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. 

Can the government stop the bubble from bursting?

Houses and Holes has another excellent post today on Wayne Swan's new plan to create a "fifth pillar" of the banking system. I'd urge you to read it in full, and am in agreement that this latest salvo from Captain Swan amounts to nothing but kicking the can down the road without addressing the real issues, which include the banks' unhealthy reliance on offshore wholesale funding. But what struck me was this insightful comment on the post by "rht":

I would agree that it is a victory for the banks and equally so for Black Swan and the Government. The last thing they want is a significant drop in house prices whilst they are in power as it would certainly cause them to lose the next election.

They know that policies such as this only " kick the can down the road" and indeed will make the eventual collapse in house prices that much worse. However they hope that they will have had a good few years in government by then and that it will then be someone else's problem. I have for some time thought that house prices will only significantly decline here in Australia when the Government and the banks no longer have any say in the matter due to external factors /events such as a significant China slow down.

In the meantime they still have plenty of ammunition in their locker in addition to the policy announced today: lower interest rates (why not ZIRP for Australia ?), covered bonds, renewed and increased grants for first time buyers, more tax breaks for investors, abolishing stamp duty and capital gains tax (causing lower govt revenues yes but who cares about balancing the budget when the property ponzi needs to be propped up for as long as possible) and they are no doubt thinking up other policies at this very moment. 

Now I have a lot of sympathy for these views and am in full agreement that the Australian government may THINK it can continue to kick the can down the road, but the question is whether or not this will be possible. Contrary to popular belief, most investment bubbles eventually collapse under their own weight, and do not need an external trigger. This is an issue I would like to write about some time soon.

In any case, let's take a quick look at the experience of the US, where an extraordinary raft of measures have been taken in a desperate attempt to reflate the economy and housing bubble, all with little success:

• The Fed slashed interest rates from 4.5% to zero 
• Government takeover of Fannie Mae and Freddie Mac, the country's two biggest mortgage lenders
• Two rounds of quantitative easing, including the Fed's direct purchase of $1.25 trillion (yes you read that figure correctly - almost 1.5 times Australia's GDP) in agency MBS
• Introduction of a new $6,500 tax credit for home buyers purchasing a principal residence (recently expired)
• The introduction of HAMP, a loan modification program designed to reduce delinquent and at-risk borrowers' monthly mortgage payments. 

I'm sure this is not an exhaustive list. But let's take a look below at what US house prices have done in the meantime. At the very least, this should make you think twice about the Australian government's capacity to dig us out of the hole we are in.

All bubbles end in tears

Via the FT's Alphaville blog, Societe Generale's Dylan Grice has some great quotes on what he sees as a major credit bubble developing in China and other emerging market economies at present:

...a bubble is not a bullish scenario. It’s not bullish for the EM economies themselves, their citizens or for the world as a whole. The fact is all bubbles end in tears. The innocent bystanders who go to work not realising that their jobs derive from unsustainable demand suddenly find they’re out of work, through no fault of their own. The investors who believe the hype – generally but not exclusively naïve retail investors – get completely wiped out, or worse find themselves in debt after leveraging into the story. Those who are sceptical, but play along thinking they’ll exit before everyone else are rarely successful... Go to Ireland and ask them how they feel about bubbles. They’ll tell you a bubble is a curse, not a blessing.

Meanwhile, back in Australia the obsession with creating more "competition" in the banking sector continues. Let's take a look at Wayne Swan's latest economic note:

We have been working to build up more competition in the banking sector since we first came to office. Even during the crisis, we made a solid start on injecting more competition into the mortgage market, even while we were taking decisive action to secure our financial system. We are working hard to support the smaller lenders by investing $16 billion in Triple-A rated RMBS, which is helping to make this a more competitive source of funding again. The RMBS market was one of the key drivers of banking competition in the decade before the crisis, helping smaller lenders to drive a significant reduction in the net interest margins of the major banks, which you can see in this Reserve Bank chart.

All of this may be true, but to borrow a phrase currently in vogue, it is kind of ignoring the elephant in the room. As Steve Keen has pointed out, in the decade before the crisis, banks responded to this reduction in their net interest margins by massively increasing the volume of credit extended to households (and reducing lending standards). In fact, they kept up their frenzy of lending right through the GFC, when the Australian government decided it would be a good idea to reinflate the bubble.

The fact is that a "lack of competition" in the Australian banking sector is a secondary issue. Introducing more "competition" so that we can sucker another generation of young Australians into borrowing six or seven times their annual income to buy an illiquid and overvalued asset is not a good idea. How about we address the real problem of TOO MUCH DEBT?

As Dylan Grice says, all bubbles end in tears. And the more we try to kick the can down the road without addressing the real problem, the worse the fallout is going to be.