Covered bonds show bank funding stress

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From Banking Day:

A recent resurgence in covered bond issuance by Australian financial institutions provides evidence of deteriorating market conditions.

The four major banks have continued issuing covered bonds since the first issues were made in November last year. But the initial rush of issuance lasted only until early March, with there being just a trickle of issuance more recently.

Suncorp flagged the possibility of changing conditions with its A$1.6 billion covered bond debut on May 30. The next day, ANZ sold HK$400 million of three-year covered bonds. The floating-rate bonds were priced at 85 basis points over Libor.

On Tuesday, ING Bank Australia told an Australian Securitisation Forum seminar in London that it was planning a domestic covered bond issue, after being encouraged by Suncorp’s success. Issuance denominated in euros, British pounds and US dollars may follow, ING Direct officials said.

On the same day, National Australia Bank sold US$1.25 billion in covered bonds on the US s144A market. The five-year bonds were priced to yield 2.032 per cent per annum or 129.5 bps over US Treasury bonds.

Some early commentary has focused on the two per cent coupon that NAB will pay on the bonds, but the proceeds would swap back into Australian dollars at about 150 bps over bank bills.

This puts NAB’s cost of covered bond debt in line with what Suncorp paid in the domestic market less than two weeks ago.

Unsecured debt, which is still the lion’s share of bank wholesale funding, typically trades roughly 30bps wider than covered bonds. This puts it at 180bps over swap, very much in line with current CDS pricing, and also clearly uneconomic for the banks over the longer term. Covered bonds at 150bps over swap are filling the breach for now with $30 billion issued of the possible $130 billion. But think on this: with the cash rate 3.5% and mortgage indicator rate at 6.15%, add the 1.5% and you’re ok with a net interest margin of 1.15bps. But subtract another 30bps and it’s starting to look awful thin.

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Of course the banks have blended funding, its not all about the market rate. They have some really low cost stuff and then they have high cost stuff.

But if a factory is supposed to produce until marginal revenue equals marginal price and that sets the production limit (or in the case of banks the lending/debt creation limit) then we are there or thereabouts.

And each additional loan the banks now write over and above what they have on their balance sheet could/will lose them money.

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Unless they reprice of course!

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.