Submitted by EconWeekly

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.)

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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.

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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 comes to pass, Spanish banks will be sitting on piles of solvent mortgage loans. There is no looming solvency crisis here.

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