Covered bonds

Found two articles on covered bonds in SMH today:

TWO of Australia's biggest banks are planning to test support from global investors for covered bonds, with the push coming just days after Canberra approved new rules allowing banks to sell the new form of bonds.

The race is on between Commonwealth Bank and National Australia Bank to become the first Australian lender to issue a covered bond, with both planning a series of investor meetings in Europe and the US from later this month.

While any transaction could still be some time away, this could translate to the raising of hundreds of millions of dollars in funds.
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A covered bond gives money market investors a claim on the underlying assets such as mortgages if a bank runs into difficulty.

Previously depositors had the rights to all of the assets of a failing bank.

This makes the bonds more attractive to investors, potentially allowing banks to borrow funds from global money markets at a cheaper rate.

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http://www.smh.com.au/business/banks-to-test-waters-with-first-covered-bonds-20111019-1m834.html

Late last week, amid the parliamentary din surrounding the carbon tax, a little bill slipped through the Senate with minimal fuss.

This was the "covered bond" legislation - yet another friendly leg-up to the banks and one which effectively lumps another $130 billion of risk into the lap of taxpayers.

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http://www.smh.com.au/business/more-largesse-for-our-struggling-banks-20111019-1m85a.html

Just wanted to know what everyone thinks the more significant and long term impacts of this will be?

They key thing they didn't mention is that it doesn't just give them a claim on the banks' assets, but the bond holders would be ahead of depositors to claim banks' assets should anything go wrong.

Just another tool to allow banks better access to credit to prop up the ponzi scheme of the housing bubble we're in.

This has bad written all over it. The next time some dumbarse regulator or politician gargles that Australian banks are better than their foreign counterparts - punch them in the face!

I found this very informative article on unintended consequences of covered bonds which I thought I should share with anyone interested:

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.

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nternational 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.

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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.

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http://www.macrobusiness.com.au/2011/11/unintended-consequences-of-covered-bonds-2/

Australia's own GFC, anyone?

Tyler Durden said:

I found this very informative article on unintended consequences of covered bonds which I thought I should share with anyone interested:

http://www.macrobusiness.com.au/2011/11/unintended-consequences-of-covered-bonds-2/

Australia's own GFC, anyone?

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isnt this almost exactly what the US were doing? they were taking all their loans bad or good, pooling them together, then chopping them up into mini loans and then re-pooling them and selling them off as bonds? this obviously lowers the perceived risk for potential bond holders, problem being is that when an asset bubble bursts completely the risk is just as high as it was originally.

given the aussie market is on its way down too i dont see anything good that can come of this.

young-gun said:

isnt this almost exactly what the US were doing? they were taking all their loans bad or good, pooling them together, then chopping them up into mini loans and then re-pooling them and selling them off as bonds? this obviously lowers the perceived risk for potential bond holders, problem being is that when an asset bubble bursts completely the risk is just as high as it was originally.

given the aussie market is on its way down too i dont see anything good that can come of this.

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Yeah it sounds like it. I remember reading one of Robert Kiyosaki's books (I know, more of a salesman than an expert) and he said a useful trait to have was to predict the future, and that this can usually be done by looking at changes to the law. So I am trying to look at this change in the law and see what effects it will have.

Correct me if I'm wrong but these bonds are written on customers' deposits - not loans? (Those would be RMBSes).

Starcraftmazter said:

Correct me if I'm wrong but these bonds are written on customers' deposits - not loans? (Those would be RMBSes).

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i believe they are written against assets (loans) and not liabilities (deposits) - and the darn things are underwritten by the stupid, stupid Government, ie the taxpayer.

Google Michael West and Covered bonds. And if you can stand it, have a geek at Barnaby Joyce's website who has a blog on this as well as many other things,

Judd said:

i believe they are written against assets (loans) and not liabilities (deposits) - and the darn things are underwritten by the stupid, stupid Government, ie the taxpayer.

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Yes - covered bonds are backed by assets, not deposits. The basic idea is that investors in covered bonds have first recourse to a pool of assets (the mortgages) should the bank not meet its repayments or breach certain covenants. If this happens, the bondholders can use the cashflow (mortgage repayments) to meet the coupons due on the bond or force the sale of the mortgages to recover what's owed. There are various methods, including over-collateralisation, to provide a buffer to bondholders. The key difference between a covered bond and rmbs is that the mortgages typically stay on the balance sheet (rmbs are typically transferred to a spv) and investors in the covered bond have recourse to the rest of the issuer's balance sheet if the covered pool is insufficient to fund losses in event of a default.

The advantage for banks is that it can lower their cost of funding, beyond that of even senior secured issues. It also gives them access to completely new, and very large, group of investors to help diversify their funding base.

Overall, it's a very good thing for Australian banks and could help people with a mortgage too… A bit of trivia - I believe that no covered bond holder has ever, since the first one was issued in 1769, has ever lost their principal.

doctorj said:

Overall, it's a very good thing for Australian banks and could help people with a mortgage too…

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The other thing is that there's actually not that much AAA paper floating around these days. There are only 12 sovereign AAAs left, 3 or 4 AAA corporate issuers in the US and a few more elsewhere. Covered bonds offer a clever way for a AA issuer (and even lower) to issue AAA paper to take advantage of that excess demand.

I have been reading a lot about the covered bonds recently. I have one question of interpretation, and please forgive my lack of understanding on this, when they discuss the spread, say, CBA, is paying i. e

Commonwealth Bank of Australia sold $3.5 billion of five-year covered notes to yield 175 basis points more than swap rates yesterday in the biggest ever offering of financial debt in the currency.

Read more: http://www.smh.com.au/business/mark...zer-for-cba-20120118-1q59v.html#ixzz1jlbd8LJd

The swap rate they are referring, is this the Australian interbank swap similar to the LIBOR?

If the bond issue was in AUD then the reference rate will be the AU swap rate. If it's in USD then it will be LIBOR.

doctorj said:

A bit of trivia - I believe that no covered bond holder has ever, since the first one was issued in 1769, has ever lost their principal.

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Is this an actual statistic? or just a hunch. I would have thought any american bond holders holding pooled asset bonds would have lost out when all the assets backing the bonds fell by upto 60%. or are the bonds backed in some other way also? surely there has to be some risk.

risk is minimised but if an asset bubble bursts i would have thought these bonds are potentially just as risky to hold as most others.

is this how it works.

investor purchases bond
bank pays investor at specified intervals
people stop paying mortgage on the backed asset
bank reposses and sells to pay bond holder

BUT if the value of the asset falls below inital bond price there is going to be a shortfall?

or am i way off?

young-gun said:

Is this an actual statistic? or just a hunch.

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A bit of both. I've not gone through the exercise of verifying each issue, but there are many sources that agree, including the Financial Times. http://www.ft.com/cms/s/0/9bbe0fa8-5895-11e0-9b8a-00144feab49a.html#axzz1jiVIExeL

young-gun said:

is this how it works.
investor purchases bond
bank pays investor at specified intervals
people stop paying mortgage on the backed asset
bank reposses and sells to pay bond holder
BUT if the value of the asset falls below inital bond price there is going to be a shortfall?
or am i way off?

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Close. Unlike a securitisation, the bond remains a liability of the bank (there's no 'true sale' of the asset pool). So if the pool cashflows are insufficient there are additional protections for the bondholder and they also typically have recourse to the rest of the bank's balance sheet like any other lender.

Protections:
- There are usually a number of eligibility criteria for the pool (e.g. maximum LTV), concentration limits (e.g. geography, single counterparty etc) so they tend to be relatively high quality loans in the first place.
- The pool is usually significantly over collateralised, often providing a buffer of 20% or more
- It is usual that non performing loans in the pool are replaced with performing loans from outside of the pool
- Regulators typically enforce a maximum amount of issuance on any single institution which is usually quite small relative to their balance sheet, meaning that there's plenty of loan stock to replace non-performing loans in the pool
- Should any of a number of ratios or other trigger events be met, the covered bond holders can put the issue into early amortisation, which may include directing a third party to sell the asset pool even before default occurs. If the sale is insufficient to fund the early amortisation, then they usually rank along side other senior creditors

And there's many more (e.g. ratings triggers etc etc). They're really very strong structurally and have stood the test of time. The danger with them comes when people mess about with the structure. I've not read the new Australian legislation yet so please take the above as general comments relating to traditional covered bonds and not specific to the Aussie implementation of covered bonds!