Pricier than expected

The Labour government of Prime Minister Julia Gillard successfully passed amendments to the Banking Act in October which now allow for the issuing of covered bonds by Australian institutions. Created from public sector or mortgage loans and backed by a separate group of loans, covered bonds enjoy higher credit ratings.


Australia, as often happens, was some way behind the more innovative New Zealanders who broke the ground in Australasia with New Zealand banks – all subsidiaries of the Australian Big Four: ANZ, Westpac, Commonwealth Bank (CBA) and National Australia Bank (NAB) – issuing their inaugural covered bonds in 2010.


Almost as a tease, Canadian banks such as CIBC and the Bank of Nova Scotia then came into the Australian market in 2010 with major kangaroo covered bond issues in Australian currency, proving that there was an Australian dollar investor base for the asset class.


Now, Australian institutions at last have the freedom to issue covered bonds, despite the qualms of the Australian Prudential Regulation Authority (APRA).


Charged with protecting the assets of depositors, APRA was outspoken in pointing out what it saw as the dangers of covered bonds, and the way in which they gave investors recourse to the assets, or cover pool of residential mortgages, backing the issue.


This, the regulator says, was contrary to its mandate to act in the interest of depositors, because with covered bonds, the investors would take precedence in the event of a bank failure. The government saw things differently, with funding diversity a greater imperative.


Major funding task

Many of the borrowings undertaken at the time of the global financial crisis, when the government effectively rented out its credit rating to guarantee bond issues by the major banks, are about to mature and the Big Four banks face a major funding task, estimated at more than A$100 billion in the financial year to June 30 2012.


There are limits, however, to what can be raised in covered bonds with banks able to issue covered bonds up to a level of 8% of their total assets, compared to a more liberal 10% in New Zealand. But even with the 8% limit, this creates a potential A$150 billion plus market for the new asset class.

In the last few months of 2011 after the final passage of the legislation, two deals were done: the first US$1.25 billion five-year issue from ANZ, and US$1 billion from Westpac, both of them in the US 144a market.


In these volatile times, timing is everything and the NAB and the CBA were subsequently both forced to abort and postpone their début issues. The fact that the CBA issue was planned into the troubled Euro market did not help matters.


“While investor interest in CBA as an issuer and the CBA covered bond structure has been very strong, heightened market volatility has meant the best path of action for CBA and our investor base is to continue to monitor the markets rather than execute a potentially poorly performing transaction,” was the official line from a CBA spokesman.


At the Australian Securitisation Forum (ASF) conference in November, ANZ’s head of structured funding John Needham was forced to defend his bank’s US$1.25 million issue, which some local commentators said was too expensive at 115bp over US Treasury mid-swaps – the same as the Westpac pricing.


Once swapped back into Australian dollars, the pricing was at 150bp over bank bills, around the same price as senior unsecured debt in the local market. This is despite higher ratings for the covered bond issued than for the banks themselves, typically at Triple A due to the concept of recourse to the bank’s underlying assets.


“In terms of our deal, pricing was 60% of the margin we would have got in the unsecured market,” Needham notes.


“There were 67 investors. We were happy with that. We had wide distribution: 75% of the issue went to real money investors, such as pension funds. “We had new investors and we had existing investors taking meaningful exposures.”


Clearing up misunderstandings

There was, however, a significant effort which needed to go into educating investors about the Australian market, he says. “Investors said to us: ‘Tell us about Australia’s housing bubble.’ There is a lot of misunderstanding about our real estate market and the way our mortgages work.”


It is a point picked up by Chris Dalton, chief executive of the Australian Securitisation Forum. “Many of these investors are first time investors in Australian exposures so there have been many questions coming from overseas,” he remarks.


“We have been fielding a lot of questions here at the ASF, and also real estate data firms have been getting questions about the characteristics and nature of Australian mortgages and the outlook for the economy.


“Investors need to know how the market works in Australia and they have been seeking the background you would expect first time investors to look for. The good news is that there is likely to be a new investor base being created by Australian issuers in offshore markets.”


The ASF was a strong champion for the legislative change which enabled covered bonds to be issued, and lobbied government and regulators alike in favour of the changes. Despite the initial standoff with APRA, Dalton is happy with the process.


“I think the legislative framework really went very smoothly in terms of a constructive and collaborative approach between government and industry,” he says. “The legislation went through Parliament quickly and was passed a bit earlier than was expected, and I think that has come at a good time in terms of the banks being able to fund themselves over the coming year.


“So the expectation for next year and 2013 and 2014 is that the Australian issuers will establish their names in both the US and Euro markets. There have already been a number of roadshows and investors have been doing their credit analysis to understand their credit limits and investment limits for these securities.”


One slightly ironic aspect to the Australian covered bond story is that while foreign covered issuers – such as CIBC and the Bank of Nova Scotia – are finding a ready reception from Australian investors who see the issues as a variation of a kangaroo bond – Australian dollar bonds issued by foreign institutions – domestic investors might be less interested in covered issues by local institutions.


“The issue is that local investors, because of their knowledge and proximity to the local market are likely to take senior unsecured debt, or they can take a residential mortgage backed security (RMBS) issue and get even more pick-up,” explains the ASF’s Dalton. “So we need to establish where covered bonds sit in a domestic portfolio.” Dalton expects the larger Australian banks to continue to tap the US markets, and eventually the Euro markets when the turmoil there subsides.


Smaller and challenged

One of the government’s reasons for changing the Banking Act was not only to give the Big Four a new diversification tool, but to give smaller regional banks and even the so-called “aggregated structures” of credit unions and building societies clubbing together an opportunity to tap the market. The idea was to promote competition and loosen the stranglehold the Big Four have on the domestic market, particularly for residential mortgages.


However, Dalton says the experience so far shows that the opportunities for smaller players are some time away. While the legislation provides for an aggregated model for small institutions to “club together,” the reality is that in the short to medium term more conventional RMBS issues are more likely.


“To be honest, I see that as a challenge for other institutions in 2012 and 2013, considering the state of the market,” he points out.


“I think it will be interesting to see if an institution like Suncorp from Queensland might come to the market. Their treasurer is talking about a domestic issue and that would be an interesting development and one to watch in 2012. Subject to any take-up there, you might see some mid-tier regional banks look at it, but for the smaller guys – building societies and credit unions – it’s hard to see them accessing wholesale markets with covered bonds in the near future.”


So for the medium term, at least, the Big Four seem likely to be the only ones likely to pursue meaningful covered bond programmes.


New debt instrument

And according to Westpac’s chief financial officer Phil Coffey, covered bonds could comprise as much as one quarter of the bank’s funding requirements over the coming years. Analysts estimate this at more than A$20 billion each year.


“One of the great things about covered bonds is that it has continued to be a market that has functioned at a time when the unsecured lending market has been unsettled by what’s going on in Europe,” Coffey told an analysts briefing after the bank announced its full year results in November.


“As for what that means in terms of margin, obviously covered bonds will be cheaper than unsecured. But at what price unsecured term borrowing is coming in? It’s a difficult one to determine. “Overall, do we think wholesale funding costs are going to increase? Yes, and, therefore, we have to manage the margin impact of that.”


So in that funding task, Westpac has a new debt instrument, as do ANZ, CBA and NAB. But global markets will have to recover significantly for any other Australian issuers to venture offshore for covered bonds. It will take some time, and require some changes in market sentiment, for other global covered bond investors to get to know any other Australian issuers.


30 Jan 2012


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