Mortgage bond and MBS market development in Spain and Portugal.

Similarly to France, Spain has set up a legal and regulatory framework with the objective to develop mortgage funding vehicles markets. However, as opposed to France, Spain has not adopted in a strict manner the German legal and regulatory framework. The great flexibility of MBS has contributed to the development of this mortgage funding instrument. In Portugal, given the high home ownership rate, the mortgage market has reached a critical mass relevant for securitisation. The new securitisation law of 1999 has set up the legal and regulatory framework necessary for a sound development of mortgage funding instruments.

I. SPAIN

A. Mortgage Lending Development

Mortgage lending has developed into a fast growing and highly competitive market segment ill Spain. The driving forces behind this trend are an increased entry by universal banks in the market for mortgage loans and especially the boom in the private housing market since the late 1980s with a related downturn in mortgage interest rate levels. Since 1992, the mortgage interest rate has come down from 68% to the current 4.8%.

Mortgage loans usually have fixed rates and low LTV ratios, and most residential properties are owner-occupied. Banks may also use RMBS as collateral in repurchase agreements.

B. Specialized Funding Vehicles

1. Mortgage Bonds-Cedulas Hipotecarias

Mortgage bonds development:

Argentaria's mortgage bond was launched at the start of 1999. In value it was EUR 1 billion with a ten year maturity listed in Luxembourg and Madrid. There was a difference in the rating compared to the German Pfandbriefe.

Jumbo issues of Cedulas Hipotecarias are one of the most significant developments in the Spanish mortgage market. This new market emerged in Spain in 1999. Moreover, Moody's has upgraded the rating for the Argentaria jumbo (AAA rated) as a result of the merger of the two institutions, Argentaria and BBV to form BBVA.

The volume of mortgage bonds outstanding currently amounts to an estimate of EUR 10 bn (as of year 2000), more than double the figure in 1998. Nevertheless, the proportion of mortgage bonds outstanding in relation to total mortgage loans only rose between 4% and 6% in the last few years and the trend is declining. This shows that the banks involved in the segment continue to prefer other refinancing channels.

Nevertheless, the market for jumbo CH is expected to keep on growing. The circle of jumbo issuers should remain relatively small as the total mortgage stock is spread over a large number of institutions, and therefore only few banks have a sufficiently large number of assets eligible as cover.

Issuers:

Credit institutions which have included their activity in the mortgage sector in their statutes, which have obtained the authorization of the Spanish Minister of Economy and Finance and which have submitted themselves to a specific supervisory body (the Spanish Central Bank).

Cedulas Hipotecarias may be issued by any credit institution who respect the few criteria mentioned above. Mortgage bonds can be issued by commercial banks, savings banks, credit co-operatives and specialized financial institutions. So far, the first two types have been carrying out most of the issuing activity.

2. Mortgage-Backed Securities-Titulizacion Hipotecarias

Mortgage market structure and legal framework:

The Spanish Central Bank-Banco de Espana--regulates the mortgage market through guidelines on lending (1). Those regulations are very restrictive:

* The maximum lending level (LTV ratio) is usually 80%.

* The maximum debt-to-income ratio (DTI)--ability to repay--is 40%, the average being 27%.

Furthermore, the use of scoring models and the credit history check of the mortgage applicants by credit agencies are part of the credit worthiness checks.

Banco de Espana has a unique database which shows all loans for over Pta 1m.

Mortgage lending represents a small portion in relation to Spanish GDP. Mortgages for private housing account for almost 80% of total mortgages.

Savings banks have the largest share of the mortgage lending market with almost 52%. Apart from a large number of smaller, regional banks, there are now savings banks operating nationally, such as La Caixa, Caja Madrid mad Caixa Cataluna. Universal banks have the second largest market share at 38%. Mortgage banks only account for 2% of the market.

Spanish mortgages are usually at a variable rate. Indeed, fixed-rate mortgages account for less than 10%. The reference rate used is generally the MIBOR, Banco de Espana's interbank rate.

MBS market development:

The Spanish MBS market is one of the most highly developed MBS market in the whole of Europe. Its increase has been spectacular. Whereas in 1997 the volume of MBS issues was still EUR 705 ran, it has risen to just under EUR 4 bn in 1998 and EUR 5.4 bn in 1999. However, since most of the issue volume has been bought by the originator, this growth is mostly the result of balance sheet and liquidity management than of disintermediation.

A major factor stimulating dais growth has been the decision in 1998 by Banco de Espana to allow MBS with all AAA rating to serve as eligible collateral for money market operations. The resulting acceptance and gradual standardization of MBS transactions has allowed regional banks especially to have access to dais capital market funding instrument.

Moreover, the volume of mortgages for private housing has increased at an average rate of 30% a year since 1995. This is due primarily to the dramatic reduction in the mortgage rate (from 68% in 1992, down to 4.8% in 2000) and secondly to the Spanish economic upturn.

Since 1998, MBS have established themselves as a source of refinancing alongside Cedulas Hipotecarias. However, at EUR 1.5 bn in 1998 and EUR 3.5 bn in 1999, the issue volume of the Spanish mortgage bonds was well below that of MBS transactions.

Rating:

The strict regulations imposed by the Spanish Central Bank lead to a very low rate of default in mortgage lending and consequently to a high rating for MBS.

C. Tax Treatment

A deduction of 20% of interest and capital payments (25% for the first 2 years) from the tax to be paid, up to the amount of ESP 750,000, and of 15% from a further ESP 750,000.

D. Legal Framework

1. Mortgage Bonds

The following elements constitute the Spanish legal framework for mortgage bonds:

* Spanish mortgage bonds follow the characteristics prescribed under Article 22(4) of the UCITS Directive.

* Law 2/1981 of March 25, 1981 on the regulation of the mortgage market & royal Decree 685/1982 of March 17, 1981

A 10% weighting for mortgage bonds was established by Royal Decree 845/1999 on May 21, 1999. This reduces the own funds requirements by half, thereby facilitating their acquisition by national mad foreign institutions. This favorable treatment is the result of the translation of article 22(4) of the Directive 85/611/CEE (UCITS) into the Spanish law (Law 20/1998 July 1, 1998), which recognizes the particular guarantees of mortgage bonds.

A decision by the Bank of Spain to accept "AAA" rated Spanish mortgage-backed bonds as collateral for liquidity borrowing has jump-started its securitisation market.

2. Mortgage-Backed Securities 

The legal framework for MBS was created in July 1992 with the Real Decreto 19/1992. This law allows the creation of independent funds, which may only invest in mortgage certificates (pools) and refinance through MBS.

These mortgage certificates are participation certificates on building loans, which securitise the exploitation rights relating to a property in the event that the underlying loan cannot duly be repaid. There is no time limit for the sale of the property, which contrast to other European countries practices.

The fund's management is taken over by a "trustee" (2), who acts on behalf of the fund. Unlike in the case of MBS transactions in other countries, this agent not only takes on the duty of control body but also actively manages the fund and partly also the way in which the MBS is structured. Both the fund and the "trustee" are legally independent from the sellers of receivables in order for the investor to be protected from the originator's insolvency risks.

E. Risk Assessment

1. Credit risk

a. Mortgage bonds

In the case of mortgage bonds, the credit risk depends on the quality of the originator and of the collateral.

Collateral:

Spanish mortgage bonds are secured by all the mortgage loans registered for an issuer, whereas public sector loans do not qualify as cover assets. The loan to value for commercial properties is 70% and 80% for home loans. Although the LTV varies according to the type of collateral, there is no such differentiation at the instrument level. Indeed, as in France, there is only one single type of CH. Cover assets remain on the balance-sheet.

The current assets of CH are limited to 90% of the volume of senior mortgage loans. However, as in the event of the issuer becoming insolvent, not only senior, but all mortgage loans-with the exceptions of mortgage loans used to cover "bones hipotecarias"--serve as security, there is a surplus cover of at least 11%.

The Civil Procedure Law was modified to facilitate and to reduce the costs of the repossession procedure. This results in a better coverage of the rights of all parties concerned in the mortgage market.

As opposed to the strict Danish legislation, there is no legal requirement in terms of mismatching.

External support mechanisms have been set up. Indeed, in the event of insufficient proceeds from the pool assets to cover their claim, CH investors rank pari passu with senior debt holders. This feature is similar to German Pfandbriefe.

Bankruptcy privilege:

Holders of CH have priority claim over assets in the event of any bankruptcy, but still come after claims from the state (taxes) and employees (salaries and wages).

There are currently discussions focused on clarifying existing Spanish legislation with reference to the privilege of the holder of the mortgage bond in the event of bankruptcy. There are still different legal opinions on this issue.

Originator:

Originators of Cedulas Hipotecarias are under the special supervision of the Central Bank of Spain.

Cedulas Hipotecarias are more exposed to the risk of a downgrade triggered by a deterioration in the issuer's general banking activities, given that they are carried out in the same legal entity and on the same balance-sheet. Indeed, there is no specific bankruptcy remoteness feature. Therefore Spanish mortgage bonds do not show clear independence from the issuer and thus enjoy a lower rating compared to similar German Pfandbriefe. The exposure of CH to credit factors not related to the underlying mortgage lending activities is further accentuated by first, the fact that there is no specific legal provision allowing for uninterrupted debt service payments on CH in case the institution is placed under a moratorium. Second, there is no specialist principle in terms of legal requirements. Indeed, credit institutions have no business or assets restrictions.

While CH are quite exposed to the risk of downgrade and the risk of default, the risk of ultimate losses or non-recovery in a default scenario should be very low given the degree of overcollateralization of 10% (mandatory minimum level).

b. Mortgage-backed securities

As already stated previously, in the case of MBS, the credit risk depends on the collateral and on the transaction structure. It is thus possible to separate the rating of the issue from the originator's financial strength.

2. Prepayment risk 

In Spain, prepayment risk exists. The legal reference about prepayment risk is the Article 50 (section 5) of the royal Decree on "Amortization of the securities".

Spanish law allows borrowers to repay the mortgage early. If the borrower has a variable interest rate mortgage, there is a maximum early repayment penalty in the legislation of 1% of the outstanding loan. For a fixed interest rate mortgage there is no legislation on early repayment penalties. However, the government has recommended that the penalty should not exceed 2.5% when switching from a fixed interest rate mortgage to a variable interest rate mortgage. For early repayment cases that are not covered above (variable or the switch from fixed to variable) the Bank of Spain has authorized a maximum repayment penalty of 5% for fixed interest rate loans.

F. Concluding Remarks

Similarly to France, Spain has set up a legal and regulatory framework with the objective to develop mortgage funding vehicles markets. However, as opposed to France, Spain has not adopted in a strict manner the German legal and regulatory framework.

Contrary to Germany, Spain had no history in mortgage bonds. Therefore, mortgage bonds and mortgage-backed securities are in competition. CH are used as a refinancing instrument by the larger banks (Argentaria, Caja Madrid and BBV in 1999). MBS allow for an aggregation of mortgages pools from several regional banks. A high degree of standardization offers a simple access to the capital market. The great flexibility of MBS has contributed to the development of this mortgage funding instrument. Furthermore, given that the legal framework is particularly favorable to MBS issuance, we can expect this instrument to become the predominant capital market funding vehicle.

II. PORTUGAL

A. Mortgage Market

The Portuguese mortgage market is a very young market and, in its current form, effectively only dates from 1993 when the regulation of mortgage lending was liberalized. Portugal has a very strong culture of home ownership: almost 65% of individuals are owner-occupiers.

Before 1992, mortgage lending was the privilege of three lending institutions. Deregulation opened the mortgage market to other banks, with an increase in competition.

The profile of the Portuguese mortgage loan market differs in many ways from other countries, primarily due to the government subsidized lending program which dominates it. Indeed, subsidized loans accounted for the majority of new origination until 1999. Higher LTV are possible in Portugal, specifically because of the subsidy program, which allows financing of up to 100% LTV for younger borrowers. The average LTV of mortgage loans in Portugal tends to be in the range of 70-80%. Nowadays, the mortgage market experiences a decline in the volume of new subsidized mortgage loan originations.

The types of products have evolved over time: variable rates indexed to prime rates gave way to fixed rate products, with fixed periods of up to 10 years. In more recent years, continued interest rate declines (from over 30% in the early 1980s to 2.5% in 1999) have seen variable rate loans with rates indexed to EURIBOR. Moreover, this sharp decline in interest rates made mortgage loans gradually more affordable to a wider range of borrowers.

B. Tax Treatment

The deduction of interest and capital payments up to the amount of PTE 297,000 (determined each year) is allowed.

C. Legal Framework

* Mortgage bonds issued in Portugal do not follow all the common characteristics prescribed under Article 22(4) of the UCITS Directive.

* In November 1999, Decree Law 453/99, the new securitisation law, was enacted. This law governs credit transfers (including mortgage loans) and allows for the establishment of Portuguese special purpose securitisation funds (Fundos de Titularizacao de Creditos-FTCs) or companies (Sociedades de Titulaarizacao de Creditos--STCs).

High regulatory charges for special purpose vehicles remain.

Implications of the new Law:

Previous Portuguese asset-backed transactions have relied on complex structures to achieve transfer of financial assets and optimal tax treatment, which required splitting the legal ownership of principal mad interest flows. The new law allows a clean transfer of the assets to the STC or FTC which is able to issue asset-backed securities in the form of bonds (in the case of the STC) or units (in the case of FTC). The STC or FTC will be exempted from any duties or tees payable, for example for re-registration of the mortgage or assignment. The registration process has been one of the factors deterring lenders in pursuing an RMBS transaction prior to the enactment of the new law. The transfer to the STC or FTC is also protected from any bankruptcy or insolvency of the selling company.

However, the new law is currently subject to some clarification from the government, specifically with relation to the withholding tax treatment of the bonds issued by the STC or FTC. If the STC or FTC were not exempted, they would be subject to withholding tax at the current rate of 20%.

D. Prospects for RMBS

A number of large Portuguese lenders have expressed an interest in proceeding with RMBS transactions. Lenders are attracted by access to a new international investor base, potential regulatory capital relief and longer-term funding. Given the volume of mortgage loans which have been originated in recent years, many lenders have reached the critical mass at which RMBS transactions make sense.

However, until the tax position of the new securitisation law is clarified, a different legal structure would need to be used for the RMBS transactions and this would clearly limit their number.

E. Concluding Remarks

Given the high home ownership rate, the Portuguese mortgage market has reached a critical mass relevant for securitisation. The new securitisation law of 1999 has set up the legal and regulatory framework necessary for a sound development of mortgage funding instruments. For example, a major obstacle to the development of RMBS transactions in the past was the registration process. With STCs' or FTCs' exemption, lenders will be more favorable to fund their mortgages through RMBS. However, as long as the tax issue is not clarified, the development of mortgage funding instruments will be hindered.

END NOTES

(1) E.g. Real Decreto 775/87 and the Pronouncement of November 1994.

(2) The largest "trustee" so far with 35% of the market share is the Titulizacion de Activos (TDA). The shareholders are seven Spanish savings banks and Bear Stearns. TDA has been in existence since 1992 and has since bought and securitised especially the mortgage claims of smaller regional savings banks on behalf of its funds TDA1 to TDA9.

MATHILDE FRANSCINI Graduated from HEC Lausanne, Switzerland in 2001. She is a titular of a Licence en Sciences Economiques, a Master in Banking and Finance (MBF) and a Certificate FAME (Financial Asset Management and Engineering). She currently works at ABB Financial Services.

TAMARA SCHILLINGER obtained a Licence en Sciences Economiques from University of Lausanne, Switzerland in 2000; a Master of Science in Banking and Finance from University of Lausanne, Switzerland in 2001-2002. Tamara is currently working for ABB Financial Services.