Spanish Mortgage
Finance Crisis
Case Study
University of Pennsylvania / Wharton School
Philadelphia/Berlin, June 4, 2013
Hans-Joachim Dübel
Finpolconsult.de, Berlin
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 mid90s to 2007 and house price
boom only second to Ireland.
Source: ECRI Database
Finpolconsult.de
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Excess Liquidity
Much of the Liquidity was Foreign
Housing 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.
Finpolconsult.de
Source: IMF, Finpolconsult.
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Channels of Liquidity Creation
Both MBS and Covered Bonds Contributed to the Credit Boom
United States 2004 – 2010
(capital mkts & insurance-based system)
Spain 2003 – 2010
(bank-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’.
Finpolconsult.de
Source: Finpolconsult, central banks., SIFMA
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Channels of Liquidity Creation
Role of Covered Bonds
Spain was the European Record Issuer 2003-07
Liabiity Structure of Cajas 1962-2009
By 2000, the Mediterranean and Madrid region cajas had already depleted their deposit base.
Solution: Ahorry Y Titulizacion
Finpolconsult.de
Source: Finpolconsult, based on Paul/University of Bochum
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Channels of Liquidity Creation
Covered 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.
Finpolconsult.de
Sources: Caja Madrid, Merrill Lynch
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Channels of Liquidity Creation
Weak Covered Bond Law
Covered bond law ‘on the cheap’



Covered Bond Overcollateralization (OC) Levels
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.
Finpolconsult.de
Overcollateralization in Spanish Cedulas
Source: Fitch Ratings
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Not Only Credit Volume, But Also Duration Matters
Product Pricing as a Determinant of the FRM-ARM Ratio
Germany
Spain
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).
Finpolconsult.de
Source: Finpolconsult.
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Risk Impact
Asset Price Inflation
Finpolconsult.de
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Risk Impact
Realized House Price Inflation is Causal for Poor Underwriting
United States, 2002 - 2010
Spain , 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
Finpolconsult.de
Source: Federal Reserve, Bank of Spain, Finpolconsult.
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Housing Policy
Exacerbating Spanish Mortgage Market Risks
Public subsidy budgets and social housing
construction in selected European countries, ca
2005
Rental sector share and incidence of mortgage
lending to vulnerable households, 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.
Finpolconsult.de
Source: European Housing Ministers, Finpolconsult for EBRD Transition Report.
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Risk Impact
High Debt Volumes and High Vulnerability to Interest Rate Shock
Household Debt to GDP Ratio 2011,
Regional
Finpolconsult.de
Share of Housing Loans with Interest
Rate Fixing Period < 5 years
Source: European Credit Research Institute/CEPS; Finpolconsult .
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The Collapse
The 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%.
Finpolconsult.de
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The Collapse
The Reality: This Attitude Made the Crisis Far Worse, for Spain
Spanish House Prices Collapsed in Slow Motion..
..Permitting (Foreign) Investors to Pull their
Money Out – Case Banco de Valencia
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 > EUR 50bln, total public exposure is EUR 400 bln (ECB plus Spanish gov)
>20% 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.
Finpolconsult.de
For sources, see Report text.
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The Collapse
The Reality: The Portfolio Is Kept Afloat
by the ECB
Banco de Valencia Funding Structure
We are told an intact ECB bailout story by
Spain:
 In June 2012 officially only 3.2% of owneroccupied mortgage loans were in default,
 Current LTVs were reported at only at 5565% (Oliver Wyman).
 True LTVs are likely higher due to misappraisals with negative equity inviting
future option-theoretic default.
Portfolio Profitability, ECB Bailout (Irish case)
Source: Banco de Valencia, Finpolconsult computations.
Also, the performing Spanish portfolio is as bad a lossmaker 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.
Finpolconsult.de
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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.
Finpolconsult.de
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The Collapse
Huge 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)
Finpolconsult.de
Source: Bank of Spain, Onvista,, Finpolconsult computations.
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The Collapse
Foreclosure 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 expost:
•
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.
Finpolconsult.de
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.
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Regulation Summary
Ideal: 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.
Finpolconsult.de
Source: Finpolconsult.
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