European Banks Bolster Capital With Shunned Bonds: Mortgages

European Banks Bolster Capital With Shunned Bonds
A pedestrian crosses the road against the backdrop of residential apartments in Madrid. Photographer Denis Doyle/Bloomberg

Spanish and Portuguese banks are leading European lenders in buying back their own mortgage-backed securities at distressed prices to bolster capital and stockpile eligible collateral for European Central Bank loans.

Banco Bilbao Vizcaya Argentaria SA, Banco Comercial Portugues SA and other lenders this year repurchased 6.6 billion euros ($8.4 billion) of asset-backed bonds they issued, more than double the level for all of 2011, according to data compiled by Deutsche Bank AG. Banks buy the debt, packages of loans in which they kept subordinated portions, for less than face value, and book a capital gain similar to the discount.

The purchases follow European Banking Authority demands that banks raise 114.7 billion euros by last week after the sharp fall in the value of bonds issued by governments in the 17-member shared currency. The deals are poised to accelerate after the ECB last month reduced the minimum ratings it will accept for mortgage securities offered as collateral for cheap loans, adding incentive to lenders to buy back debt and pledge it with the Frankfurt-based institution.

“Compliance with the EBA rules has been the main reason of all buybacks we are seeing so far, but there will be more deals since the ECB will take more of that paper,” said Frank Erik Meijer, head of asset-backed securities at The Hague-based Aegon Asset Management, which oversees 220 billion euros of assets. “Lenders with little or no other sources to raise capital and funding can turn to this strategy.”

Northern Rock

The bigger the discount the mortgage debt is trading at the larger the incentive for banks to repurchase their own deals because that translates into greater capital gains.

U.K. lender Northern Rock Asset Management Plc last month offered to buy back bonds issued under its Granite program as some were trading at 58 percent of face value. They’ve risen to 69 percent of face value after the Newcastle-based lender bailed out by the U.K government said it would offer 64 percent to 77 percent of par.

Incentives are greatest for Spanish and Portuguese lenders, where yields over benchmark rates for mortgage-backed securities are as much as 17 times higher than comparable notes pooling home loans in the U.K. Eleven Spanish banks and four Portuguese lenders have put out tenders to repurchase some of their securitizations, according to Barclays Plc data.

Few Alternatives

European lenders have few alternatives to raise capital as demand for shares of financial companies has plummeted amid the crisis over the common currency.

Sales of stock from European financial institutions fell 71 percent to 2.7 billion euros, data compiled by Bloomberg show, as Europe’s sovereign debt crisis has spread from Greece to Spain, roiling credit and equity markets. The Bloomberg Europe Banks and Financial Services Index rose 1.7 percent at 12 p.m. in London. It’s declined more than 28 percent in the last year.

Shares have fallen even as the European Central Bank pumped 1 trillion euros of three-year loans, known as the LTRO program, into the system since December, making it easier for them to fund such transactions. ECB provides the secured loans at a rate of 1 percent.

“LTRO money has made it easier for banks, especially from peripheral countries, to use funding to raise capital at a moment when other possibilities such as sale of stock or asset sales are virtually closed,” said Conor O’Toole, the London-based asset-backed securities analyst at Deutsche Bank. “Even as buybacks are at record levels so far this year, we expect a second round of tenders.”

Rating Changes

Last month, the ECB, which demands residential mortgage-backed securities to be graded by at least two credit rating companies, said it will allow a second ranking as low as the least investment grade, six steps below the prior requirement. The central bank also widened the range of asset-backed securities it accepts as collateral.

Banks can pledge between 40 and 50 billion euros of bonds, which were not eligible due to rating cuts, said Bank of America Merrill Lynch analysts including Alexander Batchvarov.

Securitizations pool assets ranging from corporate loans to mortgages and slice them into securities of varying risk. The transactions remain on the originator’s balance sheet when it retains the riskiest slices.

Bilbao, Spain-based BBVA bought back 638.2 million euros of bonds backed by mortgages, consumer and company loans in a deal allowing it to record a 250 million euro capital gain, according to a June 28 regulatory filing. Banco Comercial Portugues offered to buy back as much as 300 million euros of bonds it issued between 2003 and 2007 mostly under its Magellan program backed by residential mortgages.

Bond Spreads

Investors demand 1025 basis points, or 10.25 percentage points, more than interbank rates to hold a senior five-year bond backed by Portuguese home loans, according to JPMorgan Chase & Co. data. That exceeds the 10 percent level considered distressed. The spread for Spanish residential mortgages is 615 basis points compared with 150 for Dutch mortgage backed securities and 132 for British transactions.

House prices in Spain and Portugal are declining at the fastest pace on record as borrowers face increasing unemployment rates and lenders are contracting the financing available to potential home buyers. Spanish home prices declined 12.6 percent in the last year through March, the biggest fall since 2008, and Portugal’s retreated 8.9 percent in the last 12 months as of May, the biggest declined since 2009, according to governments’ figures.

Worst Scenario

Spain’s banks would need as much as 62 billion euros in capital to withstand a worst-case economic scenario, according to two consulting firms hired by the government to conduct stress tests on the lenders. Portugal’s Finance Ministry also said last month that the state planned to inject more than 6.6 billion euros in Banco Comercial Portugues, Banco BPI SA and Caixa Geral de Depositos SA to help the lenders meet capital requirements.

Spain, which is negotiating conditions to use a 100 billion euro rescue package for its financial sector, won agreement from its euro-area partners to open the way to recapitalizing lenders directly with bailout funds once Europe sets up a single banking supervisor. Portugal’s lenders can use a 12 billion-euro recapitalization facility that’s part of the financial assistance program agreed with the EU and the International Monetary Fund.

“The tender offers have been dominated by Spanish and Portuguese banks due to the concerns over their banking system and necessity to improve their core tier 1 ratios, ” said Dipesh Mehta, a London-based securitization analyst at Barclays. “As their bonds trade at significantly bigger discount than ABS bonds from the U.K. or Netherlands, the potential gains are bigger.”

Italian Lenders

Italian and Irish lenders also may opt to tender for mortgage-backed securities. Investors demand 500 basis points spread to hold a senior bond packaging Italian lenders, and 925 basis points to buy Irish securities.

Irish Central Bank Deputy Governor Matthew Elderfield said the country’s banks may need to raise up to 4 billion euros in additional capital in the next six years, Germany’s Boersen-Zeitung reported May 30 citing an interview.

Banks are accelerating repurchases of mortgage-backed securities at a time the deals credit quality is deteriorating. Standard & Poor’s cut 382 portions of European prime residential mortgage-backed securities in the first quarter compared with 68 in the fourth quarter last year, and 65 a year earlier, according to Association for Financial Markets in Europe data.

Sovereign Cuts

About 75 percent of downgrades of European residential mortgage-backed securities in the first quarter were related with a credit rating cut of the country where the pooled assets are located, New York-based S&P said in a June 18 report. Underperformance of the underlying collateral accounted by 15 percent of the ratings downgrades in the period.

“Buybacks will most likely continue especially from peripheral countries where the big discounts of the existing paper make the deal attractive for the banks,” said Dalibor Jarnevic, a Frankfurt-based asset-backed securities trader at DZ Bank AG. “Apart from Spain and Portugal, where we had seen a lot of activity already, we may also expect tenders coming from Italy and maybe from Ireland.”

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