The role of covered bonds in explaining house price dynamics in Spain

This paper tries to explain different nature of the dynamics during the upward and downward part of the last house price cycle in Spain. Covered bonds are introduced as an instrument which may accelerate a house price boom, while it may also serve as a source of correction to overvalued house prices in downturn, where important rigidities may be present In a serious economic stress, lack of investment opportunities motivates investors to buy covered bonds due to the strong guarantees provided, which may in turn help to revitalize the credit and housing markets. To address such regime shift, house price dynamics is modelled within a framework of mutually related house price, credit and business cycles using smooth transition vector autoregressive model, in which volume of covered bonds issued is included. Linear behaviour of such system is rejected, indicating the need to model house prices in a nonlinear framework. Also, importance of modelling house prices in the context of credit and business cycles is confirmed and causality from issuance of covered bonds to house price dynamics is found in this nonlinear structure. Finally, potential threat to financial stability resulting from rising asset encumbrance both in the upward and downward part of the house price cycle is identified. It is suggested that the collateral valuation used for the dynamic adjustment of the cover pool is done using forward looking predictions of house prices and that the rate of asset encumbrance is monitored jointly with stress testing the house prices.