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Western EuropeApril 2 2006

Portuguese expectations

While some countries are allowing a structured covered bond market to develop, others prefer to enact a covered bond law. Portugal has just passed legislation: will it experience a boom similar to its Iberian neighbour? Michael Marray reports.
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The Portuguese government had hoped to pass its covered bond law in 2005 but a general election intervened, slowing down the legislative process. Not too far behind schedule, however, the law allowing for the issuance of obrigações hipotecárias and obrigações sobre o sector público was passed in late February. All the market needs now is the president’s signature.

“It is a clean and tidy law, and a marked improvement on the early drafts,” says one Portuguese banker, who anticipates the first deals in the third quarter.

The Portuguese authorities have no doubt been casting an eye at the market in neighbouring Spain, where the issuance of cédulas has boomed, giving Spanish banks access to a vast pool of cheap funding. Pricing on Portuguese covered bonds may be even tighter than that for cédulas because, like all issuers of covered bonds from a new jurisdiction, issuers tend to encounter strong demand from investors who are looking for geographical diversity in their portfolios.

“Over the past five years, Spain has had the biggest number of housing starts anywhere in Europe, accompanied by rapidly rising house prices, whereas in Portugal the real estate market has been sluggish – though last year there was reasonably good growth of around 10% on residential mortgage portfolios,” says Arturo Miranda, vice-president at JPMorgan. “We would expect to see around €3bn of residential mortgage-backed securities (RMBS) supply out of Portugal this year, with perhaps another €2bn of covered bonds once the law comes into force,” he says.

Tight pricing

Mr Miranda expects Portuguese covered bond issues to get tight pricing, just as they do in the RMBS market. “Last year, Portuguese RMBS transactions were achieving pricing of 10 basis points (bp) or 11bp on six-year average life triple-A tranches,” he says. “This is close to the pricing on UK transactions, which is the tightest in the European RMBS market, so Portuguese issuers are clearly getting the benefit of the relative scarcity of paper out of Portugal.”

The main issuers of both public sector and mortgage covered bonds out of Portugal are likely to be the same institutions that have already made a name for themselves in the European RMBS market. Last year, there were four deals: from Banco Espírito Santo, Banco BPI, Banco Comercial Português (BCP) and Banco Totta, which is part of the Santander Group.

Wait-and-see game

There was a notable slowdown in terms of both transaction numbers and volume of risk transferred versus 2004, however, and the first RMBS deal did not appear until July. This suggests that issuers were playing a wait-and-see game, anticipating a quick passage of the covered bond law, but then pressed ahead with deals when they saw that it was being delayed.

Significantly, there was no RMBS issuance last year from state-owned Caixa Geral de Depósitos (CGD), which did its debut RMBS offering in 2003 with Nostrum Mortgages. CGD has the best credit rating of any Portuguese bank, an Aa3 rating from Moody’s.

“Espírito Santo and BCP were waiting but then came to the RMBS market,” says a Lisbon-based banker. “The institution that everyone sees as the prime issuer of covered bonds is Caixa Geral de Depósitos, which has been the strongest backer for the new legislation and which is likely to be the first issuer of covered bonds out of Portugal.

“The rest are saying: when the legislation comes we will calculate the pros and cons of going the covered bond route,” he adds. “But RMBS spreads have compressed so much that they are a very attractive source of funding, and potential covered bond issuers will have to look at the rating they can achieve. I am not sure that all originators can reach triple-A status under a covered bond and, if they don’t, then you have to see what is the pricing of one versus the other. But covered bonds will have a less costly structuring process and will be easier to issue.”

Rating agency approach

The way in which the rating agencies approach covered bonds is rapidly evolving and varies from one agency to another. For example, last year Moody’s introduced its new ‘expected loss’ covered bond rating process, known as the Moody’s EL Model. It employs a so-called joint default approach, which takes into account both the credit strength of the issuer and the value of the cover pool.

It is unclear which Portuguese covered bond issuers will be able to achieve triple-A ratings. This may vary from one agency to another, which may mean that issuers shop around for the approach that suits them best.

“As most Portuguese banks have senior unsecured ratings in the single-A area, they may not be able to reach triple-A for their covered bond issues, especially if they include Standard & Poor’s, which tends to rate these banks a notch or two below the other agencies,” notes Alberto Basu, director at ABN AMRO.

“However, they may still find it worthwhile to issue double-A rated covered bonds, given the fact that credit tiering is so narrow in today’s market,” Mr Basu says. “Alternatively, it may be possible to structurally enhance the transactions to bring their covered bonds up to triple-A.”

Analysts note that the days when there was a clear distinction between issues under covered bond laws and structured offerings are ending, and that the lines are becoming blurred as structural features are added.

Volume growth

With the first covered bond deals expected to be launched within the next six months, it will be interesting to see how RMBS volume is affected. Bankers note that covered bonds and RMBS generally grow alongside one another.

According to Moody’s, in Spain there were 26 RMBS transactions amounting to €27.6bn last year, an increase of 42% over 2004 issuance. At the same time, the volume of cédulas also grew by 42% to €54bn.

“Both markets have been growing rapidly alongside one another in Spain,” notes José de León, an analyst at Moody’s Investors Service in Madrid. “It illustrates the fact that RMBS and covered bonds are complementary funding tools, with different investor bases.”

With a population of 10.5 million versus 40 million in Spain, the arrival of covered bonds from Portugal is not going to make the same market impact as cédulas have done. Nonetheless, covered bond investors are looking forward to being able to add Portuguese covered bond products to their portfolios.

SELECTED MOODY’S CREDIT RATINGS OF PORTUGUESE BANKS:

Republic of Portugal: Aaa

Caixa Geral de Depósitos: Aa3

Banco Comercial Português: A1

Banco Espírito Santo: A1

Banco Totta: A1

Banco BPI: A2

Source: Moody’s Investors Service

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