Sunday, December 12, 2010

My Name is Bond. Covered Bond.

So, Wayne Swan's blueprint for "A Competitive and Sustainable Banking System" is out.  There is much to discuss in the plan -- which I regard as mostly a misguided distraction from the real issues -- but today I would like to focus on one element in particular: the government's plan to allow banks, credit unions and building societies to issue "covered bonds".

Now, this development was well flagged in advance and has already generated much consternation amongst some bloggers, see here for example.  But in order to examine whether or not letting Australian banks issue covered bonds is a good idea or not, a bit of background is first in order.

So what the hell is a covered bond? Firstly, it is not some newfangled instrument of financial destruction like a SIV, a CDO, or, god forbid, a "synthetic CDO squared". Covered bonds were first issued in 18th century Prussia, and today, are the main source of housing finance in Europe, with some 2.4 trillion euros of outstanding issuance as of 2008.

In essence, they are corporate bonds that are secured, or "collateralized", by a pool of assets -- usually mortgages. Covered bonds have become very popular with investors because of their perceived safety. Unlike the "originate and distribute" model of mortgage-backed securities, in the case of covered bonds, banks must keep the mortgage loans on their balance sheet and hold capital against potential losses. If the bank goes under, the pool of loans is "ring fenced" from the issuer's other assets, and reserved exclusively for paying any obligations owed to the covered bondholders.

To protect the interests of investors, the pool of mortgage loans is typically "overcollateralized" -- ie in many cases, the pool value is required to be 105% of the outstanding bond liabilities. Furthermore, the LTV of the pool (in Europe, usually a maximum of 80%) must be maintained by the issuer. This means that the underlying properties must be regularly revalued, and the pool has to be updated to maintain its credit quality: ie any nonperforming loans must be quickly replaced with sound ones.

Because of the on-balance-sheet nature of the mortgage pool backing covered bonds, in theory banks have a greater incentive to lend prudently as they are not simply slicing and dicing their loans into RMBS and flogging them to the next greater fool as under the failed securitization model. In short, there is a lot of built in protection for the investors of these bonds.

So let's look at the positives and negatives as this all applies to Australian banks. From the issuer's perspective, the ability to issue covered bonds opens up a new source of relatively low cost funding in a variety of maturities. To the extent that this reduces the unhealthy dependence of Australian banks on overseas funding, it is a positive.

But there are some major problems. When a bank becomes insolvent, depositors are supposed to have first claim on a bank's assets. But if an institution has issued covered bonds, the size of the pool available to bail out depositors and other creditors is reduced. The bondholders have to be paid out in full, even if that means there isn't enough left over to cover all the depositors. Now, as in most countries, in Australia the government insures deposits to help prevent bank panics.

What this means is that effectively, covered bonds shift risk to the deposit insurer -- and ultimately the taxpayer -- in order to protect the interests of the covered bondholders.

In most countries, there are regulations to ensure that taxpayers are protected from this risk. For example, to make sure that all the high-quality assets are not promised to covered bondholders -- with only the poorest-quality assets left to pay off the depositors -- the US deposit insurer, the FDIC, has recently mandated that the share of covered bonds in an institution’s total liabilities cannot exceed 4%. Furthermore, the LTV of loans in the pool is capped at 80%.

In the draft of its plan, the Australian Treasury attempts to reassure us with the following words:
Australian depositors will continue to have absolute certainty over their deposits under the Financial Claims Scheme, which is a permanent feature of Australia's banking landscape.
The Financial Claims Scheme also allows the Government to levy the banking industry to recover any taxpayer money used to pay depositor claims in the very unlikely event an institution fails and selling its assets does not recover taxpayer funds in full. This means Australian taxpayers will continue to be fully protected.
The Treasury will also consult on the appropriate level of cap to be placed on covered bond issuance for individual institutions, for example five percent of an issuer's total Australian assets. This will ensure a substantial buffer of assets to cover depositor claims, making it extremely unlikely that a levy under the Financial Claims Scheme would ever be needed.
The first thing that worries me about this text is that I see nothing about the required credit quality of the pools. Will they be limited to an LTV of 80% or below, as is the practice in Europe and now the US? If the eligibility criteria for the Australian Office of Financial Management's RMBS purchases (95% LVR; $750,000 loan size) is anything to go by, we could be in very big trouble indeed. Secondly, this Business Week article about the newfound popularity of covered bonds in the US identifies another major risk.
FDIC Chairman Sheila C. Bair is aware of the threat of covered bonds to her insurance fund, so she has decided that the FDIC won't allow covered bonds to exceed 4% of bank liabilities at first. Trouble is, that low ceiling prevents covered bonds from making a meaningful contribution to mortgage availability. So count on it: If covered bonds catch on, there will be political pressure to increase that ratio, allowing more bank assets to be encumbered, and thus beyond the FDIC's reach. 
No doubt covered bonds will prove popular with both banks and investors in Australia, too. Will policymakers be able to resist calls for a relaxing of any ceiling on their issuance?

And finally, if you are a foreign investor holding existing Australian bank debt today, wouldn't you suddenly be demanding a higher risk premium, since any surge in covered bond issuance effectively subordinates your claims?

In summary, compared to the old "originate and distribute" model of securitization, covered bonds have some attractive properties, both for banks and end investors. They could also increase the stability of our banking system by diversifying the banks' funding sources. But there are some serious questions to be asked about the risks involved. If the eligibility criteria and ceiling on issuance are not conservative enough, we are creating a major risk for taxpayers.

Can we really expect the government to get these details right? I for one am very sceptical. 


  1. Thanks for the detailed explanation - and I too am skeptical of the government getting this one right.

  2. Cheers, thanks for the comment. It's depressing how little faith we all have in our government!

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