Recently Australia passed legislation so that Australian ADI’s can issue covered bonds and last week APRA released a paper and APS 121 Guidelines on how APRA is going to regulate the issuance and management of covered bonds. But the legislation and the regulator have created an infrastructure which may have serious consequences for Australia’s banking system.
The issue is not about covered bonds per se but the rules and infrastructure within which they’ll operate and be managed. The Australian finance system has many unique features eg, how its markets operate and are concentrated, and the high level of offshore debt on its major bank balance sheets. Australia has banks with a majority of lending assets in residential mortgages secured over generally regarded unaffordable housing. Yet regulation copying legislation from other jurisdictions rather than taking these local circumstances into account.
Covered bond markets originated in Europe with many varied structures from the framework outlined in Australia’s legislation. However, the Australian approach is not uncommon. Banks from Germany and France are by far the biggest issuers. Originally, covered bonds were a means of banks’ obtaining secure funding for assets when those institutions did not have a large deposit base. Whilst this continues, the market is open to all types of banks for differing types of funding purposes. European covered bonds are primarily purchased by European investors which also mostly purchase the bonds of their own country’s issuers. There is a very strong domestic investor base for covered bonds in all the main issuing countries. This is not the case for Australia.
In order to work through the implications of APRA’s paper on covered bonds and the legislation, I needed to take account of how the offshore capital markets behave, the legal implications of secured assets, the bank’s Pillar 3 disclosure under Basel II, rating agency criteria for covered bonds and the covered bond deals that are being marketed to offshore investors by Australia’s major banks right now.
I’ll explain my concerns in the simplest terms possible.
Covered bond structures are usually similar to securitisation structures except that the bank that puts up the assets to support the bonds also guarantees the covered bonds. Under Australian legislation, a bank transfers assets such as residential mortgages into a special purpose company, which is used as security for the issue of covered bonds. Holders of covered bonds have a priority claim for repayment against the covered pool assets over all other creditors of the bank. Banks can issue many types of different cash flow and maturity securities as covered bonds. The bank can and is required in certain circumstances to replace and replenish assets in the covered pool periodically.
Clearly the simple priority that covered bondholders have over other bank creditors can be argued to weaken bank’s balance sheets. But the situation is more complex because of over collateralisation requirements and the state of Australian bank’s balance sheets.
Under APRA’s proposed regulation, the banks’ capital requirements do not change by issuing covered bonds. The reasoning is that as the bank is guaranteeing the covered bond which is secured against the bank’s assets the liability is the same. The issue is that due to the markets and rating agency requirements a bank must put in more assets than covered bonds issued. In effect, the unsecured creditors of the bank lose the benefit of those extra assets or over collateralisation transferred to the covered bond pool. APRA’s requirement to minimise this effect is to limit the issue of covered bonds by a bank to 8% of its total assets.
To determine, the size of the issue let’s look at the covered bond deals now being marketed by our banks to offshore investors. Attached is access to summaries of Fitch’s credit rating opinions for the current ANZ, NAB and Westpac covered bond programs using residential mortgages as collateral. The covered bond market globally, generally requires a AAA rating for a bank to issue securities in any volume. Rating opinions are based on the quality of the assets in the covered bond pool and the amount of over collateralization. Credit rating agencies solely determine the AAA and therefore the level of over collateralisation in a covered bond structure.
In the covered bond deals referenced for ANZ, NAB and Westpac the amount of over collateralisation, rounded up, is 20% in order for the covered bonds to receive a AAA opinion. Whilst I am referencing Fitch, the other two agencies will have similar numbers. Please note that neither the bank nor the regulator determines the level of over collateralisation.
So if those banks were to issue to the maximum of the APRA limit of 8% using residential mortgages as the covered pool and assuming the 20% over collateralisation remains relatively static, the amount of security or capital denied to the unsecured creditors is 20%*8% which equals 1.6%. But if we are looking only at residential mortgages which make up about 50% of the balance sheet, then the 1.6% becomes 3.2% of the amount of mortgages. That appears significant for a highly geared finance business, but how significant? Let’s compare that number with the bank’s balance sheets.
Australia’s major banks use an IRB approach under Basel II for calculating risk-weighted assets. If we examine the Pillar 3 disclosures (available on their websites and the ASX site) of the referenced banks NAB, ANZ and Westpac we’d find their residential mortgage books carry about a 20% risk weight. NAB a little above that number and the other two below but the rounded risk weighting is 20%. So what’s the minimum capital requirement? It’s 8% of the risk-weighted assets. So the minimum capital requirement for ANZ, NAB and Westpac for residential mortgages is 20%*8% which equals 1.6%.
In summary, if the bank’s in question issue covered bonds with the collateral of residential mortgages to the maximum allowed, then twice the minimum regulatory capital supporting the unsecured lenders of the total bank’s mortgage book would be transferred to support the covered bond holders.
The main issue with covered bonds, however, is beyond the regulators reach if we continue with the current and proposed covered bond legislation and regulation. The amount of over collateralisation, ie 20% in the programs referenced, is determined by the credit rating agencies and whatever criteria they may determine from time to time is needed to provide their opinions.
Both the banks and APRA are comfortable with 1.6% minimum capital to cover the risks of residential mortgages on bank’s balance sheets. Even taking account of the AAA and other issues within covered bond structures 20% is a high level of over collateralisation. That’s because when rating covered bonds the agencies are very conservative in their opinions severely stressing the risk of the assets so that AAA can be maintained in stressed times. However, the AAA and therefore the level of over collateralisation is also dependent on the bank’s credit rating.
International buyers of covered bonds are normally AAA buyers only. Australian covered bond programs are squarely aimed at these investors as evidenced by the banks’ recent international road shows. If a security is downgraded or even in danger of downgrade these buyers will need to sell the bonds at “market”. As Australian banks are all on similar risk levels, any issue with any of the banks’ covered bond programs that may lead to a downgrade may create an unstoppable contagion of selling. Therefore the banks will maintain AAA levels in the covered bond programs in preference to the balance sheet lenders and depositors.
The credit rating agencies also provide opinions on the banks themselves. So as the collateral requirements of covered bonds may increase, the banks are in danger of downgrade after meeting the over collateralisation requirements of covered bonds to maintain AAA. This would be a dilemma with the bank’s unsecured lenders and rating agencies in separate camps.
In stressful times, a scenario where there is a quick spiral down of bank balance sheet strength as more and more collateral (or better collateral) is posted to protect the covered bond holders to the detriment of the balance sheet lenders and depositors, possibly creating systemic risk in the whole financial system.
Finally, many may believe that the whole issue of over collateralisation is much ado about nothing as the over collateralisation in covered pools is provided by quality assets and therefore full recovery can be expected. I disagree with that premise. If there was a problem with a bank and its covered bond pool, the trustee of the covered bond pool acts in the interests of the bondholders not the bank or its creditors. Any fire sale of assets, especially if the details of the assets are unknown, will result in a discount; the only question is how much.