May 16 (Bloomberg) -- Spanish mortgage defaults are triggering losses for holders of AAA rated bonds sold by Banco Santander SA, the country's largest lender.

Investors in the highest grade portions of 2.8 billion euros ($4.33 billion) of bonds issued by Santander last year will have to wait about 8 years for the debt to mature, rather than little over a year when the notes were issued, Santander said in a report to investors this month. The maturity was extended because of rules designed to protect the holders against default.

Spanish mortgage arrears are at the highest in at least six years after the biggest monthly jump in the jobless rate since the 1993 recession to 9.6 percent.

``We may see more of these situations if arrears keep rising,'' said Markus Herrmann, an asset-backed debt analyst at HSBC Holdings Plc in London. ``There are other Spanish deals out there with similar structures.''

Banks create mortgage-backed bonds by packaging home loans into securities of varying credit ratings and returns. The highest ranking notes pay the lowest yields because they are last to absorb losses.

Losses are starting to mount after Spanish homeowners fell into arrears on 2.7 percent of the mortgages included in Standard & Poor's RMBS Delinquency Index in the quarter ended Dec. 31. That's up from 2.23 percent in the third quarter and almost four times the rate in 2002 when S&P started compiling the data, the ratings company said in March.

Demand Slumps

The defaults caused demand for Spanish mortgage-backed bonds with the highest credit ratings to slump, increasing yields to about 195 basis points over benchmark rates from 20 basis points in July 2007, according to data compiled by UniCredit SpA.

The mortgages included in the Santander Hipotecario 3 bonds are riskier because the amount borrowed is close to the value of the property with the average loan-to-value ratio at 88 percent, according to data in a report to investors this month.

Investors stand to lose money as the maturity is extended because they are locked into a lower interest rate for longer, preventing them from reinvesting at better rates elsewhere.

The price of the 422 million euros of Santander's AAA bonds may drop to below 85 cents on the euro from around the ``high 90s,'' according to Rob Ford, a portfolio manager at Synapse Investment Management in London.

``For the guy who bought what he thought was a one-year bond, it's all of a sudden looking very, very horrible,'' said Ford, a former head of asset-backed debt trading at Barclays Capital. He doesn't own the bonds.

A spokesman for Santander in Madrid declined to comment.

Rule Breach

The Santander, Spain-based bank's deal included three senior AAA rated notes called A1, A2 and A3 that were designed to be repaid one after the other, starting with A1. When borrowers fell behind on more than 1.5 percent of the loans included in the bond, rules were triggered requiring all senior bonds to be repaid equally.

The clause increased the average life of the A1 portion to 8.3 years from 1.3 years. Investors will still receive the same annual interest of 6 basis points more than the Euro interbank offered rate. A basis point is 0.01 percentage point.

`Similar Triggers'

Holders of the 1.54 billion euros of A2 bonds will be repaid after 8.2 years rather than 7.3 years, Santander said in its investor report. The notes pay annual interest at 14 basis points over Euribor.

The maturity of the 411 million euros of A3 bonds was shortened to 8.4 years from 17.4 years. The interest is 20 basis points over benchmark rates, according to data compiled by Bloomberg.

``I'm not aware of any other transaction in Spain facing similar triggers yet,'' said Santiago Rubio, who helps manage 13 billion euros as head of fixed income at La Caixa's asset management unit in Madrid.

The payment delay won't cause the deal to be downgraded, said Rui Pereira, head of Fitch's structured finance unit in Madrid.

Standard & Poor's said this week it may downgrade 74 million euros of notes in a 1.9 billion-euro consumer loan- backed transaction sold by Santander.

Spain's 10-year property boom is coming to an end and faces a potential ``hard landing'' which may hurt the country's lenders, Moody's said in a report last month. The ratings company has a negative outlook on the nation's banks.

To contact the reporters on this story: Neil Unmack in London at nunmack@bloomberg.net; Esteban Duarte in Madrid at eduarterubia@bloomberg.net

Last Updated: May 16, 2008 11:19 EDT