous cross ownership making it less likely - but Metrovacesa recently had to pony up 500 bn for a margin call related its investment in Repsol when the parent company traded below a limit.

Good work. Can we get your take on the Spanish current account deficit, please?

Anonymous -

The household credit issue, although it exists, is another way in which 'Spain is different'. Step outside the cities and credit cards are rarely used. I lived off them in Canada, but months go by and it doesn't come out of my pocket here. If credit is involved, it's extended by the store itself on an informal basis. In any regard, my guess is it's pretty unusual to see a person sporting plastic with a 20,000€ limit - let alone maxing it out. The 'instant approval' 6,000€ loans at 25% might be another matter, but the Banco de España started exercising a bit of moral suasion in that regard starting a year ago.

None of the above is to say that it's not already turning into a bit of a rough go.



Francisco said...

In response to my anonymous commenter from NY (3/5/08):

Thanks for leaving a comment. Please stay tuned to EconWeekly.

Interest rates on mortgages have been going up since the fall of 2005. On September 30 of that year the 1-year Euribor, the rate to which most variable-rate mortgages are pegged, was 2.32%. Twelve months later it stood at 3.72, and on September of 2007 it was 4.73. Between 2005 and 2007, the rate of mortgages in arrears, but not yet in default ("ratio de dudosidad," to use the Bank of Spain's terminology) went up from 0.39% to 0.6%. That may look like a significant increase, but Spain is still worlds away from the default rates of over 5% seen in the early 90s. (Not so in the US.)
(Check out this graph:

Mortgage interest rates will stay high for a while, mainly because banks have more trouble to finance them now than they did six months ago. But now that the real estate bubble is over, demand for housing will subside, which will help contain the growth of mortgage rates.

Moreover, as I explain in the post, the ECB will have more leeway to cut interest rates as macroeconomic demand slows down all over Europe.

Finally, the government is in an excellent budget position to absorb part of the increase in mortgage payments. Accumulated surpluses allow the government now to shore up borrowers in a pinch. The incumbent administration, up for re-election next Sunday, has announced that it will subsidize mortgage renegotiations. And if the challenger party wins, they would a adopt a similar proposal (they would be under strong pressure to do so). A government bailout of mortgagees introduces moral hazard problems, but that's a different story.

My biggest worry about Spain is how the country is going to generate the economic growth we've seen in the last ten years from now on. Productivity growth is low, and the construction sector represents a disproportionate share of the economy. A quick solution would be to lower corporate tax rates and attract productive foreign investment (as opposed to foreign investment on property, of which we've seen so much), as Ireland did. But I doubt whether Spanish workers have the human capital needed for this to work.

In the medium run, of course, the solution is to invest in adoption of technology (not development at this stage, just adoption) and increasing the quality of scientific and technical training of the workforce.

To summarize: a banking solvency crisis is unlikely, and so are massive increases in the default rates. A macroeconomic recession, however, is almost certain.

Charles Butler said...

Speaking of productivity, education and the like, the Consejería de Educación of the Junta de Andalucía is currently touting sizeable economic rewards over a four-year period for teachers that accomplish certain measurable goals with their students. Without commenting on the effectiveness of this plan to lift Andalucía out of the academic slums, it's interesting to note that individual high schools would choose to sign on to this program voluntarily if 2/3 of the teachers voted in favour.

At the school where my wife teaches the proposal was rejected 62-28, the staff thinking that the drawbacks of permitting the Junta to stick its nose into their classrooms and comment on their teaching skills was not compensated for by the 5,000€ they stood to gain.

It's a tall order.

Anonymous said...

A prediction that will turn out to be terribly wrong.

Anonymous said...

Spain’s next prime minister “will spend the next four years cleaning up an economic mess of a scale not witnessed in Spain in modern times,” according to the London-based Financial Times.

Indeed, almost all Spaniards agree that the economy has replaced terrorism as the central issue in this election. The housing bubble, which has been the driving force behind a credit-financed spending boom, has burst. (Some 20 percent of the Spanish economy is related to housing, twice as high as the rest of Europe.) After 15 years of incredible growth, the Spanish economy is now in big trouble.

GDP growth is slowing fast and unemployment (8.6 percent) is up to the highest level in 11 years. Inflation (4.4 percent) has hit a 12-year high and retail sales are down for the first time in many years. The service sector, which accounts for more than half of Spain’s economy, is shrinking and business confidence has hit a record low. The Spanish manufacturing sector is also at its weakest in more than six years. According to a recent poll, more than one-third of Spaniards rate the economy as “bad” or “very bad” (up from 25.4 percent last year).

Spaniards are also loaded down with debt. Spain’s household debt is at record levels of nearly €600 billion. Millions of Spaniards with a mortgage are now paying more than 55 percent of their wages on principal or secondary home repayments, double the percentage considered healthy by most banks. A recent poll shows that 70 percent of Spaniards are struggling to make ends meet. Spanish consumers failed to pay back €11.5 billion worth of debt in 2007, a 30 percent increase over the previous year.

Adding to the woes in Spain is the deteriorating current account imbalance. Spain has the second highest current account deficit (10 percent of GDP) in the industrialized world (after the United States). The Banco de España recently sold 80 tons of gold, presumably in order to finance the current account deficit.

Both candidates have been focusing on Spain’s deteriorating economic situation by relying on old-fashioned populism; they have attempted to attract voters on the back of generous political handouts. Zapatero says he will increase social spending to ease the economic pain. Rajoy wants to cut spending and stimulate the economy with corporate and income tax cuts.


Anonymous said...

The Bank of Spain now has updated figures for the default rate on Spanish mortgages. The rate for March was 1,11% and for the cajas it is now 1,235%.

Put those figures on there and this graph really does start to look like the one in the early 90s.

Anonymous said...

Now that it's 2011 and Spain is an economic basketcase it's clear that the writer of this article got almost everything wrong.

Anonymous said...

...And Fritvet, got almost everything right.

Also find it funny this quote as well, "Zapatero says he will increase social spending to ease the economic pain. Rajoy wants to cut spending and stimulate the economy with corporate and income tax cuts."

Dear god don't let Rajoy anywhere near this government. He will let the sly trick of banks/inmobalarios kicking people out of homes so they can collect their interest from already evicted mortgages whilst collecting from current tenants.