Spanish Mortgage Finance Crisis Case Study University of Pennsylvania / Wharton School

1. Spanish MortgageFinance Crisis Case Study University of Pennsylvania / Wharton School Philadelphia/Berlin, June 4, 2013 Hans-Joachim Dübel 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 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’. Source: Finpolconsult, central banks., SIFMA

5. Channels of Liquidity CreationRole 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 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 CedulasHypotecarias from savings banks as collateral for the issuance of joint Cedulas. Performance • AyTjumpstarted 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: AyTdid not underwrite Cajas, these were entitled to issue through the entity, • Cajaswere 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 Overcollateralization (OC) Levels Overcollateralization in Spanish Cedulas 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, • Impliesthat 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. 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 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. 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 < 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 > 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. For sources, see Report text.

15. The Collapse The Reality: The Portfolio Is Kept Afloat by the ECB 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. 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.

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.