Australia’s big four banks received some bad news on May 18: international ratings agency Moody’s Investor Services was downgrading them from Aa1 to Aa2.
The drop was unwelcome, yet not entirely surprising. Moody’s had put the banks on a negative ratings watch earlier in the year and said it would review the banks’ dependence on the global wholesale lending market. And the drop itself brings the ratings agency in line with rivals Fitch and Standard & Poor’s.
But it still spooked the market. It highlighted the fact that while Australia’s banks may have weathered the global financial crisis extremely well, their dependence on borrowing to fund their own lending – otherwise known as wholesale funding – leaves them highly exposed to volatile credit market conditions.
The banks have since attempted to reduce their reliance on wholesale funding, but it remains a major vulnerability in this new, credit-conscious environment; hence Moody’s downgrade. Worse, as things stand it would take years for the lenders to reduce their addiction to wholesale funding.
It’s that inherent weakness that has forced Canberra to consider reopening the door to a form of funding it had long cast aside: covered bonds.
Covered bonds are comprised of debt that has recourse to a pool of underlying assets such as mortgage payments. They are a lot like types of securitisation, except that the issuer keeps the liabilities on its balance sheet instead of spinning it off into a separate financial vehicle.
The bonds tend to be of high quality, which means they get high ratings. And the banks believe they will offer a major new funding source. Canberra agrees, and it is set to allow Australian financial institutions to issue covered bonds as part of a package of banking reforms expected to pass into law later this year.
If it does so the uptake is likely to be major. Up to A$150 billion (US$158.68 billion) of covered bonds are expected to be issued in the next five years, potentially accounting for 10%-20% of the major banks’ funding.
“While it’s not a silver bullet, the introduction of covered bonds will go some way in helping Australian banks manage rising funding costs,” says Stephen Ries, a spokesman for ANZ.
But it is not all smooth sailing until the introduction of covered bonds. Many Australian investors say they will shun the bonds because they already have enough exposure to existing bank debt. There is also the possibility that the new bonds could offer the big four banks an even greater advantage over their smaller competitors, which are less likely to be able to make issues due to their lower credit ratings.
Key to the success of this budding market will be the ability of Australia’s banks to buy each other’s debt, and attract investors from overseas into the market. The potential is there, but sizeable obstacles exist.
Wholesale funding flaw
Australia’s government had long banned banks from issuing covered bonds because they were at odds with the country’s laws designed to protect depositors. Regulators were worried that the interests of depositors would come second to the interest of covered bond holders if a bank collapsed.
Covered bonds are ‘dual recourse’, which means that bondholders have two ways to get their money back. They have recourse to the underlying pool of high-quality assets that remains on the issuer’s consolidated balance sheet and must at all times be equal to the principal on issue. If the cover is insufficient they then have recourse to the issuer itself.
The dual recourse nature of the bonds means that they are usually ‘AAA’-rated. It’s this latter point that makes them particularly appealing for a set of banks with major funding needs. And Australia’s banks are certainly that.
According to the Australian Bureau of Statistics, the country’s lenders raised A$1.47 trillion to fund themselves during 2010, of which 46.5% came from volatile wholesale funding – and 59% of that amount was source from offshore. The uncertainty of this funding source was a primary reason for Moody’s to downgrade the banks.
The agency’s senior vice president, Patrick Winsbury, says the global financial crisis had underlined the speed with which shifts in investor confidence can impact bank funding. While banks have grown their retail deposits strongly amid subdued credit markets since the crisis emerged, much of that growth was sourced from corporates and would be depleted when credit demand picked up.
Set against these difficulties, covered bonds offer a very appealing alternative source of funding. The debts are a source of longer duration and more stable funding than the sometimes fickle and volatile wholesale capital markets.
They can potentially offer cheaper funds too. Typically covered bonds are priced around 50 to 60 basis points (bp) over BBSW (bank bill swap rate), while equivalent senior unsecured debt prices around 80bp-100bp over, RMBS (residential mortgage-backed securities) 100bp above, and deposits 100bp-150bp higher.
The hope is that by opening the door to cheaper funding via covered bonds, banks will in turn feed their savings through to end users.
“[Covered bonds] represent a cheaper form of funding from global debt capital markets that you would hope and expect to feed through at the margins to lower interest rates and lower cost of funds for the rest of the economy,” says Alex Sell, chief operating officer of the Australian Securitisation Forum, which promotes development of securitisation.
Unbanning bonds
Given the dangers posed by the Australian banks’ current funding vulnerability to the stability of the country’s entire financial system, Canberra has in effect had its hand forced over introducing covered bonds.
In mid-December the government announced its ‘Competitive and Sustainable Banking System’ reforms, which would make it easier to issue corporate bonds to retail investors, potentially allow for the trading of Commonwealth Government Securities on exchanges – and pave the way for banks, credit unions and building societies to issue covered bonds.
Canberra has explained its about-face over covered bonds by saying that depositors are now adequately protected by the Financial Claims Scheme, wherein the Government effectively insures deposits of up to A$1 million.
The government announced its draft legislation in March. There is a cap on the value of the ‘cover’ pool of assets of 8% of banks’ assets in Australia. Eligible assets in the pool include cash, government debt, residential mortgages with loan-to-value ratios no greater than 80%, and first-ranking commercial mortgages with a maximum LVR of 60%. Government debt is restricted to 20%.
Some banks have called on Canberra to raise the 8% cap, to raise the LVR on residential loans to up to 95%, and expand eligible assets to include assets such as bank-issued commercial paper and residential mortgage backed securities (RMBS). But few expect major changes to the draft legislation.
Crimping competition
While the impending introduction of covered bonds has been welcomed by many, not least the banks themselves, not everyone approves. Some argue that letting lenders issue covered debt could further weaken competition in Australia’s banking market.
John Sorrell, head of credit at fund manager Tyndall Investments, says that because small domestic Australian banks cannot issue AAA-rated paper “it will have a negative effect on competition in that this funding source has created a competitive advantage for the major banks”.
But with the legislation expected to enter parliament this month and be finalised in July, it looks like such concerns have been brushed aside by a government more fearful of the consequences of another credit crunch.
The banks are already rubbing their hands at the thought of issuing the new debt. Sell says he expects the four majors – ANZ, Commonwealth Bank of Australia, National Australia Bank, and Westpac – to make a couple of issues before the end of the year.
Some smaller lenders, including Suncorp and the Bendigo and Adelaide Bank, could also make issues based on their corporate credit rating, but Sell doesn’t expect them to issue early, and only after the majors have set the tone and pricing expectations.
Most observers expect A$150 billion-worth of cover bonds to be issued, dependent upon investor appetite. That in turn is likely to be determined by sovereign debt issues, and investors’ views on Australia, individual banks and the Australian housing market.
“What you might expect is that after about five years they’d have reached that 8% [annual funding] limit,” Sell says.
Asiamoney asked the four major banks, who have lobbied strongly for covered bonds, a series of questions related to the bonds, including whether they planned to issue later this year if legislation passes.
The NAB and CBA did not comment. ANZ’s Stephen Ries says: “We are yet to decide if we will issue covered bonds this year but it’s important to note that we already well on the way of securing our funding requirements for the year.”
A Westpac spokesman did not comment on whether and when the bank planned to issue bonds and noted they were still prohibited. He says that the bank understands legislation may be introduced to parliament before the third quarter, but when the new laws will be passed was unknown to the bank.
When asked if Westpac had any concerns with the government's proposed legislation, the spokesman says that the federal treasury “has been very engaging”.
“They have been very open in getting feedback on the legislation,” he adds. “They are very keen to get a suitable legislation introduced in Australia; we are comfortable that this will be the case.”
The spokesman said that covered bonds would be one of a number of funding tools available to banks, but “to the extent that they diversify bank funding options they will be a useful addition.”
Pursuing pension funding
For all their reticence to speak about covered bonds, the desire of the main Australian lenders to issue covered bonds will be high. But will it be matched by the interest of investors?
One of the justifications the Australian government gave for its decision to allow covered bond issues is that it would help “channel” Australia’s superannuation (retirement) savings through the financial system into the economy.
But many local investors say they’re not interested in local covered bonds.
Sell says the onshore views are mixed. “I’m hearing that as well,” adds George Bishay, portfolio manager at BT Investment Management.
Sorrell says that Australian demand comes down to pricing, but the likelihood of domestic buyers for covered bonds issued by the four major banks is relatively low.
“They (local investors) are happy enough with senior paper,” he says. “Covered bonds are still exposure to the banks – so you’re not removing exposure. But with covered bonds you’re getting a lower return. You’re better off in senior debt.”
Sorrell says his fund won’t be buying unless extreme events caused covered bonds to go “haywire” and spreads were very tight to senior bonds.
“Some regard it as a different asset class; some regard it as more of a liquidity asset,” he says. “We don’t agree with that. We have no problem with them (covered bonds) in a credit sense. But they don’t remove exposure to the bank involved. They just use up available credit.
“If we wanted to invest in Westpac, we’d rather use senior paper. We have confidence in Westpac. We don’t need the extra security of having collateral posted.”
BT’s Bishay said local investor demand is expected to be weak because some investors don’t see the value of covered bonds when they compare the likely spreads on the deals to to the higher ones enjoyed by residential mortgage-backed securities deals and senior bank bonds.
Offloading to offshore accounts
Given the distinctly lacklustre onshore investor interest, Australia’s banks are likely to focus their efforts on gaining international fund manager support.
It’s likely to be a successful tactic, with European investors who are most familiar with covered bonds being particularly likely to bite.
“They not only want covered bonds ordinarily, but also want some diversification – away from the euro and away from Europe,” says Sell. “From Australian covered bonds they get currency and geographic diversification.”
He adds that Canadian covered bonds provide a good analogy. While some were taken up by US and Canadian investors, most have been bought by European accounts.
One issue that may give offshore investors pause for thought is the state of the Australian property market, which has started posting falls and which many economists agree is highly overvalued.
Sorrell states that this could cause some offshore investors to worry about the Australian property market.
“European investors are very comfortable with covered bonds; they have been issued there for centuries,” he says. “But there is still the issue of the Australian housing market. They would be concerned about property prices, given that the assets underlying the covered pool are Australian mortgages. But the claim on assets would still give offshore investors a good degree of comfort.”
Yet despite market jitters the recent Moody’s downgrade does not look set to affect any future covered bond issues.
“The big four banks remain highly rated and strong entities,” says Sorrell. “If anything, the stable outlook on the ratings encourages a belief that the AAA rating on the big four’s covered bonds will be stable.”
Replacement investments
While offshore investors are likely to be the backbone of covered bond issues from Australia, it would be unwise to completely count out interest from local investors.
While many fund managers are likely to see these new bonds to merely be less rewarding ways to gain exposure to Australia’s banks, some may compare the ‘AAA’-rated notes to Commonwealth, semi-government, and supra-national debt issues. Each of these sets of bonds also boasts ‘AAA’ ratings and high liquidity, and they are likely to be tighter priced, making bank covered bonds relatively appealing.
Investors that currently hold government-guaranteed bank paper would be another source of investor demand.
When Canberra guaranteed bank paper during the height of the global financial crisis, some investment managers sold government bonds and bought the bank paper because it was offering a higher yield.
“I know investors in Commonwealth government bonds and semi-government bonds who have used the government guaranteed bank paper as relative value against semi-government and government bonds,” says Bishay. “They [government guaranteed bank paper] start to mature off in 2012. Some of those investors will probably look to covered bonds to potentially take up that space.”
Another source of local demand will be from Australian banks themselves. It’s likely that the lenders would buy each other’s covered bonds to help them meet the liquidity requirements of Basel III.
“The banks have incentive to buy paper for their own use,” says Sorrell. “They will – to the extent permissible – buy each other’s covered bonds. So there is potential demand in Australia but not from fund managers.”
Central bank support
The extent to which the banks would be allowed to do this remains unclear.
The new Basel III global liquidity requirements include guidance over the required liquidity coverage ratio (LCR) that banks need to maintain, as part of its efforts to ensure that lenders can survive liquidity shocks. However the Australian Prudential Regulatory Authority (APRA) has not included covered bonds as part of liquidity assets that banks can count towards their LCR.
But APRA has said it would consult on the issue of including covered bonds, and observers believe it will most likely decide to include them before the requirements come into force in 2015.
Covered bonds could also be used indirectly by the banks to meet liquidity requirements. APRA and the Reserve Bank of Australia (RBA) have agreed that banks can establish a ‘committed secured liquidity facility’ with the central bank to cover any shortfall between the larger banks’ and financial institutions’ (around 40) holdings of high-quality liquid assets and LCR requirements.
Basically, this means that the RBA will provide a liquidity facility for ‘repo’ eligible assets. The banks will pay a liquidity fee to the central bank to allow the security to form a liquid asset – if a bank needs liquidity the RBA will provide it by purchasing the asset.
“The banks will be looking to use covered bonds to repo with the RBA under the proposed facility,” Sorell says.
Despite questions about local demand and the impact of competition, covered bonds are a good step for Australia’s financial system, banks and investors.
“Covered bonds are another asset class to invest in that are highly rated and liquid,” Bishay says. “They provide another sector for us to invest in and will form part of our relative sector allocation decision.”
Given enough time, Canberra’s move to uncover covered bonds could even cause Moody’s and its fellow ratings agencies to reconsider their views on the funding stability of Australia’s top lenders.