Here come the rate cuts, not

From Banking Day:

The Australian Government will set the cap on the percentage of assets that can be used to support covered bonds at eight per cent, the Financial Review reports – up from the cap of five per cent suggested by the Government back in December.

For some weeks, talk in banking and government circles has indicated a higher cap was likely. The corresponding cap in New Zealand will be 10 per cent of assets.

The Government will introduce the bill to enable banks to sell covered bonds into Parliament today. This requires an amendment to the Banking Act to override the existing depositor preference provisions.

Covered bonds, which involve banks pledging pools of assets as security to investors in wholesale debt, are widely used by banks in Europe as a wholesale funding option. Banks in Australia are anxious to make use of this option. They are a more flexible instrument than another alternative – the securitisation of asset pools – which requires a clean sale of assets to a separate trust.

Assets eligible for use in covered bonds will be residential mortgages, government bonds and cash.

And according to Bloomberg:

The plan is higher than the 5 percent originally proposed by the government and means the nation’s four biggest lenders will be able to sell as much as A$150 billion ($152 billion) of the notes, according to Westpac Banking Corp. (WBC)

Well, that’s splendid. Indeed it is, says Deutsche in a client note:

Scenario analysis shows reduced funding costs could add ~2% to earnings

We estimate the cost of issuing covered bonds will be 60-100bps lower than existing wholesale debt. Assuming: covered bonds are issued up to the limit; wholesale debt is displaced; and that the cost of the wholesale debt that does remain increases by 10bps, then the net reduction in funding costs would add ~2% to cash earnings. This benefit would likely play out over a number of years (as covered bonds are issued and other funding rolls off over time).

Hmmm…that is if the wholesale funding is displaced, as opposed to built upon, and the newly minted borrowings aren’t poured into new mortgages via the falling credit standards that the RBA warned against yesterday. Which hopefully won’t happen because of just such vigilance.

Deutsche could also be wrong if we recall that Gail Kelly recently declared on the ABC’s 7.30 that she would cut interest rates when her cost of funds began to fall. Surely we can expect an imminent unilateral rate cut for mortgage holders!

Not likely.

But the issuance of covered bonds does present a related problem for the banks. If they issue a bunch of them and displace wholesale debt, it will be that much harder to make the case for more unilateral rate rises, even if swap rates are rising, as Deep T. argued yesterday.

Finally, if you’re wondering whether covered bonds will hold up better than other wholesale debt in a crisis then the answer you are after is ‘a bit’, according to the RBA:

Covered bonds were not immune from the effects of the financial crisis but did prove more resilient to severe market stress and, with European Central Bank (ECB) support, have recovered faster than other wholesale funding instruments, such as asset backed securities and unsecured bank debt. The relative resilience of covered bonds is to be expected: the dual recourse and cover pool replacement provisions put covered bond investors in a better position than those holding asset-backed securities and unsecured debt. The European mortgages that typically back covered bonds also became less distressed than the US mortgages that backed many US residential mortgage-backed securities (RMBS). Nonetheless, despite providing more safety to investors, covered bond issuers’ access to debt markets became seriously disrupted during the crisis, suggesting that the robustness of covered bonds should not be overstated.
Houses and Holes


  1. I would certainly ask a risk premium when I put my savings to banks who issued this covered bond. I hope all smart depositors will do the same and this will cancel-out the interest rate savings they got from the bond by having to pay more for their deposit funding.

    • In that case, smart depositors shall still consider the degree of risk premium required for each of the banks, depending on their level of covered bond issuance, i.e. the bank that issued more of this is riskier then the others and should be paying more in their deposit interest rate to compensate depositors.

  2. I think permanent government deposit guarantee is also included the covered bond bill.
    So won’t the taxpayer be paying the risk premium already?

    • Correction: * Permanent government deposit guarantee is also included in the draft covered bond bill scheduled to be introduced in the parliament *

      • True BUT have they put a amount on it yet? I would suggest the $1M is out the window, replacing it with a $100K or $250k. I think the Govt have worked out if the deposit guarantee is still in place at $1M and the banks can sell covered bonds, all the risk is then transferred to the Govt, Basically all $150B dollars worth. (Can somebody say Ireland)

        $20 bucks the Govt have worked this out and wont release the FCS amount until the Covered bonds legislation has passed parliament.(Which is July BTW, FCS expires in Oct, which they have already said a decision will be made 2 months before ie Aug)

  3. There is no ‘risk premium’ to bank deposits because the deposits are guaranteed by the Australian Government.

    If you ignore the title of ‘covered bond’, it is actually a reverse ‘credit default swap’ where you swap the underlying asset instead of the interest coupon. The purpose is to create a class of ‘super senior’ creditors which ranks ahead of everyone else.

    In this world, you cannot get something for nothing. A ‘covered bond’ attracts lower interest rate because it’s more secure, however it does so by offloading the risk to the bank’s other creditors, like deposit holders. This is why the banking law forbids it. However, since deposits are guaranteed by the Australian government, the risk is simply offloaded to the Australian taxpayers.

    We’re way past the point of ‘moral hazards’ already, and the banks knows they’ll always be bailed out. Like it or not, the Australia taxpayer have become the largest unsecured creditor of our banks, and the ‘covered bond’ simply makes us even less secure.

    • Thanks for the update. But, can anyone provide any link on the deposit guarantee bill ? Is there any available information about the guaranteed limit amount and whether it will be temporary / permanent, etc ?

      I thought it was supposed to be temporary and soon to be expired in Q4 / 2011.

      Very sad development.

    • So wouldn’t that mean that wholesale funding costs would go up. As they would be further down the list of creditors to be paid and would therefore require a larger risk premium?

    • miker,Do you really expect the banksters to look beyond a 1-2 year horizon? As long as they can ensure this year’s profitability and bonuses, they are a happy puppy.
      I think covered bonds are a short-term fix for the banks to roll-over (refinance) their existing wholesale funding, especially those government guaranteed wholesale funds that are reported to expire in the next 2 years. It is pure coincidence that both figures are roughly equal to $150 billion :). Since banks have to pay a premium on the government guarantee, I expect them to buy back these bonds and re-issue covered bonds in their place.
      If this sh!t holds together for another 1-2 years, I expect some more “banking reforms”, all in the name of fostering competition. One possibility I can think of, is that AOFM gets more cash to buy private RMBS or there may be an outright free taxpayers guarantee on private RMBS. Since exit fees are banned, the big 4 banks can then let their walking wounded mortgage mugs refinance out of their books into the taxpayers books via the private RMBS market. As long as the banks can keep the bad loans down, their profitability keeps on shining.

  4. There was this news report that said $150 billion could be raised with covered bonds, under the the current 8% cap in the draft.

    Not a single news report in the mainstream media ever mentioned anything about the risk dumped on the taxpayer – have they signed on a code of silence on this with the banksters?

  5. It’s just making things messier and messier and that puts the pro’s, i.e. the banks, at an advantage over the normal people via the increased opaqueness it causes. They are the only ones who have the time to spend analysing the overly complicated financial system that results from all these twists in the rules and that is what gives them their advantage.

  6. I find it so sadly amusing how people so easily accept their government selling their constituents out in order to favour the banks.

    Any basic understanding of the fractional reserve banking system must apprise you that the whole concept, and objective, a priori, doesn’t favour you.

    Have you all become Pavlov’s dogs?

    The next step is imprisonment and torture and being found “guilt” before a trial such as the case of Julian Assange.

    After this, when you realize that you have been had, they shoot you in the cause of “national security”.

    Oh, you say, how can you say such terrible things? Look around you. the battle between “us” & “them” has begun -= and they have all the guns.

    And all you have is naivety!

    The trend is set…. firmly.