There may well be a new type of security on the Australian bond markets once the next phase of the economic recovery takes hold: covered bonds. These are essentially securitised mortgages that stay on a lender’s balance sheet, so if things go pear shaped, the investors in these bonds have a much more secure asset to back their investment.
It’s therefore not unusual for a tranche of covered bonds to be given a higher rating than the financial organisation issuing the paper.
While covered bonds have been popular in Europe for centuries, and are attracting attention in North America – even New Zealand is looking hard – they are not permitted in Australia. But this is by regulation, not legislation.
A year and a half ago, covered bonds were promoted as one way in which mortgage originators, especially those outside the Big Four banks, could access capital markets. Charles Littrell, executive general manager of the Australian Prudential Regulatory Authority was not impressed, noting that "covered bonds are not considered to be consistent with depositor preference provisions set out in the Banking Act and hence are prohibited."
In other words, the primary consideration is that the rights of depositors to have first go at any assets of the financial institution must not be eroded.
That was in April 2008. Fast forward half a year, and Australia’s savers have their deposits guaranteed by the federal government. And also in the background is a directive from the G20, to which Australia is a paid-up member, to find ways to increase liquidity of banks.
Add to the mix APRA’s ADI Prudential Standard APS 210, which is a directive to banks to hold higher levels of government or sovereign debt and it’s very much a case of be careful what you wish for.
And Australia’s highly rated – and already highly regulated – banks are not happy. For instance, when ANZ raised $1.25 billion in 5-year non-government guaranteed debt a month ago, Rick Moscati, the bank’s group treasurer, made the point that uncertainty caused by APRA's APS210 discussion paper on liquidity was already causing him headaches. In particular, there was limited interest from other bank’s treasuries due to uncertainty over whether they can hold each others’ paper and still meet liquidity requirements.
"ANZ's view is that highly rated bank paper will continue to play an important role in liquidity management as it would be impossible for Australian banks to satisfy their liquidity requirements simply via [Commonwealth Government securities],” Mr Moscati said at the time.
So it is that a working group from the Australian Securitisation Forum, the peak industry body, has decided now is the time, with the chopping and changing of rules on the banks’ capital requirements, to revive interest in covered bonds. The ASF is, however, adopting a variation on its previous approach, using the changing regulatory environment to sell its message.
"The working group is going to be concentrating on the potential benefits to the banks of covered bonds in meeting the desire of APRA and others to reduce their reliance on short-term funding – rather than going to the sources such as the US [private placement] market,” says Chris Dalton, the ASF’s chief executive officer.
Conditions may be on their side this time. There is a limited supply of suitably rated bonds, and with the improving economy, the chance that forecast issuance will in fact be lower in coming years – leading to a degree of tension between the banks and APRA over liquidity.
And so, as Dalton notes, a new type of highly rated security would be useful here. "We’re sticking with our position that a legislative framework is needed to provide all parties with the greatest certainty and provide greatest protection for deposit holders,” he says.
While deposit-holder protection has been, and is likely to remain a major sticking point, the ASF sees the eventual lifting of current government guarantees on retail deposits as offering a glimmer of hope. "In winding that back, there is the chance to introduce a clear legislative framework of deposit holder protection, and covered bonds can be looked at in this context."
Outside the ASF, there is a feeling things might change this time. Alex Mufford, a partner at mid-tier law firm Henry Davis Yorke, is building expertise in anticipation of a change in regulations. He reckons that "sure as eggs” Australian covered bonds will be permitted at some point in the future. "APRA has rejected covered bonds for very good depositor protection reasons, and that’s why the ASF is suggesting legislative change,” he says.
Some institutional investors are also becoming used to having a very highly-rated class of securities to park their money, although Dalton disagrees with any suggestion that covered bonds will be direct replacements for government-guaranteed bonds – when the day eventually arrives for the protection to be lifted.
"I don’t think covered bonds should be seen in exactly the same light [as AAA-rated government guaranteed bonds] but they generally achieve a rating above that of the issuing bank, and there is a quite deep global market when it comes to investing in covered bonds. It is a way in which the Australian market can step away from the government guarantee.”
Dalton also points out that there is a definite funding advantage for banks, too. "We saw Westpac go to the US bond markets this week and raise $US3 billion in 3-year notes at 19 basis points over US Libor. German banks are issuing 5-year covered bonds at a single figure margin over Libor – these are big benefits: longer dated debt at a cheaper rate," Dalton says.
"I see covered bonds as a real tool for smaller banks and ADIs to get back on a competitive footing with the larger banks – as a source of funding it’s better than what they can do without access to the extra security,” says HDY’s Alex Mufford. "While it won’t be as good a deal for these smaller banks as what the big banks will get, the gap is narrower.”