Australia | Mar 29 2011
By Greg Peel
The words “collateralised debt obligation” are enough to send a shiver down the spine of anyone impacted by, or able to simply appreciate, the recent Global Financial Crisis and its origins. The butterfly which caused the storm was the trickle of defaults in the US of subprime CDOs, a form of mortgage security.
That storm finally resulted in the fall of Lehman Bros and the near collapse of the global financial system, were it not for massive central bank and government intervention. And it was all about the packaging up of humble mortgages.
Understandably, mortgage securitisation all but shut down offshore and in this country in the wake of the GFC. Lack of securitisation funding saw the collapse, closure or sale of many smaller institutions that relied on this cheaper source of funding given their credit ratings made offshore funding simply too expensive, the latter camp including St George and BankWest. There have since been a handful of mortgage securities issued, but realistically no one expects or wants that business to become fundamental again.
One might be surprised to learn, therefore, that last week the Australian Treasury outlined a draft bill proposing exactly that – the return of mortgage securitisation. What the Treasury is proposing, however, is a very different form of mortgage security – the “covered bond”.
Australia did not really see any level of subprime mortgages or related CDOs sold locally — most of the damage was done offshore. Not that they were totally absent, and the preponderance of “no doc” and high loan-to-value ratio mortgages meant that there was still securitised mortgages of questionable quality. CDOs were highly complex instruments. In simple terms the nature of CDOs meant packaging up and on-selling mortgages from brokers to banks to hedge funds and other investors – a maze which rendered the actual end-holder of a mortgage unclear in many cases.
Covered bonds are different in that rather than on-selling the mortgages themselves, banks keep the mortgages and only on-sell the interest payment stream. A package of prime mortgages is still considered by ratings agencies to be AAA (“safe as houses”), albeit requiring of a higher risk spread (interest rate) than government debt. Mortgages that continue to reside in bank loan books are also a lot “safer” than those for which ultimate responsibility is questionable.
Covered bonds in reality are little different than good old finance company debentures, which allows investors to buy units in the interest payment stream from a collection of car loans, for example. Income from the sale of the debentures allows finance companies to offer more loans, leading to more debentures. The finance company profits from taking a cut in the middle of the loan rate to the borrower and the coupon rate to the debenture holder.
And that's exactly how covered bonds would work for banks. They will write mortgages at a certain interest rate, and then sell units (the bonds) to investors at a slightly lower coupon rate, with the spread representing a profit margin. Income from the sale of the bonds can then be used to finance further loans.
When banks go offshore for funding, they do so by typically issuing debt in the form of bonds maturing in 4-5 years which are purchased by mutual funds and so forth. These bonds are on the bank itself, not on some collection of loans. Thus one must take into account the bank's exposure to bad debts among other things, and in Australia's case the big banks are rated around AA, not AAA. Collections of prime mortgages – those with low loan-to-value ratios and plenty of accompanying paperwork – can be rated AAA, as noted, meaning the coupon needed to attract investors is less than that which the bank itself has to offer when issuing typical funding bonds.
In other words, covered bonds are a cheaper form of finance for Australian banks than offshore funding.
Since the collapse of the mortgage securitisation market in Australia, bank funding costs have been on a steady rise as bank bonds issued in the pre-GFC days of cheap money roll off to be replaced by bonds issued in the very expensive money days of the GFC and its wake. Given maturities are typically around five years, there are still expensive lumps of funding sitting on bank balance sheets which are still to roll off into the now cheaper funding environment. Westpac, for example, has stated its offshore funding costs will not begin to reduce until late 2012.
In the interim, banks have competed heavily for the cheapest form of funding – deposits – such that margins have been squeezed from both sides. Mortgage securitisation provided a funding source that sat in between offshore-issued bank bonds and local deposits in cost, and covered bonds are ostensibly the same, with a much reduced risk. Deutsche Bank, for example, estimates the cost of issuing covered bonds will be 60-100 basis points lower than offshore funding, adding around 2% to Australian bank earnings. The Treasury will limit total covered bond financing to 8% of total assets.
As JP Morgan notes, the timing and size of the covered bond issuance allowed closely matches that which the banks will lose once the government's deposit guarantees – put in place after the fall of Lehman – expire. The ability to issue covered bonds will also assist Australian banks in satisfying the various aspects of the Basel III rules on bank capital and liquidity ratios.
So everyone's a winner. The banks can raise cheaper funding. This will directly and indirectly offer a reduction in mortgage rates for Australian homeowners. And those looking to maintain a portion of their investment portfolio in fixed interest have a higher return option on offer than just government paper.
Covered bonds, incidentally, are not specific to mortgages and can be issued over any from of qualifying loan. Nor are they a new phenomenon. Indeed, covered bonds have long been popular in Europe given a history going back several hundred years.
