Spanish Mortgage Finance Crisis

1
Spanish MortgageFinance Crisis Case
Study University of Pennsylvania / Wharton
School Philadelphia/Berlin, June 4, 2013
Hans-Joachim Dьbel Finpolconsult.de, Berlin
2
Excess Liquidity Housing Credit Inflation
Spanish Housing Loan Debt Tripled Rel. to GDP
Housing Loan Outstanding to GDP
Spain was an emerging mortgage market by the
early 1990s. Debt creation dynamics mid-90s to
2007 and house price boom only second to Ireland.
Source ECRI Database
3
Excess LiquidityMuch of the Liquidity was
ForeignHousing Loans and Current Account Deficit
( of GDP)
2000 - 2010
Causality goes both ways ? Capital exporting
investors seek high-volume assets (LatAm
sovereign, commercial RE). Housing is just the
latest such asset class, deemed safe easy to
originate, trade. ? The target economies (U.S.,
Spain) overdevelop both housing and the financial
sector and seek more capital imports (through
deep securities markets) to keep the credit boom
going.
Source IMF, Finpolconsult.
4
Channels of Liquidity CreationBoth MBS and
Covered Bonds Contributed to the Credit Boom
Spain 2003 2010 (bank-based system)
United States 2004 2010 (capital mkts
insurance-based system)
European commercial banks did not materially act
differently from U.S. GSE/Finco/Bank mix. Main
carrier of credit boom in both cases were high
volume debt securities sold esp. to foreign
investors. This required large, centralized bond
issuers US Fannie/Freddie, Inv Bks Germany
Depfa, Eurohypo Spain Ahorro Y Titulizacion.
Source Finpolconsult, central banks., SIFMA
5
Channels of Liquidity CreationRole of Covered
Bonds
Liabiity Structure of Cajas 1962-2009
Spain was the European Record Issuer 2003-07
By 2000, the Mediterranean and Madrid region
cajas had already depleted their deposit
base. Solution Ahorry Y Titulizacion
Source Finpolconsult, based on Paul/University
of Bochum
6
Channels of Liquidity CreationCovered Bond
Conduit Ahorro y Titulizacion of Spanish Cajas

• Setup
• Ahorro y Titulizacion (Spain, Madrid) joint
  issuer of Spanish savings banks (Cajas),
• Cedulas TDA, F.T.A. is a special purpose fund
  under Spanish law with limited liability,
• Sole purpose of the Fund to acquire Cedulas
  Hypotecarias from savings banks as collateral for
  the issuance of joint Cedulas.
• Performance
• AyT jumpstarted the Spanish covered bond market,
  helping Spain to become the largest European
  covered bond issuer 2004-6.
• Spanish covered bond issuance extended mortgage
  boom beyond deposit base, Cajas extended their
  leverage,
• Key problem AyT did not underwrite Cajas, these
  were entitled to issue through the entity,
• Cajas were supposed to provide cash collateral
  when prices dropped, but eventually were unable
  to do so,
• New issuance stopped with crisis.

Sources Caja Madrid, Merrill Lynch
7
Channels of Liquidity CreationWeak Covered Bond
Law

• Covered bond law on the cheap
• Compensated for by large levels of
  overcollateralization.
• Overcollateralization means a subsidy by the
  deposit insurer to the covered bond investor,
• Implies that banks cannot be put into insolvency
  (Indy Mac problem).
• Structural weaknesses
• Assets are not ring-fenced, no due diligence,
• No constraints on issuers (overleaf),
• Law design forces investors to claim seniority
  during bank insolvency,
• Considerable market risk (typically 5 yr bonds
  swapped from fixed to float), high OC does not
  guarantee roll-over by private investor. Law says
  nothing on ALM.
• Large credit risk arising from weak appraisal
  rules, collateral risks (often no title), lending
  to corporates (developers), lending for
  unfinished construction and vacant land.
• CRA and regulator remained passive.

Covered Bond Overcollateralization (OC) Levels
Overcollateralization in Spanish Cedulas
Source Fitch Ratings
8
Not Only Credit Volume, But Also Duration
MattersProduct Pricing as a Determinant of the
FRM-ARM Ratio
Germany

• Spain 1994 law change
• permitted ARMs
• Made linking to indices mandatory
• 5 different indices offered, but soon Euribor
  became dominant index.
• Initial consumer protection bias against FRM.
• Capital supply is measured in duration expected
  amount of time that capital is left to the
  borrower without repricing.
• ARMs have low durations.
• Low durations mean that effective capital supply
  is multiplied.
• Before 1994, most Spanish lending was fixed-rate
  (before 1982 reforms, special circuit).

Spain
Source Finpolconsult.
9
Risk ImpactAsset Price Inflation
10
Risk ImpactRealized House Price Inflation is
Causal for Poor Underwriting
Spain , 2002 - 2010
United States, 2002 - 2010

• Many issues on the agenda of regulators (e.g.
  Financial Stability Board) are the result of
  price risk
• Cyclical increase in loan-to-value ratios (as
  opposed to structural) constant LTV rule?
• Extension of loan maturities and negative
  amortization features Spain from 20 to 30, 50
  years
• Higher frequency of interest-only periods and
  initial teaser rates
• Lower spreads for both prime and non-prime
  lending
• Low-documentation lending

Source Federal Reserve, Bank of Spain,
Finpolconsult.
11
Housing PolicyExacerbating Spanish Mortgage
Market Risks

• Rental sector share and incidence of mortgage
  lending to vulnerable households, ca. 2005

• Public subsidy budgets and social housing
  construction in selected European countries, ca
  2005

• High-leverage mortgage markets can remain stable,
  if debt is targeted to the middle class
  (Denmark). Spain
• Legacy of rent controls led to de-facto
  discrimination in a large multi-family building
  stock.
• Privatization of social housing during the 2000s
  into the house price boom, zero new investment as
  private market was booming.
• Met a wave of 5 million immigrants (Romania,
  Morrocco, Colombia, Ecuador).?Spanish Subprime
  made affordable through Euribor
• Result leverage targeted to vulnerable
  households.

Source European Housing Ministers, Finpolconsult
for EBRD Transition Report.
12
Risk ImpactHigh Debt Volumes and High
Vulnerability to Interest Rate Shock
Household Debt to GDP Ratio 2011, Regional
Share of Housing Loans with Interest Rate Fixing
Period lt 5 years
Source European Credit Research Institute/CEPS
Finpolconsult .
13
The CollapseThe initial Spanish reaction
crisis, what crisis?
Interest rates on outstanding loans in the
dominant national mortgage portfolios in four
European countries, 2003 2010
Mortgage default rates, 2001 2009
U.S. median interest rate 2010 ca 5.75.
14
The CollapseThe Reality This Attitude Made the
Crisis Far Worse, for Spain
..Permitting (Foreign) Investors to Pull their
Money Out Case Banco de Valencia
Spanish House Prices Collapsed in Slow Motion..
Banco de Valencia had to be rescued by the Span
gov with 4.5 billion EUR (investment is entirely
lost) Total fiscal loss estimate so far gt EUR
50bln, total public exposure is EUR 400 bln (ECB
plus Spanish gov) gt20 of the loss has to be
paid by small savers that invested in
subordinated debt and hybrid capital sold in 2009
(permitting another extension of the
crisis..). Foreign investors in senior unsecured
and covered bonds were left off the hook.
For sources, see Report text.
15
The Collapse The Reality The Portfolio Is Kept
Afloat by the ECB

• We are told an intact ECB bailout story by Spain
• In June 2012 officially only 3.2 of
  owner-occupied mortgage loans were in default,
• Current LTVs were reported at only at 55-65
  (Oliver Wyman).
• True LTVs are likely higher due to mis-appraisals
  with negative equity inviting future
  option-theoretic default.

Banco de Valencia Funding Structure
Portfolio Profitability, ECB Bailout (Irish case)
Source Banco de Valencia, Finpolconsult
computations.

• Also, the performing Spanish portfolio is as bad
  a loss-maker as the Irish, just on a larger
  scale
• New lending rates reflecting cost are 200bp above
  historic lending rates,
• Without ECB subsidies the mortgage portfolio
  would be loss-making in its entirety.

16
The Collapse Severe Impact on Covered Bonds Market
Reversion of Pricing of Bank Funding Instruments
in Spain

• Private Investor Market Collapse
• Downgrades Double hit real estate and
  (correlated) local governments, Only 2/48
  Cedulas retain AAA, 9/48 rated BBB, all trade
  like junk!
• Multi-seller Cedulas were hit by Caja crisis,
  major incentive problems with individual issuers,
  
• Jumbo market closed between June 2011 and
  September 2012,
• Outside a few private banks, no pricing advantage
  of covered bonds over senior unsecured (chart),
• Massive O/C (currently 100 and higher) and LTRO
  have sucked out all the good collateral in the
  banking system.
• Ironically, Spanish banks issue more covered
  bonds than ever.. right into the ECB balance
  sheet.

17
The CollapseHuge Bank Solvency Risk arising from
Index Tracker Lending
Euribor minus Long-term Deposit Rates
Pricing of Euribor based Covered Bond issued by
Spanish Cajas

• Clearest sign of comm bank-dominance use of
  interbank indices
• Index-tracker ARM have destroyed lender solvency
  across Europe
• Basis risk even in good times e.g. 1 year
  Euribor rates funded by 3 month Euribor swaps,
  covered bonds (swapped from fixed into 3 month
  Euribor) and deposits (reviewable rates).
• With the crisis (rise in deposit rates, collapse
  of swap and bond market), the performing index
  tracker portfolio in Spain became a large a loss
  maker. Huge (spread) duration as few borrowers
  prepay loss-making loans. Major loss-maker also
  in the UK (no new lending)

Source Bank of Spain, Onvista,, Finpolconsult
computations.
18
The CollapseForeclosure Records, Slowly
Improving Consumer Protection

• Inadequate consumer protection/ foreclosure law
  framework
• No consumer insolvency law there is risk of high
  residual debt remaining with households.
• No debt discharge rule similar to other,
  typically catholic, European countries.
• Contrast to corporates (developers!!)
• Typically means government intervention ex-post
• Hungary foreclosure volume limits
• Ireland de-facto complete moratorium.
• Spain is an exception
• Government is a large owner of regional
  banks/ex-Cajas with biggest problems.
• The first foreclosed and evicted households were
  migrants who enjoyed less political protection.
• Solutions
• Debt redemption through short sales, but only if
  the bank agrees.
• Conversion of repossessed stock into social
  housing.

Proportion of Foreclosed Mortgages

• Resistance to foreclosure is strongly rising as
  unemployment affects even the prime portfolio
• First eviction moratoria e.g. for families with
  young children.
• Defaults are likely to worsen as borrowers
  realize that the negative equity situation cannot
  be cured.
• Solution not low rates, but debt forgiveness.
• Partial DF programs are being implemented.

Source BBVA.
19
Regulation SummaryIdeal Reduction of System
Vulnerability to Global Liquidity Shocks

• Increase in Leverage and Mismatch of Housing
  Finance Systems to be Unwound

• 1. Vulnerability of systems featuring high
  borrower leverage, mismatch, dubious valuations,
  small rental sector to a given liquidity shock
  is maximal.
• 2. Such risk layering increases the impact of a
  given liquidity shock on prices, credit growth
  (pass-through).
• 3. Liquidity shocks themselves are maximized by
  financial innovation, autonomous (portfolio)
  capital flows, aggressive cross-border entry.
  Interaction between flows and innovation central.
• 4. Once house price and credit inflation is
  produced, this dominates all other commonly cited
  credit risk factors..

• Implication Volcker Rules for the mortgage
  markets
• Discourage leveraged interest rate risk
  speculation by borrowers with their most
  important financial asset, equity in housing
• Discourage (leveraged) interest risk speculation
  by mortgage lenders and force interest rate risk
  to be taken by institutions.

Source Finpolconsult.