When S&P Global Ratings reviews the covered bond legal framework of a given jurisdiction under our covered bonds criteria, we focus primarily on the degree to which the cover pool assets are isolated from the risk of insolvency of the issuer for the benefit of the covered bondholders, and whether the insolvency is likely to impede full and timely payments on the covered bonds. If we conclude in our analysis that the covered bonds are unlikely to be affected by the insolvency of the issuer, then we may assign a rating to the covered bonds higher than the rating on the issuer. Specifically, our legal review focuses on five key aspects. Below we set out our understanding of how the Spanish Royal Decree Law as amended by Royal Decree Law 11 2022 (the "Decree Law") may address these five aspects.

Overview Of The Decree Law

On June 28, 2023, the Spanish government published Real Decreto Ley (RDL 5/2023), amending as well as supplementing certain aspects of the Nov. 3, 2021, and June 25, 2022 Royal Decree Laws and providing background explanations on why these amendments were considered necessary. This is the second update to the Spanish covered bond framework, the first one being in June 2022. The update from 2022 looked to also transpose into Spanish law the substitution assets regime contemplated in the EU Directive 2019/2162 on the issuance of covered bonds and covered bond public supervision (the Covered Bond Directive). The main changes introduced in June 2022 related to the requirements for and limits on property valuations for loans to be added and maintained in the cover pool, the clarification that only entities with a Spanish credit institution license can issue covered bonds, and a clarification on substitute assets for other guaranteed loans. The changes introduced in June 2023 include the possibility for issuers to actively manage the available overcollateralization (OC--subject to pre-approval from the cover pool monitor), clarification that the administrator's right to accelerate covered bonds upon issuer insolvency applies only if the value of cover pool assets is less than the value of the covered bonds, and the allowance of property valuation reassessments to be performed using automated valuation methods.

The Decree Law, as amended, came into force on July 8, 2022, and replaced existing Spanish covered bond laws. Since implemented, issuers had to amend existing covered bond programs to comply with the Decree Law. These amendments did not give rise to an early redemption right for existing covered bondholders.

General Provisions And Legal Structure

The Decree Law defines the cover pool (conjunto de cobertura) as a specific pool of assets that guarantee payment obligations linked to a covered bond program, and that are registered and segregated from other assets in the issuer's balance sheet. This differs significantly from the situation until now of outstanding cédulas hipotecarias bonds (CHs; or mortgage covered bonds) and cédulas territoriales (CTs; or public sector covered bonds), which were backed by the issuer's entire nonsecuritized mortgage and public sector loan books, respectively, and which, until July 8, 2022, benefited from substantially higher levels of credit enhancement than the Decree Law requires.

Cover Pool

Covered bond programs must be backed by a cover pool comprising primary assets, liquid assets, and if applicable, derivative instruments and substitution assets, all as defined in the Decree Law. These assets will have the sole purpose of guaranteeing the issuer's payment obligations to the covered bondholders and to the counterparties of the derivatives registered in the cover pool's asset register. Issuers must have policies and procedures in place to ensure that the assets in the cover pool are diverse, in terms of structure, duration, and risk profile.

Segregation is achieved through the inclusion of the assets in the cover pool special register (the register), which ringfences the cover pool backing the covered bonds, and legally isolates it from the issuer's general creditors.

Each covered bond issuer must appoint a cover pool monitor (órgano de control), that must be approved by Bank of Spain, to ensure the covered bond program complies with the requirements of the Decree Law. Should the issuer be subject to resolution or insolvency, the cover pool monitor must certify the existence of cover pool assets in the register, which are then legally transferred to a separate estate managed by a special independent cover pool administrator appointed by the insolvency judge or Spain's Fund For Orderly Bank Restructuring (FROB) and agreed with the Bank of Spain for the benefit of the covered creditors. The Bank of Spain approves and supervises each covered bond program on an ongoing basis.

Asset Valuation And Loan-To-Value (LTV) Ratio Limits

Each asset guaranteeing the loan in the cover pool must be valued at the time it is registered in the cover pool (or be verified that there is no deterioration in its value since the date of the most recent valuation). Valuations can never exceed the original valuation and must be updated at least annually following the criteria of Bank of Spain Circular number 4/2017 of 27 November. Once mortgage assets are included in the cover pool, the issuer should verify, at least annually, if the value of the asset deteriorates significantly. This can be done either internally or externally and using automated valuation methods. However, if significant deterioration is proven, then the asset valuation must be updated through a report by an external expert.

LTV limits

Mortgage loans, when registered in the cover pool, cannot exceed 60% of the value of the underlying commercial property and 80% of the value if the underlying property is residential. If a loan in the pool subsequently becomes ineligible (due to a devaluation in the underlying property, for example), it can remain in the cover pool, but only the part of the loan up to the respective limit can be used to calculate OC.

Overcollateralization requirements

The cover pool must have at least the minimum OC required in the Decree Law for each type of covered bond--for example, 5% for CHs compared with the 25% OC required for the eligible mortgage book under the prior law.

The June 2023 amendments to the Decree Law include in article 10 bis that the issuer can add additional voluntary OC to the program. The cover pool monitor must approve any removal of voluntary OC, as required in article 30, provided minimum OC or contractual OC levels, as defined in this RDL, are not breached.

The Decree Law does not detail the consequences of the pool falling below the minimum OC levels, other than considering it to be a serious infringement. Under the prior law however, there were remedies available if OC levels were breached.

Liquidity requirements

The cover pool must also include a liquidity buffer comprising specific high-quality liquid assets available to meet net cash outflows on the covered bond program for the succeeding 180 days, which could be positive for our cash flow analysis.

Amendments from June 2023 include a new paragraph under article 44 that states that during the separate estate's existence, the estate will not have to comply with liquidity requirements, the OC requirement described in article 10 bis, nor other requirements related to the credit quality of the assets, such as granularity and diversification and size.

Maturity extensions

The Decree Law permits, but does not require, covered bonds to have maturity extensions under prescribed conditions, including approval from the Bank of Spain. The Decree Law does not specify the maximum extension period and whether issuers will need an additional license to issue these soft-bullet bonds. To ensure later maturing covered bonds are not redeemed earlier than extended covered bonds, the Decree Law provides that any extension cannot affect the original maturity dates of outstanding covered bonds nor their priority ranking. It is not clear to us whether this restriction applies only to outstanding soft-bullet covered bonds, or also to hard-bullet bonds without a maturity extension.

Five Key Factors In Our Assessment

As mentioned above, our legal analysis of covered bonds focuses on five key aspects: (i) the segregation of the cover pool assets and cash flows; (ii) the risk of acceleration of payments to bondholders, payment moratorium, or forced restructuring of the covered bonds; (iii) OC limits; (iv) the treatment of hedging arrangements; and (v) access to funding after the issuer's insolvency.

Segregation of the cover pool assets and cash flows

In assessing this factor, we examine whether the cover pool assets are fully available to meet the obligations under the covered bonds.

As set out in the Decree Law, the issuer must register the cover pool assets in the cover pool special register (the register). After the issuer's insolvency, the assets in the register will be materially segregated from the issuer's insolvency estate and available in full to meet the issuer's obligations to covered creditors.

If the cover pool is insufficient to fully satisfy those obligations, covered creditors will rank pari passu with the issuer's ordinary, unsecured, and unguaranteed obligations.

Once covered creditors are fully paid, any excess cover pool assets registered in the cover pool will become assets of the insolvency estate.

There is no cross collateralization among cover pools. If one pool has excess assets, and another pool is deficient, covered creditors of the deficient pool do not have a privileged claim on the pool with excess assets. Each of an issuer's covered bond program is individually ringfenced and valued.

Third-party execution risk.  As part of our asset isolation analysis, we also examine the extent to which any issuer's third-party creditors might be able to enforce claims against the cover pool assets. If an issuer becomes insolvent, registered assets will be segregated from the assets of the issuer bank and managed by the special cover bond administrator. Those assets will not form part of the issuer's insolvency estate until covered creditors are fully paid. These assets are protected against rights of third parties and can only be clawed back into the issuer's insolvency estate if the insolvency officer can prove fraud.

Commingling risk.   Our analysis of segregation also considers commingling risk, which is the risk that collections received from the cover pool assets prior to or following the issuer's insolvency could be used in the issuer's general banking business or fall into the issuer's general insolvency estate and therefore be lost or temporarily unavailable to make full and timely payments on the covered bonds.

The Decree Law provides that covered bonds are guaranteed by all the registered assets that form part of the cover pool without the need for any other formality. The guarantee includes all registered assets, including current and future flows of income from those assets identified in the register. Covered bondholders will be preferred creditors as defined in the Spanish Civil Code and if the issuer becomes insolvent, they would have a special privilege as defined in Spanish insolvency law. In our view, upon insolvency and material segregation of the cover pool, all proceeds of registered assets will only be available to pay covered creditors.

However, because we do not believe a statutory pledge over the proceeds of the cover pool assets held as cash can effectively mitigate bank account risk, we could stress in our cash flow analysis that some collections are lost, unless the collection account to be held is with a suitably rated bank, in accordance with our counterparty criteria (see "Counterparty Risk Framework: Methodology And Assumptions," published on March 8, 2019).

Setoff risk.  In our analysis, we also consider setoff risk, or the risk that borrowers may be entitled to deduct amounts owed to them by the issuer (for example, amounts on deposit) against their repayment obligations under the loans in the register, thereby reducing the amount available to pay covered creditors. The Decree Law does not address set off directly. However, we understand that borrowers are unlikely to meet the legal requirements for set off contained in the Spanish Civil Code, and therefore setoff risk is likely limited.

Risk of asset removal following the issuer's bankruptcy.  Finally, we also consider the risk that an asset that no longer satisfies the eligibility criteria is removed from the cover register to the detriment of covered creditors following the issuer's insolvency when the issuer is no longer able to replace it.

The Decree Law places no obligation on the special cover pool administrator appointed after the issuer's insolvency proceedings to remove cover pool assets that fail to meet the eligibility criteria. We understand that if an asset ceases to satisfy the required eligibility criteria following an insolvency of the issuer, it cannot simply be removed from the cover register. The Decree Law grants broad powers to the cover pool administrator to manage and dispose of the registered assets to protect the rights and interest of the covered creditors until all liabilities are fully paid in accordance with their terms. These Powers include using cover pool assets' cash flows or the liquidity reserve to pay covered creditors; obtaining third-party financing (excluding retail deposits) and pledging assets in the pool to secure those financings; disposing of covered assets; and calling for the maturity of covered bonds to be extended.

Risk of acceleration of payments, payment moratorium, or forced restructuring of the covered bonds

Acceleration of payments.  We assess the risk that an insolvency of the issuer could result in an automatic acceleration of the covered bonds and liquidation and distribution of the covered assets on a pro rata basis to covered creditors.

The Decree Law explicitly provides that issuer resolution or insolvency will not:

• Trigger the automatic early termination of the covered bonds or the payment obligations related to them;
• Empower the covered bondholders to request an early redemption of the covered bonds;
• Suspend the accrual of interest on the covered bonds; or
• Trigger the maturity or early termination of derivative contracts in the pool.

The June 2023 amendments to the Decree Law clarify in article 44 that if after the transfer of the pool to the special estate following the issuer's insolvency, the assets' total value is lower than the liabilities' total value, the special administrator will--subject to approval of a simple majority of covered bondholders--accelerate the maturity of the covered bonds, liquidate the cover pool assets, and distribute the proceeds pro rata to covered creditors.

Moratorium.  Any moratorium imposed on the issuer's insolvency estate will not affect the separate estate.

Forced restructuring.  The Decree Law does not contemplate a forced restructuring of the covered bonds in the event of issuer insolvency. Issuer insolvency will not trigger an early redemption of the covered bonds, nor will it disrupt any payment obligations under the covered bonds. Registered covered assets are protected against the rights of third parties and cannot be clawed back into the issuer's insolvency estate unless the insolvency officer can prove fraud. In addition, if the pool is liquidated (which can only occur if the value of assets [including the required OC and liquidity buffer] is lower than liabilities and a simple majority of covered bondholders approve), the Decree Law provides that after deducting related costs and expenses, liquidation proceeds will then be paid to the bondholders and derivative counterparties, in proportion to their claims.

OC limits

The Decree Law introduces minimum OC requirements. Under our covered bonds criteria, additional OC above those requirements may be needed to achieve a given rating level. Under the Decree Law, the issuer may provide for higher OC exceeding the statutory minimum in the form of eligible cover pool assets. The Decree Law implicitly confirms that any overcollateralization in place at the time of the issuer's insolvency cannot be released to the general insolvency estate by the issuer's insolvency officer until the relevant issue is fully amortized.

The assets in the cover pool can only be clawed back or challenged in specific circumstances. The insolvency officer would have to prove fraud in the constitution of the mortgage, corresponding agreements, or in the incorporation of the assets into the special register. Third parties' good faith rights in the portfolio are in any event protected.

Under the Decree Law, secured loans in arrears for more than 90 days can be used to calculate the level of minimum OC required. Due to uncertainty regarding their future performance, we stress loans in arrears for more than 30 days, assigning them a higher default probability.

Treatment of hedging arrangements

Derivatives may be included in the covered pool provided they hedge risks associated with the cover pool assets or covered bonds and provided the relevant derivative documentation does not allow for early termination upon an issuer insolvency. As per the Decree Law, derivatives that are registered form part of the separate legal estate and are available only to satisfy payments to covered bondholders and derivative counterparties (which rank pari passu between themselves).

The Decree Law does not specify the priority of termination payments that may be owed to the derivative counterparty in the event of its insolvency. Accordingly, we will consider those payments to be senior in the waterfall of payments in our analysis.

Access to funding after the issuer's bankruptcy

In our analysis, we aim to understand the options available to the cover pool administrator to raise liquidity to address maturity mismatches between the cover pool assets and the covered bonds. This is to facilitate continued full and timely payment on the covered bonds on their scheduled payment dates. These options can include the ability to incur new debt using the cover pool as security in the lender's favor, the sale of cover pool assets as needed, and the entry into repurchase agreements.

Under the Decree Law, the special administrator is responsible for and has broad authority to manage the cover pool assets for the benefit of the covered creditors. This includes disposing of assets and using the proceeds to pay redeeming covered bonds, incurring third-party financing, and pledging assets of the cover pool to secure those financings. Subject to Bank of Spain approval, it can also transfer all or part of the cover pool to another covered bond issuer.

How The Decree Law Will Ultimately Affect Ratings

The Decree Law simplifies the Spanish covered bond legal framework: All covered bonds, new and outstanding, are governed by it. In our view, it enhances transparency and supervision and aligns the Spanish Covered Bond framework to other European frameworks. The June 2023 amendments have been included to clarify certain provisions of the Decree Law, which still supports our view of a very strong legal covered bond framework in Spain. Since the implementation of the Decree Law, all the Spanish covered bond programs we rate have been amended to comply with it. We have reviewed the amended programs and affirmed our ratings on all Spanish covered bond programs, as each issuer has maintained the level of OC commensurate with each rating level as outlined in our criteria.

Related Criteria

• Counterparty Risk Framework: Methodology And Assumptions, March 8, 2019
• Covered Bond Ratings Framework: Methodology And Assumptions, June 30, 2015
• Covered Bonds Criteria, Dec. 9, 2014

Related Research

• Global Covered Bond Insights Q3 2023: Strong Issuance Is Here To Stay, June 29, 2023
• Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain, June 26, 2023
• Spanish Covered Bond Market Insights 2023, June 14, 2023
• Covered Bonds Could Ease The Pain In European Commercial Real Estate, May 16, 2023
• Covered Bonds Outlook 2023: Sailing Through Choppy Waters, Dec. 6, 2022