STRUCTURED FINANCE RESEARCH

Credit FAQ:

The Spanish Covered Bond Market Explained

Primary Credit Analysts: Mark S Boyce, London 02071768397; mark.boyce@standardandpoors.com Ana Galdo, Madrid (34) 91-389-6947; ana.galdo@standardandpoors.com Secondary Contacts: Roberto Paciotti, Milan (39) 02-72111-261; roberto.paciotti@standardandpoors.com Antonio Farina, Madrid (34) 91-788-7226; antonio.farina@standardandpoors.com

Table Of Contents
Frequently Asked Questions Related Criteria And Research

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Credit FAQ:

The Spanish Covered Bond Market Explained

The Spanish mortgage covered bond market is the largest in the world, with outstanding issuance totaling 407 billion in 2012. Spanish mortgage and public sector benchmark issuance (that is, with a notional amount of at least 500 million) placed with investors reached 11 billion in the first 10 months of 2013. This is down by more than 50% compared with the same period in 2010, but it still represents the third-largest total from any country this year. Many southern European lenders took advantage of the European Central Bank's three-year long-term refinancing operations in 2011 and 2012 to meet their short-term funding requirements. This has reduced their need to seek wholesale financing of any kind in recent quarters, including covered bond funding. Nevertheless, established Spanish lenders have continued to turn to covered bonds in 2013, partly to demonstrate market access and maintain investor relationships. Debut issuers have also tapped the market, citing funding diversification benefits. Meanwhile, high oversubscription figures for recent Spanish placementswhich offer attractive spreads, relative to issuance from some core European countriesimply that investor demand remains strong. All of this suggests that covered bonds will remain a key funding source for Spanish lenders over the medium term. Here, Standard & Poor's Ratings Services addresses the most frequent questions that we receive about the Spanish covered bond market.

Frequently Asked Questions

What are the frameworks for issuing covered bonds in Spain?
There are currently five legislative frameworks for issuing Spanish covered bonds, mainly differentiated by the eligible cover pool collateral and the extent of bondholders' claims on the lender's balance sheet. Securitization transactions backed by covered bonds from multiple issuers ("multi-cdulas") constitute the sixth form of Spanish covered bonds. The Spanish government is also reportedly considering a legislative framework for covered bonds collateralized by loans granted to small and midsize enterprises. Cdulas hipotecarias. Cdulas hipotecarias are mortgage-backed covered bonds that credit institutions (commercial banks, official credit entities, savings banks ["cajas"], credit co-operatives, and financial credit establishments) can issue under legislation passed in 1981 (Ley 2/1981). Under the legislation, eligible collateral comprises performing, unencumbered mortgage loans secured on residential and commercial property, property under construction, and land. This eligibility is subject to certain loan term and loan-to-value (LTV) ratio restrictions. (Encumbered mortgage loans would include, for example, those pledged to holders of "bonos hipotecarios" [see below]). Under the law, an issuer's outstanding balance of cdulas hipotecarias cannot exceed 80% of eligible collateral, giving a legal minimum overcollateralization of 25%. This is high, relative to many other jurisdictions: For example, required overcollateralization for German Pfandbriefe, French Obligations Foncires, and U.K.-regulated covered bonds range from 2% to 8%. Unlike other covered bond jurisdictions, in Spain, the pool of eligible mortgages only establishes an issuance limit, but the legislative framework does not limit the assets to which covered bond investors have recourse if an issuer defaults. That is, by law, the issuer's entire unencumbered mortgage book collateralizes its outstanding

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cdulas hipotecariasnot just the eligible loans. In practice, this means that cdulas hipotecarias benefit from substantially higher levels of credit enhancement than the eligible overcollateralization. According to European Covered Bond Council (ECBC) data, outstanding issuance of cdulas hipotecarias totaled about 407 billion at year-end 2012, or more than 90% of outstanding legislatively-enabled Spanish covered bonds. We currently rate 12 cdulas hipotecarias programs: Banco Bilbao Vizcaya Argentaria S.A., Banco Popular Espaol S.A., Bankia S.A., Bankinter S.A., Barclays S.A., Caixabank S.A., Catalunya Banc S.A., Deutsche Bank, S.A.E., Ibercaja Banco S.A., Kutxabank S.A., NCG Banco S.A., and Cajas Rurales Unidas. Bonos hipotecarios. Ley 2/1981 also governs credit institutions' issuance of bonos hipotecarios, another type of mortgage-backed covered bond. The characteristics of the mortgages that are eligible to back bonos hipotecarios are identical to those for cdulas hipotecarias. However, only a specific cover pool collateralizes bonos hipotecarios, rather than the entire mortgage book. Loans backing the issuance of bonos hipotecarios are excluded from the pool of loans backing the issuance of cdulas hipotecarias. The legal minimum overcollateralization is 2%. No Spanish lenders have issued bonos hipotecarios to date. Cdulas territoriales. Credit institutions can issue cdulas territoriales to fund public sector lending, under "Ley 44/2002", a law that became effective in 2002. All of the issuer's outstanding loans granted to public sector entities in the European Economic Area collateralize cdulas territoriales, except those granted to non-Spanish entities that fund export finance and international business expansion. Outstanding issuance of cdulas territoriales cannot exceed 70% of these loans, giving a legally required overcollateralization of 43%. Outstanding issuance of cdulas territoriales totaled 33 billion in 2012, or about 8% of outstanding legislatively-enabled Spanish covered bonds, according to the ECBC. We currently rate one issuance of cdulas territoriales from Banco Bilbao Vizcaya Argentaria. Cdulas de internacionalizacin. The government introduced cdulas de internacionalizacin in 2012 under a law (Real Decreto Ley 20/2012) to help credit institutions finance loans that are linked to export contracts for goods and services, and loans granted for international business expansion. Under the law, the lender's entire unencumbered book of such loans that meet certain criteriafor instance, being of "high credit quality"count as eligible collateral. Outstanding issuance of cdulas de internacionalizacin cannot exceed 70% of eligible collateral. No Spanish lenders have issued cdulas de internacionalizacin to date. Bonos de internacionalizacin. In 2013, the government introduced bonos de internacionalizacin in "Ley 14/2013" to allow lenders more flexibility in funding their export finance lending. Bonos de internacionalizacin are secured on a specific pool of loans that are linked to export contracts for goods and services, or granted for international business expansion, rather than the lender's entire loan book. Loans backing outstanding issuance of bonos de internacionalizacin are excluded from the pool of loans backing the issuance of cdulas de internacionalizacin. Under the law, the value of outstanding bonos de internacionalizacin must be at least 2% below the present value of eligible assets. Legal asset eligibility requirements for bonos de internacionalizacin are identical to those for cdulas de internacionalizacin, with the additional requirement that the loan's risk weighting under the relevant bank capital regulations must be at most 50%. No Spanish lenders have issued bonos de internacionalizacin to date.

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Credit FAQ: The Spanish Covered Bond Market Explained

Multi-cdulas Multi-cdulas are securitization transactions that repackage covered bonds from multiple issuers. This product came about in the early 2000s primarily to allow smaller cajas and other lenders to access the international wholesale capital markets. The individual issuers typically pooled smaller issuances of cdulas hipotecarias or cdulas territoriales (between 200 million and 500 million each) to a minimum of about 1 billion to achieve a wider distribution and to allow better secondary market trading. In the multi-cdulas structure, a special-purpose entity ("Fondo de Titulizacin de Activos"), managed by a securitization fund management company (or "gestora"), acquires covered bonds from several issuers. All of the covered bonds have the same coupon rate, scheduled payment dates, and legal maturity. The special-purpose entity issues pass-through bonds (the multi-cdulas) with notional amounts and payment characteristics matching the backing covered bonds. Multi-cdulas are typically "soft bullet" bonds, whose legal maturity can extend if one or more of the backing cdulas' issuers defaults. This allows for a workout of the issuer. During the extension period, a liquidity facility or reserve fund helps to mitigate potential timing mismatches between incoming interest payments from the backing cdulas and the scheduled interest payments due on the multi-cdulas liabilities. We currently rate 42 multi-cdulas transactions, with an outstanding notional balance of about 86 billion.

How do the different legislative frameworks differ?

We provide further details about the legal frameworks in Appendix 1.

Why are target overcollateralization levels so high for cdulas hipotecarias?

Our target credit enhancement levels for Spanish covered bonds are higher than in any other country (see chart 1). This reflects high levels of credit and market risk and, to some extent, less granular cover pool information. In our view, falling house prices since 2008 and high levels of mortgage arrears have increased credit risk for the Spanish covered bond programs that we rate. Reported cover pool LTV ratios don't account for house price declines following loan origination, since the law does not require issuers to publish this information. We use indexed LTV ratios in our rating analysis, which generally lead us to assume higher losses upon default than we would assume using original LTV ratio information. Meanwhile, high levels of arrears in Spanish cover pools lead us to assume a higher foreclosure frequency than in some other countries. Our target credit enhancement measure also reflects interest rate risk. Cdulas hipotecarias programs that we rate don't have recourse to hedging agreements registered in favor of the covered bonds. As a result, additional credit enhancement is required to cover the risk of interest collections from the typically floating-rate assets being insufficient to cover interest amounts due on the fixed-rate covered bonds. If there is a mismatch between the stressed asset and liabilities cash flows, we model the sale of the assets. We discount the generated asset cash flows at stressed interest rates plus a spread shock. The latter reflects observed secondary market spreads for Spanish mortgage collateral. The resulting addition to the stressed interest rate of between 700 basis points (bps) and 1,000 bps is also relatively high compared with some other countries. We also assess cdulas hipotecarias' credit quality relatively conservatively because, unlike in most countries, Spanish issuers only provide stratified cover pool information, rather than loan-by-loan data. As a result, we make relatively conservative assumptions about, for example, loan seasoning, current and original LTV ratios, and the proportion of

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Credit FAQ: The Spanish Covered Bond Market Explained

the assets that are remortgage loans. These assumptions tend to increase our target overcollateralization requirements.
Chart 1

To what extent have issuers of cdulas hipotecarias actively managed overcollateralization levels to maintain ratings?
Spanish mortgage covered bond law requires issuers to maintain 25% overcollateralization. Issuers may also choose to maintain a particular level of overcollateralization in order to sustain the ratings on their programs. The maintenance of these overcollateralization amounts has become more difficult in recent years, as sluggish mortgage originations have shrunk issuers' outstanding loan books. However, since 2009, Spanish issuers have retained a substantial proportion of issuance on their balance sheets, rather than placing it with investors. This has given them flexibility to amortize some of their covered bonds in order to comply with legal or target overcollateralization requirements. Issuers have also more actively managed asset-liability mismatch risk by issuing longer-dated covered bonds. We have observed both activities, which have led to upgrades in a few cases.

How have Spanish covered bond ratings changed over time?

Since 2008, we have lowered our ratings on all of the Spanish covered bond programs that we rate (see chart 2). Lower Spanish sovereign and bank creditworthiness, rising credit risk stemming from macroeconomic deterioration, and

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Credit FAQ: The Spanish Covered Bond Market Explained

changes to our view of Spanish asset refinancing risk, have all reduced Spanish covered bonds' creditworthiness, in our view. We now rate six out of 13 programs at the 'BBB' rating level.
Chart 2

How does Standard & Poor's rate multi-cdulas?

As noted above, multi-cdulas transactions are effectively securitization transactions that repackage underlying covered bonds (either cdulas hipotecarias or cdulas territoriales). As such, we analyze these transactions in a similar way to collateralized debt obligations (CDOs), rather than covered bonds. If a cdulas issuer defaults just before the final maturity date, the rated multi-cdulas bonds would, according to their terms and conditions, typically be subject to an extension of the bond's scheduled maturity. The legal maturity date of multi-cdulas bonds is usually later than the final maturity date on the underlying covered bonds. This allows for a potential delay in receiving principal payment if one of the backing covered bonds defaults. We generally assume that if a backing covered bond defaults, then a full principal recovery would eventually take place after the recovery period of the issuing bank. Therefore, our multi-cdulas rating analysis reflects our view of the likelihood that the available liquidity facility or reserve fund would be sufficient to mitigate potential interest shortfalls during the recovery period, following the default of any covered bond issuer. The recovery periods that we assume are equal or shorter in length than the

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Credit FAQ: The Spanish Covered Bond Market Explained

extension period provided for in the terms and conditions of the bonds.

Will the renewed regulatory focus on asset encumbrance in Spain push up issuance of bonos hipotecarios?
Cdulas hipotecarias have accounted for all mortgage-backed covered bond issuance in Spain so far. We understand that this is partly because some issuers consider that the issuance of bonos hipotecarios entails greater operational and administrative complexity. Investor interest in the product has also traditionally remained low, given the relatively high available overcollateralization for cdulas hipotecarias. However, recent press reports suggest that Spanish issuers could begin to face some regulatory pressure to reduce asset encumbrance levels. In theory, this could lead some lenders to issue bonos hipotecarios, which are collateralized by a specific mortgage pool, rather than the lender's entire mortgage book. That said, we note that available overcollateralization for cdulas hipotecarias programs have fallen in recent years. In many cases, overcollateralization levels are not much higher than target levels, or the legal minimum (see chart 3). This suggests that several issuers may not have much scope to issue bonos hipotecarios, while maintaining the ratings on existing cdula hipotecaria programs.
Chart 3

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Credit FAQ: The Spanish Covered Bond Market Explained

Table 1

Comparison of Spanish Covered Bond Legal Frameworks

Cdulas hipotecarias Ley 2/1981, of March 25, on the regulation of the mortgage market. Governing legislation Legislation in place since 1981 1981 Bonos hipotecarios Same as for cdulas hipotecarias. Cdulas territoriales Ley 44/2002, of Nov. 22, on measures for the reform of the financial system. 2002 Cdulas de internacionalizacin Real Decreto Ley 20/2012, of July 13, on measures to ensure fiscal stability and promote competitiveness. 2012 Bonos de internacionalizacin Ley 14/2013, of Sept. 27, on the support for entrepreneurs and their internationalization.

2013

Supervision Eligible assets

The Bank of Spain is responsible for ensuring regulatory compliance, and for sanctioning breaches. There is no specific cover pool monitor. If the issuer becomes insolvent, the insolvency administrator is responsible for looking after the interests of covered bondholders. There is no separate cover pool administrator.

Same as for cdulas hipotecarias.

Same as for cdulas hipotecarias.

Same as for cdulas hipotecarias.

Same as for cdulas hipotecarias.

First-ranking residential Same as for cdulas mortgage loans with hipotecarias. original LTV ratios up to 80%. The 80% limit is raised to 95% if the loan benefits from a guarantee from a credit entity other than the originator. The term of the loan must be 30 years or less, for loans granted after the enactment of Ley 1/2013 of May 15, 2013. First-ranking commercial mortgage loans with original LTV ratios up to 60%.

Loans to public sector entities in Spain.

Loans linked to the financing of goods and services export contracts, or businesses' international expansion. The loans must satisfy one of the following requirements:

Same as for cdulas de internacionalizacin, with the additional requirement that the loan's risk weighting under the relevant capital regulations for credit institutions must be at most 50%.

Loans to public sector entities elsewhere in the EEA, except for those linked to the financing of goods and services export contracts, or businesses' international expansion.

1. The borrower is an EMU public sector entity, outside Spain.

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Table 1

Comparison of Spanish Covered Bond Legal Frameworks (cont.)

Up to 50% of the original value of the property under construction or land. The total value of these loans cannot exceed 20% of the total eligible portfolio. 2. The borrower is a non-EMU public sector entity, a multilateral development bank, or an international organization, provided that the borrower is of sufficient credit quality to allow the covered bonds to benefit from preferential treatment under the relevant capital regulations for credit institutions. 3. Regardless of the borrower, the loan benefits from a guarantee from a credit export agency, public sector entity, or an entity acting on behalf of a public sector entity. The guarantor must be located in the EMU. 4. Regardless of the borrower, the loan benefits from a guarantee from a non-EMU public sector entity, or from a multilateral development banks or an international organization, provided that the guarantor is of sufficient credit quality to allow the covered bonds to benefit from preferential treatment under the relevant capital regulations for credit institutions. The issuer must maintain a register listing all cover pool loans, and, if applicable, substitute assets and derivatives associated with the covered bonds. The register must identify loans that qualify as "eligible assets". The issuer must publish the "essential data" from the register in its annual accounts. The issuer must maintain a register listing all cover pool loans, and, if applicable, substitute assets and derivatives associated with the covered bonds. The issuer must maintain a register listing all cover pool loans. The issuer must publish the "essential data" from the register in its annual accounts. The issuer must maintain a register listing all cover pool loans, and, if applicable, substitute assets and derivatives associated with the covered bonds. The issuer must publish the "essential data" from the register in its annual accounts. Same as for cdulas de internacionalizacin.

Restructured and nonperforming loans, as well those that are currently due and payable, are not eligible.

Asset register Substitute assets

EMU government Same as for cdulas bonds, and those issued hipotecarias. by the Spanish Official Credit Institute.

None.

EMU government bonds, and EMU-guaranteed bonds quoted on a regulated market.

Same as for cdulas de internacionalizacin.

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Credit FAQ: The Spanish Covered Bond Market Explained

Table 1

Comparison of Spanish Covered Bond Legal Frameworks (cont.)

Cdulas hipotecarias quoted on a regulated market, provided that neither the issuer of the cdulas hipotecarias nor any entity in its group originated any of the underlying loan collateral. Bonos hipotecarios, Spanish securitization transactions, and any other bonds quoted on a regulated market with a credit rating equal to or greater than that of Spain, provided that neither the issuer of the cdulas hipotecarias nor any entity in its group originated any of the underlying loan collateral. Bonds issued by the Spanish Official Credit Institute, provided that the Institute is not the issuer of the cdulas de internacionalizacin.

Cdulas hipotecarias, cdulas territoriales, and cdulas de internacionalizacin quoted on a regulated market, provided that neither the issuer of the cdulas de internacionalizacin nor any entity in its group originated any of the underlying loan collateral.

Bonos hipotecarios, bonos de internacionalizacin, and any other bonds quoted on a regulated market with risk weighting of at most 50% under the relevant capital regulations for credit institutions, provided that neither the issuer of the cdulas de internacionalizacin nor any entity in its group originated any of the underlying loan collateral. Limit of substitute assets (as a proportion of the outstanding covered bond balance) Cover pool All mortgage loans on the issuer's balance sheet not already encumbered (for example, by bonos hipotecarios issuance) A specific pool of mortgage loans. All of the issuer's outstanding loans to public sector entities in Spain. All of the issuer's outstanding export finance loans and those funding international business expansion that satisfy the "Eligible Collateral" criteria, except those collateralizing issuance of bonos de internacionalizacin. A specific pool of export finance loans and loans funding international business expansion. 5% 10% N/A 5% 10%

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Credit FAQ: The Spanish Covered Bond Market Explained

Table 1

Comparison of Spanish Covered Bond Legal Frameworks (cont.)

Substitute assets, if applicable. Substitute assets, if applicable. All of the issuer's outstanding loans to public sector entities elsewhere in the EEA, except for those linked to the financing of goods and services export contracts, or businesses' international expansion. Substitute assets, if applicable. Substitute assets, if applicable.

Cash flows from any derivatives linked to the covered bond issuance. Issuer's balance sheet Cover pool location Legally-mandated OC (Excess of eligible assets over the outstanding covered bond balance) Mandated measures to correct a breach of the legal minimum regulatory OC Within 10 days of an OC breach, must cover the required OC shortfall via a deposit of cash or public funds with the Bank of Spain. The issuer must also take any of the following steps to restore the OC to the regulatory minimum within four months: 25%

Cash flows from any derivatives linked to the covered bond issuance. Same as for cdulas hipotecarias. 2% (based on the present value of the eligible assets) Same as for cdulas hipotecarias. 43%

Cash flows from any derivatives linked to the covered bond issuance. Same as for cdulas hipotecarias. 43%

Cash flows from any derivatives linked to the covered bond issuance. Same as for cdulas hipotecarias. 2% (based on the present value of the eligible assets)

Same as for cdulas hipotecarias.

Following an OC breach, the issuer must cover the required OC shortfall via a deposit of cash or public funds with the Bank of Spain. The issuer must also take either of the following steps to restore the OC to the regulatory minimum within three months:

Following an OC breach, Same as for cdulas de the issuer must cover the internacionalizacin. required OC shortfall via a deposit of cash or public funds with the Bank of Spain. The issuer must also take any of the steps described for cdulas hipotecarias to restore the OC to the regulatory minimum within three months.

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Credit FAQ: The Spanish Covered Bond Market Explained

Table 1

Comparison of Spanish Covered Bond Legal Frameworks (cont.)

1. Acquire in the market (if necessary) and amortize outstanding cdulas hipotecarias (or bonos hipotecarios, cdulas de internacionalizacin, or bonos de internacionalizacin, as applicable). 2. Increase the eligible loan balance. 3. Increase the amount of substitution assets up to the legal maximum. None. The weighted-average maturity of outstanding bonos de internacionalizacin cannot exceed the weighted-average maturity of the loans collateralizing the bonds. None. None. None. 1. Acquire in the market (if necessary) and amortize outstanding cdulas territoriales.

2. Increase the eligible loan balance.

Asset-liability management Regulatory treatment Compliance with UCITS article 52 (4) Compliance with CRR Article 129

Compliance with UCITS article 52 (4) Compliance with CRR Article 129

Compliance with UCITS article 52 (4) Compliance with CRR Article 129

Compliance with UCITS article 52 (4) Compliance with CRR Article 129

Compliance with UCITS article 52 (4) Compliance with CRR Article 129

N/A--Not applicable. OC--Overcollateralization. LTV--Loan-to-value. EEA--European Economic Area. EMU--European Monetary Union. UCITS--The European directive on undertakings for collective investment in transferable securities. CRR--European Capital Requirements Regulation. Source: Standard & Poor's.

Related Criteria And Research

Covered Bond Ratings Are In A State Of Fragile Equilibrium, Oct. 9, 2013 Global Covered Bond Characteristics And Rating Summary Q3 2013, Sept. 11, 2013 (published quarterly) Credit FAQ: The French Covered Bond Market Explained, Sept. 5, 2013 Sovereign and Bank Downgrades Are Weighing On Covered Bond Ratings, July 18, 2013 Categorization For Spanish Covered Bond Programs Revised To Category 2 Following Review, Nov. 29, 2012 Covered Bond Ratings Framework: Methodology And Assumptions, June 26, 2012 Revised Methodology And Assumptions For Assessing Asset-Liability Mismatch Risk In Covered Bonds, Dec. 16, 2009 Spain Embraces Structural Diversity In The Securitization Of Covered Bonds, Dec. 2, 2004
Additional Contacts: Structured Finance Europe; StructuredFinanceEurope@standardandpoors.com

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Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com

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