Life Down Under
Australia is leading the way in preparing a legislative base to support the emergence of a covered bonds market. With deals already coming to market in Australia and New Zealand the demand is clearly there, and the changes could pave the way for other Asian countries to follow suit. Manju Dalal reports.
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Australia is on the brink of finalising its guidelines for its covered bonds market, and intends the text to form the basis of legislation by the third quarter. The discussion period on the issue closed on April 22, with around 10 submissions made during the consultation period offering various suggested improvements to the guidelines.
“The current draft legislation meets most requirements except that some technical issues,” said Christoph Anhamm, head of covered bond origination at RBS. For example, “prudential norms need to be sorted out.”
As per the draft guideline released in March, deposit-taking institutions in Australia are allowed to issue up to 8% of the value of their assets in covered bonds. At present, only foreign issuers are allowed to issue such bonds in the country. Domestic bankers are prohibited from doing so, with the current banking legislation placing the depositors before the debt holders.
The new covered bond legislation proposes to amend the Banking Act to pave the way for these issuances while still keeping the depositors interest intact by extending a permanent guarantee on their deposits.
The Australian draft law caps the original loan-to-value ratio at 80% for residential loans and 60% for commercial loans. It limits the cover pool to first mortgages over residential and commercial property, cash, government debt and hedging instruments. Government debt is restricted to no greater than 20% of the value of all assets in the cover pool.
While most market participants accepted the proposed LTV caps are fairly standard, most wanted room to include loans with higher LTV (of say up to 90%) to provide some flexibility to the issuers. Bankers also felt that issues like increase in LTV after the issuance of the covered bond and over-collateralisation in the pool backing a covered bond need to be addressed more explicitly.
“Portfolio bias is a particular issue with the collateral constraints set to 80% LVR and 60% LVR respectively for RMBS and ABS in Australian covered bond portfolios,” said Macquarie’s Maher. “There is a risk – albeit small – that average LVRs would increase in the on-balance sheet portfolio. Given that APRA provides capital relief for insured mortgages (including greater than 80% LVR), then expanding the allowed collateral to include insured mortgages (with higher LVRs) would mitigate this bias and also be consistent with the current administration of the regulatory capital requirements for ADIs.”
The new rules also give the Australian Prudential Regulation Authority enough powers to regulate and come out with prudential norms on the covered bond issuances.
With the cap set at 8%, the four major Australian banks are expected to rise up to A$150bn-$160bn (US$161bn-$171bn) through covered bonds – sufficient size to kick-start the new asset class in the country. Credit unions and building societies will also be allowed to issue covered bonds.
Australian banks have to dramatically increase liquidity by 2015 under the new liquidity coverage ratio requirements. Consequently, in the first year following the implementation of the legislation the Australian market is likely to see issuance of A$10bn-$12bn. Ted Lord, head of covered bonds at Barclays Capital, believes that the first covered bond issue from an Australian bank could be for A$1bn or more.
Most market participants predict the first few issues will be domestic, with Australian issuers subsequently having to look towards more mature markets in Europe for big-ticket covered bond issues.
“The local market could easily absorb the covered bond issuance on to bank liquidity books,” said Stephen Maher, head of debt markets research at Macquarie Group. “But this form of roundelay may be negatively viewed by the prudential regulator and would represent poor investor diversification practice. I would expect that issuers would endeavour to tap as many separate markets as possible in order to maximise investor diversification.”
The demand for covered bonds will also be underpinned by a significant upcoming wave of government guaranteed redemptions that will begin this year. Australian banks took about A$140bn of such guaranteed debt with three to five years maturity in the aftermath of the global financial crisis, when it was difficult to raise money with without sovereign help.
Recent covered bond issuance has already established a good response to covered bond risk in the Australasian market. Globally, covered bond outstanding in 2010 was €2.2trn from 300 institutions in over 30 countries, according to the Reserve Bank of Australia.
“Covered bonds are basically nothing more than a financing technique but a regulatory framework will add much to the comfort of the investors particularly in regards to the assets used as collateral,” said Anhamm.
The industry has predominantly seen covered bond pools backed by residential mortgages, commercial mortgages or public sector debt. There are however proposals that suggest the greater use of aircraft financing, credit card receivables, student loans, SME loans and auto-loans as collateral.
“We firmly believe that a pooling model can also materialise in the Australian market but a number of things have to happen before that including fixing the final pooling structure as well as the respective equity requirements,” Anhamm said.