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How Australian Banks Use Covered Bonds to Play a Dangerous Game

When Kevin Rudd’s political obituary is written – perhaps as soon as today – a great deal of focus will be on the coup that deposed him as prime minister and the coup de grace that ended the political misery of the Labor party. For anyone interested in Rudd’s biggest impact on Australian life, the focus should be on how he encouraged tens of thousands of Australians to take on crippling debt and bet on higher house prices.

The First Home Owners Grant (FHOG) of 2008 was Rudd’s reaction to the Global Financial Crisis. The basic thrust of the response was this: borrow more and everything will turn out just fine. The government doubled the grant on existing homes from $7,000 to $14,000. It tripled the grant on new homes to first-time buyers to $21,000. The Big Four Australian banks have increased their share of the mortgage market to 86% since the FHOG was first introduced and then extended.

Rudd’s response was straight out of the Keynesian playbook. In Europe and the US and Japan, government borrowing increased in an attempt to stave off the end of the credit boom. Rudd followed suit there, too. Australia turned a $20 billion surplus into a quick annual deficit. That deficit has grown into a formidable $200 billion debt since. It shows no signs of getting smaller.

Australia survives the GFC by loading up on debt

Australia survives the GFC by loading up on debt

Rudd’s only particular twist on the Keynesian playbook was the FHOG. He wasn’t content with blowing up the government’s balance sheet. He set charges and the fuse under the entire private sector housing market. The bizarre result, as our friend Dr. Steve Keen has pointed out, is that Australia spent the Global Financial Crisis doubling down on housing and extending the household debt-to-GDP ratio to 150% – the highest level in the Western world.

No matter what happens to Rudd today, his financial legacy is already written in years of red ink. The story won’t end with his relegation to the backwoods of the Labor party. Australia’s banks are labouring under the global impression that they’re exposed to a housing crash. One particular solution to the bank’s “funding crisis” isn’t turning out the way anyone expected.

Ratings agency Fitch downgraded Commonwealth Bank, NAB, and Westpac to AA – from AA on Friday. Fitch’s move wasn’t groundbreaking. S&P downgraded the Aussie banks in November. But Fitch did add this bit:
A high reliance on wholesale funding makes maintaining investor confidence key. Factors such as Australia’s high household debt levels, elevated house prices and increasing reliance on Asia for trade may all impact this confidence, particularly if economic conditions in the region were to deteriorate significantly.

This is a mixed message. Australian banks rely on off-shore debt markets for 40% of the funding they need to make loans. It DOES sound confusing that a bank has to borrow money in order to loan it. Banks have to get their money from somewhere too, even with fractional reserve lending. It’s more expensive to get that money.

Deposits have grown at Aussie banks since financial markets tanked in 2009. That’s mostly thanks to high interest rates on bank savings accounts and an aversion to the stock market. But banks still need to refinance $90 billion in loans this year – without the benefit of a government guarantee. That’s not just pocket change.

Which brings us to the covered bond market. Covered bonds were cooked up last year by the banking sector and Treasurer Wayne Swan as a way for banks to secure access to more funding if global credit markets break down. Actually, that’s not fair. Covered bonds have been around in Europe for quite awhile. They ARE new to Australia though.

How a Covered Bond Works

The premise behind a covered bond is that it’s a secure debt. If you buy a bond from the bank – which is to say if you loan money to the bank – the bank pledges you collateral as security. As a secured creditor, you get first dibs on that collateral if the bank should ever run into a catastrophic event (that never happens in the banking sector, though).

The covered bond market was supposed to open up a new source of funding for Australian banks by “unlocking” their balance sheets. Banks are allowed to use different pools of assets to pledge as collateral for the bonds. The main two pools of assets are depositor funds (your money) and home mortgages (your house).

A funny thing has happened on the way to lower funding costs through covered bonds. They didn’t lower costs. The introduction of the covered bonds has actually shifted all borrowing costs higher for Australian banks. It’s created a new class system within the capital structure of a company, which is so exciting we’ll get to it shortly.

This all started to become clear when Westpac and Commonwealth Bank sold a combined $6.6 billion worth of covered bonds in January. The trouble was that both had to pay a higher interest rate than they expected. Without getting too complicated, the rate of interest on a covered bond is usually at a premium to a swap rate (which we won’t get into here). Westpac and CBA paid premiums much higher than they expected.

This has immediate consequences for other bonds issued by banks. “The high spread at which the covered bonds were issued effectively means investors in all other bank securities need to be paid a greater premium,” said Andrew Gordon at FIIG Securities Ltd in Sydney. In other words, the covered bonds are dragging yields on other bank debt up because covered bonds are secured and other bank debt is not.

The spread between the interest rate on covered bonds and the swap rate varies. Sometimes it’s bigger. Sometimes it’s smaller. The size of the premium depends on investor confidence and global credit markets.

But when you sift through all the financial details you see that Australia’s banks are playing a dangerous game. The assets of the big four – $932.5 billion in housing loans – are secured by Aussie houses. Assets can change in value, especially when house prices fall, like they did last year in the biggest calendar year drop on record, according to Bloomberg. Meanwhile, the banks are incurring new debts via the covered bond market, using the same assets as collateral.

In the class system emerging in financial markets, bank depositors are proletarians. Secured and unsecured bondholders can probably sleep well at night. If the bank can’t pay back its debts, creditors have first recourse to the bank’s assets (your house, your deposits). Equity investors should probably take a cold shower after reading this and ask themselves why you’d want to be at the bottom of the capital structure in the event of a liquidation of a bank.

The even better question is why you’d want to invest in a business whose earnings growth is dependent on the expansion of debt…when the world is in the throes of a credit depression? You’ll be swimming upstream for several years.

Of course the whole issue of who gets paid what in the event of liquidation only matters if the bank fails. And from a political perspective, it’s unlikely an Australian bank would ever be allowed to fail. Depositors would be bailed out via the Financial Claims Scheme. Everyone else – the secured creditors, the unsecured creditors, and the equity investors – would fight over scraps based on legal hierarchy.

None of that will ever happen, though, because Australia’s housing market could never crash. Even if homes are severely unaffordable…and even if the global credit crunch is driving up borrowing costs…and even if Aussie banks are having resort to more convoluted ways to borrow money…Aussie house prices will be just fine, which means bank assets will be just fine, which means everything will be fine.

Tomorrow…why everything may not be fine after all.


Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning is the Editor-in-Chief of The Daily Reckoning Australia and the author of 2005’s best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 as a small-cap analyst. From 2000 to 2005 he was the managing editor of Strategic Investment, where he recommended gold and warned of the US housing bubble. Dan has covered financial markets from Baltimore, Paris, London and, beginning in 2005, Melbourne Australia, where he is the Publisher of Port Phillip Publishing. To follow Dan's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
Dan Denning

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  1. Rod says:

    When they started selling covered bonds I started pulling cash out and putting it into gold.

  2. Peter says:

    Dan Denning
    Have been wondering for some time about covered bonds.
    Questioned pre Christmas Westpac (my bank) at length about the security of money on deposit (both term depsoit and normal bank acct.)
    What happens in case of a bank failure etc.?
    they rabbitted on about the changes to the Govt. Guarantee.
    What I was never able to get from them was whether or not my “funds” on deposit was in full or part subordinated because of the covered bonds they had issued.
    Whilst I can, in a vague sense,understand that home mortgages can be subordinated on the basis that people with home loans have borrowed money from the bank.It seems reasonable that the bank borrow against those loans in the form of covered bonds which subordinates the home loan on the basis that the house would still be retained by the home loan holder but the group (the holder of the covered bond) owning the loan would change.
    But, in the case of subordinating deposit funds in the worst case scenario, a bank depositor would be left standing in a queue waiting to be paid if any thing was left. In my view this is not ethical. Do you have a opinion? I really don’t think that the normal person is aware of the implications of covered bonds. The Banks are very guarded in what they say. There is no plain english expanation about what has happened. It might be worth writing an article on the issue to expose the farce. It’s absolutely likely that the banks will not like what you have to say if you did a full investigation.
    Rgds Peter

  3. trested says:

    Dan, that is an interesting take on things. End game in the making?

    Peter, don’t worry! I’m sure the politicians and fat cats will be well taken care of in the event of some calamity befalling the banking system. While the depositors may get very little, they will still collect their generous superannuation and other benefits.

    After all, we are all equals – apart from that group which is more equal than you and me.

  4. Lachlan says:

    Good one Dan and good one Peter. I want to see Dan or other writers investigate covered bonds more fully too.

  5. nv says:

    A Covered Bond is as simple as;
    “The premise behind a covered bond is that it’s a secure debt. If you buy a bond from the bank – which is to say if you loan money to the bank – the bank pledges you collateral as security. As a secured creditor, you get first dibs on that collateral if the bank should ever run into a catastrophic event (that never happens in the banking sector, though).”;
    “In the class system emerging in financial markets, bank depositors are proletarians. Secured and unsecured bondholders can probably sleep well at night. If the bank can’t pay back its debts, creditors have first recourse to the bank’s assets (your house, your deposits). Equity investors should probably take a cold shower after reading this and ask themselves why you’d want to be at the bottom of the capital structure in the event of a liquidation of a bank.”
    It’s not rocket science folks, bond holders are ‘covered’, the rest are not.

  6. Laks says:

    Some OK points here, but people getting a bit mixed with some of the terms used I think. Some points to keep in mind:
    * Covered bonds can only take up around 8% of the assets of the bank I believe.
    * Covered bonds are indeed secured against the mortgages in the mortage pool, but NOT secured by the deposits. Keep in mind that a mortgage is an asset of the bank, whereas a deposit is a liability of the bank – it is not used as security as mentioned in the article. A covered bond holder cannot take your deposits per se, they have access to the assets of the bank – which support your deposits.
    * As such Deposit holders become structurally subordinated to the Covered bond holders indeed, up to the 8% allowable.
    * The rising cost of debt was not really a function of the covered bonds being issued, was more a function of increasing funding costs for all banks late last year due to the Euro crisis.

  7. Richo (the second) says:

    …but an equity investor probably has a market with greater liquidity to dispose of shares v a covered bond holder where there is not much of a market for liquidity. (referenced from a good article in the Sunday Age by Andrew Potts last weekend). Plus the equity holder can hedge with put options or CFDs.

    I was thinking of getting into covered bonds as a bit of diversity but decisded to be content with a mix of RBA Bonds, cash and shares.

    Even if covered bonds do provide cover in the event of bankruptcy by the time the liqudators take their “fee” there may not be much cover left.

  8. Peter 27 Feb 12 says:

    The follow up.
    We all genuinly need help to understand the reality of the issue of Covered Bonds means. Let’s be clear
    The challenge for you or the written media. Is that someone with a full understanding what is going on provide an explanation.
    Still hoping Dan takes up the challenge with his skills to write a simple factural article about Australian Government Legislation that has allows the majority of banking institutions to issue covered bonds. How they affect the security of existing bank stakeholders/customers, share holders, depositors and borrowers.

    I guess that I and the vast majority are the proliteriate (NV 28/02), certainly that’s the way my bank has treated me, rather than properly respond they in fact they offered to close all of my accounts. It just got to hard for them to explain.

    Lak’s response 28/2
    “It’s not rocket science folks, bond holders are ‘covered’, the rest are not”. Seems to sum up the way I have been treated, but I for one do not accept that this is right in any way or fair play.

    The vast majority of stakeholders either do not seem to care, largely because I suspect they have not grasped the potential of what could occur in a bank failure (won’t happen never will!!!!). I further suspect because the Banks have not fully explained. (the propectus for covered bonds if you can gst a copy runs on for a sbbstantive number of pages)

    In fact in the early stages they advised that they did not know what I was talking about.

    It might be one thing to say that they can only issue covered bonds to the 8% of their asset value but that’s not the point.(if I undestand correctly the assets subordinated are in a segreated pool(ringed fenced), which resides within the total pool of assets within the bank).

    What is not clear and undisclosed is whether or not the money that I have on deposit is or ever will be in a ring fenced pool as equity held as secuirty for covered bonds on issue or to issue.

    My situation is simple I deposit money because I get a return on investment, the return comes from borrowers and bank investments. The money was deposited long before covered bonds existed (At this stage after six months I do not know whether or not the money I have deposited is in the pool of assets that the bank has offered as part of the securities when they sold their covered bonds).

    So most probably I am wrong to think that my bank is in breach of the simple hand shake contract we had when the inital deposits were made.

    The simple contract being that the money would be available unencumbered or subordinated during and at the end of the term deposit or as when required from normal deposit accounts.

    Let’s all be realistic about this it’s not a matter that one party have a higher position than another. It a matter that the banks and other’s ensure that if they borrow money, use depoitors funds or lend money that they are able to balance the books come judgement day. (in other words the event that all say will never happen!!!!!).

    I await with interest.

  9. Lachlan says:

    the next step in the debate is for someone to qualify their assertions with some relative documentation

  10. Peter' 2 March 2012 says:

    Lachlan 28/02/2012 “the next step in the debate is for someone to qualify their assertions with some relative documentation”.
    I am not sure if this is the information you are seeking.

    I have an email from a Senior Westpac Executive that states in his words not mine in it’s closing as following:-

    “As to your question of your funds on term deposit being subordinated to holders of covered bonds; through a sequence of very remote and unlikely circumstances, that is correct. In context, the covered bonds represent only 0.5% of assets, and the assets of Westpac in Australia are fully available to meet Westpac’s deposit liabilities in Australia.

    Regarding the disclosure requirement, we believe we have met all obligations”.

    I could go on to talk about the Government Gaurantee on deposits but maybe I should leave it for a later time so as not to confuse the relative security issues of monies on deposit.

    The document is available, and I was absolutely dumfounded by the last sentance as he did not advise where it was either selectively, publicly or privately disclosed.

    As previously stated I think it has gone beyond the potential for the event that may or may not happen, it’s a situation that all depositors and people wth home loans be made aware of what subordination of their assets means. That they armed with the knowledge, either leave their bank and bank elsewhere. As well the Government needs to be taken to task to repeal the Legislation that was given assent on the 17 October 2011.

    The referenced Leglislation is as follows:-
    Banking Amendment (Covered Bonds) Act 2011
    Administered by: Treasury. Originating Bill: Banking Amendment (Covered Bonds) Bill 2011. Registered, 24 Oct 2011. Date of Assent, 17 Oct 2011

    Lachlan, Hope this in part properly responds to your on going interest.

    Dan Denning, How can you get your article into the main stream press.
    either people dont’t know or don’t care. It needs more exposure.

    The big issue is staed in your carefully written par.

    “The covered bond market was supposed to open up a new source of funding for Australian banks by “unlocking” their balance sheets. Banks are allowed to use different pools of assets to pledge as collateral for the bonds. The main two pools of assets are depositor funds (your money) and home mortgages (your house)”.

  11. Michael says:

    Don’t our deposits become mortgages when lent out.

  12. Mark says:

    At the end of the day, the banks really don’t give a shit about its small fry depositors, as deposits are a ‘liability’. Best not to expose yourselves too much too this unknown potential ‘covered bonds’ issue. All the banks are interested in is looking after capitalist fatcat big players first and foremost, and making the biggest returns (profits) possible while playing the age old PR game.
    The game of having mum and dad depositors and homeloanees think they are getting better interest rates, and having ‘security’ with that particular institution ,who, by the way, give paltry interest returns on deposits compared to the banks actual ROI with depositors’ hard earned life savings.

  13. Frank says:

    It goes somewhat like this: The bank does not own your deposited money,as Laks correctly states. Let’s say you deposit $100,000 with the bank. The bank owes it to you (as a liability). It then lends it out to X. secured by a mortgage over his home. owes the bank $100,000 plus interest (say 5% p.a. i.e. $105,000) at the end of 1 year. That debt, which is owed to the bank, is an asset of the bank.

    Now multiply this by 1000 (borrowers) for the purpose of this example. The bank’s assets are then $105,000,000 (which is owed to it). It owes to the depositors around $100,000,000 (more in fact, but I will disregard any interest payable to them). Its net assets are therefore in fact only $5,000,000(of which it has to pay taxes and all expenses such as salaries, bonuses, rents etc. during the year).

    The bank issues covered bonds of, say, up to 5% of the value of its assets ($105,000,000)and it takes on liabilities to repay those at the end of the year at $525,000 plus, let’s say,4% interest. This means it then owes $546,000 to covered bond holders plus the $100,000,000 it already owed to depositors = $100,546,000. But of course it has also lent out the covered bond moneys at a higher interest rate, say 5%. That has increased its assets by $551,250 ($525,000 plus 5%) to $105,551,250.

    Now things go wrong. The $5,000,000 has gone to expenses. The homes securing the mortgages drop 20% in value, i.e. instead of $100,000,000 they are suddenly worth only $80,000,000. The bank’s liabilities remain $105,551,250, i.e. $25,551,250 more than its assets. The bank gets into trouble. For instance, some of the loans it owes to other banks fall due, it does no longer comply with equity/debt ratio’s, or there is a run on the bank because investors/depositors lose confidence in it. If it cannot call up sufficient mortgage loans (which may not be good for the mortgagee i.e. you) or borrow enough funds on short notice, it will not be able to pay out, is insolvent and may go into receivership or liquidation, unless it is bailed out.

    The receivers/liquidators will take, say, $3,000,000 or more in salaries and expenses. The covered bond holders will get their $546,000 plus further interest, say by that time another 4% i.e. $567,840 because they are secured creditors (over the mortgages).The tax department will get any tax owing. The depositors who are owed $100,000,000 plus interest will have to make do with less than the remaining $76,432,160 which may dwindle further if confidence does not recover. In other words: instead of all creditors carrying the loss, the depositors will be carrying it, losing around 25% of their deposits in this example.

    Conclusion: Covered bonds are good for the banks, not necessarily for its depositors, even if they are limited to a percentage of the bank’s assets.

  14. Graham Paterson says:

    One question Frank – can you give me any evidence of one single depositor who has had his/her balance reduced because it has been lent out? If you have never heard of the fractional reserve system used by all the banks, it may pay to do a bit of research. Here are a couple of explanations from banking authorities going back over the years – The way private banks operate is well documented, such as the 1924 confirmation from Mr. McKenna, the Chairman of the Midland Bank in the UK. He explained, ‘Every bank loan and every purchase of securities by a bank creates a deposit (out if thin air) and the withdrawal of every bank loan and the sale of securities by a bank destroys a deposit’.
    More recently, Robert B. Anderson, Treasury Secretary under Eisenhower made the statement in 1959, ‘[W]hen a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.’
    That’s why the current system is one huge ‘Ponzi’ scheme and why no bank can ever withstand a run by their depositors because, most of the deposits are made up of this fictitious “money” created by the system.

  15. Ron says:

    Worked examples by Frank is interesting. But there are some overlooked assumptions. Firstly, Bank will never fail ( or allowed to fail ). Secondly, the printing press will never break down. Thirdly, because of first and second assumptions, house prices will never fall. So the original figures would be preserved. Every one involved would not suffer in terms of the existing figures of their investments or deposits. For all we know, there might not be a 20% depreciated price for the house prices but a 20% upwards increase. The bank assets likewise will be similarly compensated as an increase. The only problem left for all is that at the end of the day, everyone gets their original dollar figures, but by that time, a loaf of bread is no longer $4.00 but maybe $400.00. That my friends, is what the politicians and money market manipulators see today as the solution to the current debt crises unfolding !

  16. Biker says:

    It has ever been thus, Ron. My grandmother noted that a loaf of bread cost one farthing (a quarter penny) in London, back in ’84.

    (Let’s see if something _this_ innocuous gets posted! :D )

  17. Nick says:

    It seems to me that the Banks are only interested in moving overpriced houses off their books, and passing the problem on to someone else via covered bonds. The really scary thing is that if the Bank decides not to pay the bond holders, then the bond holders could sell your home even though you have never missed a mortgage payment. At least that’s how I read it. I does not seem to require the failure of the bank, just a default by the bank to pay the bond holders. It appears to me that covered bonds are a simple risk mitigation strategy.

    According to the BANKING AMENDMENT (COVERED BONDS) ACT 2011 (NO. 125, 2011) – SCHEDULE 1

    Banks are restricted to only issuing bonds over no more than 8% of the value of their assets by the following clause “An Authorised Deposit Institution must not issue a covered bond if the combined value of assets in cover pools securing covered bonds issued by the ADI would exceed 8%…of the value of the ADI’s assets in Australia.”

    HOWEVER and this is the scary part…

    “The value of assets in a cover pool must be at least 103%…of the face value of the covered bonds secured by the assets.”

    This clause means that as house prices must rise by at least three percent from the date the bonds were issued, either or that more houses and deposits will be added to the pool of assets available to the bond holder. If house prices drop, as they have been, and far enough it could quite quickly mean that the vast majority of houses and deposits are moved into the “cover pool”. I am not good at math so it would be interesting to see just how far houses would have to fall before every asset in Australia is in the cover pool and “beneficially owned” by the bond holders.

    I can only see a catastrophe approaching.

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