CBA pays the price

One of the major themes talked about during 2011 was private sector debt. The big unanswered questions were not only whether the private sector would re-find its appetite for debt, but also whether the banking sector would be in a position to match that appetite if it did appear.

Moving into 2012 that theme still stands, so one of the big questions for the Australian economy,  and more specifically the Australian housing market, is whether the Australian banks are going to be able to source funds at a rate that allows them to maintain interest rates in line with any movements by the RBA.

One of the big hopes from the banks was that recent changes to legislation allowing them to issue covered bonds would alleviate some of the funding strain. Covered bonds are a form of secured debt issuance and should, in theory, provide a more affordable source of funds over standard unsecured bonds.

However, back in November last year Houses & Holes observed that the initial use of covered bonds hadn’t gone according to plan with some banks paying around 150 bps over bank bills and CBA pulling an auction because the rate had spread out to 175bps.

Those rates are high and certainly not what you would expect to pay for secured debt in normal circumstance. As a reference government guaranteed unsecured debt was being issued at +190bps during the GFC and that included the government fee.

This week the Australian banks returned to the markets with new covered bond issuances, this time in Europe, under the perceived shelter of the ECB’s LTRO that was supposed to provide them with some cover from the European banking stress. The problem is that , as I have explained over the last few days,  the LTRO hasn’t really gone according to plan and the results for the Australian banks are not good at all.

From the AFR:

Australia’s banks are battling escalating wholesale funding costs as they establish their presence in the 200-year-old European covered bond market.

“Price is going to continue to be an issue for all banks around the world so long as there is continued uncertainty in the market and none of the pressures have gone away,” said Commonwealth Bank of Australia group treasurer Lyn Cobley.

On Wednesday, CBA became the first Australian bank to issue a euro-denominated covered bond, raising €1.5 billion ($1.9 billion) in a five-year transaction.

CBA got in ahead of a competing deal from rival National Australia Bank, which launched its own trade with similar terms as CBA was finalising orders for its bond issue.

CBA’s issue was managed by BNP Paribas, HSBC and Royal Bank of Scotland and was the largest covered bond sale by an Australian bank since the federal government first allowed local financial institutions to issue the securities in November.

“To get €1.5 billion for an inaugural deal in this market, despite considerable competing supply, is a great result, and demonstrates the depth of the European covered bond market,” said BNP Paribas managing director Kate Stewart.

Despite the success of the transaction the debt raising was expensive and converted back into Australian dollars at about 2.2 percentage points over the benchmark bank swap rate, or 6.6 per cent.

220bps for secured debt is a very high price to pay. Given that the general rule of thumb is that secured bond spreads should be half to two-thirds that paid on unsecured bonds it is obvious that unsecured debt markets are effectively closed to Australian banks, perhaps even in the event  of a renewed government guarantee.

That CBA was prepared to pay this price speaks volumes about its need to roll over debt. And that’s not great news for mortgage holders. As John Symond observed today, also in the AFR:

There is not a bank out there lending on new loans that is making a cracker. But they know that in the next six to 12 months they will be able to reprice their books by not passing on all the rate cuts.

And who’s to say funding costs have peaked?

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  1. Good article DE. I can’t see why they would have been hopeful for a positive outcome.

    I’ll be very interested to see what happens if/when the RBA drop rates again. Surely the banks cannot pass on any rate cut – I’d be thinking they will be trying to figure out how to increase rates! This will not be a popular issue in the public arena.

    • I think CBA said they are reducing the discount avaialable on package loans.

      So they are effectively raising rates!

      • Interesting. I’d think that the majority of their loans are packages.

        For some time the banks have offered cheaper rates via their ‘discount’ packages and kept higher ‘standard’ rates which very few people used. Perhaps they used this strategy in advance as a back-up plan… if so, that is a good move.

        They can move towards their standard rates under the guise of not raising rates.

        • This is the oldest retailing trick in the book, sell everything at a discount for a period and then take the discount away, I’m surprised it’s taken the banks so long to get in on the act. Genuine Fakhari rug anyone?

  2. Deus Forex Machina

    MY Lord…what a price to pay even if it was an initial transaction for the CBA.

    RBA rates are going to have drop much more than 25 points to counter this type of pressure on the banks and by extension their customers.


    • ???

      If cost of funding is high and RBA rates (i.e. revenue if passed through) drops won’t that just make the margin squeeze worse?

      Or are you talking about demand increasing due to a rate drop?

      • My understanding is that the covered bond issue impacts on the cost of their tier 1 capital, but the lower RBA rates help with the fractional reserve lending… as long as they don’t have to pass on the cut.

      • The rate the bank must pay on the bonds moves with the interest rate (BBSW) and normally so does the rate they charge on their loans.

        So if the Interest rate goes down, but they don’t pass it on in the home loan rate they will be making more money. ie, they will be paying less to service the bonds, but receiving the same amount from the loans.

    • Yes, apparently it’s only banks and retailers that should have to answer questions about ripping people off. Developers on the other hand…..

      • I think you meant local government rather than developers. Developers are only passing on the cost of bureaucratic inefficiencies why else would the Federal Government’s Building the Education Revolution decide it needed to legislate to circumvent all local planning instruments to get the job done.

        • No I meant developers. I did a number of small-medium projects in the 10 years leading to 2007. Rarely did I find the costs of Government interference excessive. Onerous at times, yes but for those that managed cashflows properly (i.e. avoided excessive debt financing) it was just another phase of each project.

        • From the jobs I have worked on during the Building Education Revolution, I’d say the government wasn’t so much worried about cost, but rather how fast to get rid of the cash. One job was a refurbishment and the adding of an Activity Hall. All in all it cost about $4 million, just a pity the school will be shutting down soon (as everyone knew it would) because of a lack of students. It was depressing to see how much of the spending was utterly unnecessary and how often schools were not given what they wanted. We even did work on two boarded up schools which, no doubt, will be torn down for res. development (if they haven’t been torn down already).

          • It sure was wasteful and I’ve got serious concerns about the nature of the wealth transfer between the Government and it’s ‘preferred’ contractors.

            I’ve got links to a small country town that had some work done on it’s school. The local trades couldn’t get a look in despite their ability to do the job for about 10% of the final project value. It’s become folklore there, but seems to be consistent with many other stories. The job involved superficial reno works on the school toilets and a multi-purpose room. Final cost = $150K.

  3. So being somewhat of a novice at this marco finance thing, I’m wondering how the banks manage to make money when they don’t pass on the interest rate cuts enacted by the Reserve? Is that because they can borrow domestically at a lower cost than they can by having a bond auction in Europe?

    If wholesale costs continue to increase I can’t imagine they would absorb the cost anyway – one way or another interest rates will have to go up won’t they –

  4. Jumping jack flash

    Banks will need to raise rates soon:
    Cost of funding is increasing
    Nobody is really borrowing
    Bad debt rising (slowly, but rising)
    Risk is increasing

    Interest was originally charged to cover the bank’s bad debts. When people are borrowing up big, they can afford to lower them, there is enough interest coming in with the increased volume of new debt to cover any bad. Additionally it entices new borrowers.

    But when nobody is borrowing despite super low rates and risk is increasing then (eventually) the only way is up. Otherwise the bank is exposed to all kinds of nasty shocks.

    But, then again, we have the trusty taxpayer so that changes everything.

  5. dissonanceMEMBER

    Why are Aussie banks paying extortionate spread to borrow recently LTRO printed ponzi Euros and therefore essentially re-capitalise broke EU banks with Australian’s hard earned?

    If the world is broke and in the grip of a liquidity crisis then surely the RBA is equally able to print and lend at 3 years and 1% (or whatever) the readies required by Oz banks to roll-over. Leaving aside the obvious question of moral hazard, this outcome would see interest rates set and controlled by the RBA as desired, a massive transfer of wealth to the EU at punitive rates replaced by internalisation of funding costs within Oz, the RBA making a tidy profit off the printing exercise, interest rates for savers remaining at reasonable levels (an important part of the national income stream) and maybe the AUD dropping slightly in recognition that ‘we are all printers now’ relieving further stress from our economy.

    Call me crazy, just sayn.

  6. A bit off topic, but why were banks restricted from issuing covered bonds until now? What was the rationale behind it?

    • The idea was that depositors should be first-line creditors. That is if the banks fail then depositors should be paid first. Covered bonds have the potential for this not to be the case.

      However, given that everything in the universe is now covered by the Australian taxpayer it is all a bit irrelevant.

  7. OK, at this point in time I _MAY_ be jumping the gun, but to me this is it, the turning point before my eyes.

    With the cost of funding now blowing out, the banks will get in the RBA’s ear to lower the cash rate.

    I can not see any alternative. (and really the essence of any response I am after)

    But once the rate is lowered, and it looks like it will be required to be 50bp, there goes the AUD.

    A lower AUD will make it more expensive to roll over the next tranche of debt, thus the spiral begins.

    Is there any other policy measure left?

    I won’t speculate further on marginal adjustments of discretionary spending, or foreign monetary measures, they are unknowns.

  8. I find it staggering that an Australian Bank would pay that much for offshore funding. Have domestic investors really been tapped out at deposit rates of around 6% ? Why on earth are super funds, government connected industry super funds at that, continuing to funnel billions into offshore secondary equity markets for dubious theoretical diversification benefits, where they could be picking up a 6% yield for the next five years ?

    • Your assumption that offshore investment markets offer poor opportunities compared to Aussie cash is flawed in my opinion.

      You don’t think there are many people who have already moved their super fund to cash or TDs? I think you will find that there are many that have done so.

      Are you saying that everyone should be in Aussie cash? After tax and the rate of inflation the real return is not high.

      US shares have better opportunities than Aussie share right now, yet many Aussie shares, which are currently slightly below fair value (IMO), pay 6%+ dividends and franking credits. The DOW companies pay around 2.5% dividends and they are growing.

      If the Aussie dollar moves back towards 70c to USD at some point, then Aussie cash looks even worse. If we have banking problems or more RBA rate cuts, then this is more and more likely. This makes Aussie cash look like a poor option over the medium term.

      I don’t agree with you that 6% Aussie cash will last over the next five years, and definitely don’t think it provides a great risk/reward opportunity over that time-frame.

      • Not wanting to take this too far off topic, but how has the US equity market (about 50% of offshore equity allocations in super funds) held up against Australian cash for the past 10 years ? Does a European and American recession generally bode well for equity markets ?

        What is the diversification benefit of holding international shares when risk spikes and correlations go to 1 ? How have these holdings actually reduced risk in Balanced funds ?

        The default option of most super funds targets about 20% in overseas equities, adjusted tactically. I dispute that money is flowing out of those default Balanced options into cash and fixed income options for the majority of super fund holders.

        I put it to you that super funds and their default option members would be better off buying domestic bank issued bonds at 6% for 5 years, and accordingly reduce their exposure to offshore equities for the same period.

        • One does not invest based on the past, but on the future. To compare one asset class to another over a past 10 year period and then project diversification benefits as a result makes no sense from an investment strategy perspective.

          I’m saying that currently US stocks have some good value. A US recession is not relevant at this stage because that value is based on factors which are already at play. I’m referring to the next five years from an investment strategy perspective. Diversification benefits only come in to play when someone has a poor/no investment strategy – e.g. typical balanced fund.

          I put it back to you that offshore equities (specifically US multinationals) will do much better than domestic bank bonds at 6% over the next five years. If anything, currency devaluation will do the job.

          • > “One does not invest based on the past, but on the future. To compare one asset class to another over a past 10 year period and then project diversification benefits as a result makes no sense from an investment strategy perspective”

            I agree – shame most asset allocators have failed to grasp that over the past 30 years. That aside, I would still assign a high probability that correlations between asset classes will be much higher than historical data would suggest, that there is a high probability of US equity markets underperforming domestic cash (most super funds have effectively passive exposure anyway so stock picking doesn’t come into it) which begs the question – what is the risk diversification benefit from investing in offshore equities ?

            Most super funds will hedge their offshore exposure, so what difference currency movements ?

            My tactical call would be to underweight offshore equities in favour of domestic fixed income for the next few years, but that is a whole other forum.

            At a completely personal level (to the extent it is possible or desirable to detach that from investment reasoning) I do not have an issue with super funds being diverted (where there is some reasonable investment justification) to where there may be providing a secondary social benefit. I would say that reducing funding costs for banks relative to a 6.6% offshore covered bond issue is not a bad thing.

          • The diversification of US equities is that they are highly likely to outperform Aus cash by a wide margin.

            I think the past decade US equity performance is completely unrelated to Aus cash and therefore any assumptions based on past performance are based on coincidental factors. My view is that US equities will do much better.

            On a risk adjusted basis, I think that cash is a poor choice due to the known currency devaluation. If our rates drop further and if inflation rises further – which is my view – then cash will be substantially eroded. On a longer term view, cash is the WORST possible investment class for this decade due to the fact that the solution to too much debt has been decided. That solution is to increase the quantity of cash and thereby decrease the value of cash, whilst artificially suppressing interest rates. I think substantial cash holders could be wiped out in a decade. How do you treat that in terms of diversification?

            I also think that AUD is unlikely to get much stronger as it is reliant on higher rates, stable banking system and stable China. Therefore, one has a choice to invest offshore without currency hedging.

            I do have an issue with super funds being dictated to invest on the basis of social initiatives. The reason for this is that it is essentially forcing people to make investment choices which are likely non-optimal. This is the job of the government and NOT private capital. Private capital must invest in productive and efficient enterprise. It is for this reason that capitalism is breaking down.

            There is no way I would ever think that providing cheap funding to Australian banks from my own capital. Governments are doing this by printing money, which is achieving a similar outcome, however it is only holding back the inevitable. That which is unsustainable must be cleared out so that sustainable economics can grow.

          • >”The diversification of US equities is that they are highly likely to outperform Aus cash by a wide margin”.

            Highly debatable, but therein lies someone’s alpha, I guess. Asset allocators at the start of this century started with the same supposition on US equities, implicitly derived from historical returns, to justify increasing their allocations.

            >” I think the past decade US equity performance is completely unrelated to Aus cash and therefore any assumptions based on past performance are based on coincidental factors”.

            Of course, but I am only talking about assigning a probability to future asset class performance based on where we are today. We just disagree on which will outperform, so let’s check back in five years. I will emphasise that I am only talking five years invested in 6% coupon bonds to correspond with the maturity of CBA’s covered bond issue, and to make the point with that arbitrarily chosen (but plausible) rate that it would hypothetically be a better funding avenue for the banks.

            “I think substantial cash holders could be wiped out in a decade. How do you treat that in terms of diversification?”

            I am not talking about cash, and only talking about 5 years.

            >”I also think that AUD is unlikely to get much stronger as it is reliant on higher rates, stable banking system and stable China. Therefore, one has a choice to invest offshore without currency hedging.”

            Agree, but even if funds do wind down their hedges at this level, they are rarely so brave as to go fully unhedged. Super funds can profit from currency moves in their alternatives bucket – much cheaper and risk efficient to do a pure currency play with forwards without any regard to equities if that is your view.

            I am not talking about forcing people into social initiatives that are going to burn their wealth. There are plenty of wealth enhancing strategies that will do that for them sufficiently as it is.

            As for whether private capital invested in secondary equity markets is productive is a whole other issue.

            Leaving aside how we got into this mess, it would be a relatively more desirable social outcome for me that banks were able to pass on the benefits of cheaper funding, particularly where there are large pools of domestic funds available, and where there is a perfectly reasonable case to be made that they are being poorly allocated.

          • I have good reasons to think that US equities are now at a point where they display good value. Based on my economic indicator, they have not looked this good since 2003. However, time will tell if the economics fall apart or not.

            Obviously that is speculation – which is the backbone of all investment decisions. However the purpose of diversification is obviously to reduce the risks of getting it wrong. I would prefer to see a model of relative value diversification as opposed to a static measure – however that is just me. Everyone must make their choice and live with the consequences.

            With regards to secondary equity markets, I cannot fathom how having secondary equity markets is not productive. They fit a purpose just as do secondary credit markets. They are a marketplace and allow for relatively efficient allocation of capital. This means that there is a greater supply for capital for new business opportunities (e.g. capital raising etc).

            Furthermore, why even make a comment like this? Debt markets are highly risky when debt is not constrained. This is the mess that we are now in. Debt markets are therefore useful to a point, but beyond that point they are destructive. Why focus on owning debt in a world of saturated debt, compared to owning the equity of productive enterprise?

            Debt capital is only useful to a limit. Equity capital is the lifeblood of productive enterprise.

            If you want to subsidise the banks, that is your choice. However the reason why they are facing this issue is that they have too much debt to refinance. Giving cheaper credit to the banks to give cheaper credit to borrowers is just taking from savers and giving to borrowers. It is a zero sum decision and there is a loss on one side and a gain on the other.

            I suspect that the government/RBA may end up trying to provide cheap credit if things get out of hand. This will penalise savers and the reason why holding too much cash over the next 5 years could be a bad idea.

          • From a whole of portfolio risk perspective, how much diversification can you honestly expect by tweaking strategic allocations between domestic and global equities, particularly when markets take fright to the extent they did in 2008 ? Unless you were heavily weighted to fixed income/cash on the beta side and long volatility in your alpha bets there was pretty much no solace; and statistically ‘impossible’ correlations gave the diversification dogma the lie. I strongly suspect this will be the new normal for quite some time.

            I have no problem with relative value, but I think super funds can play that just as easily through TAA or other macro strategies without the physical allocations.

            Just to be clear, it would only require super funds’ balanced options to take a marginal shift away from global equities to fixed income to potentially provide domestic banks with lower funding costs than they are likely to face in the coming years. Funds will still be left with plenty of punters’ coin to play in the global equity sandpit.

            As for secondary equity markets not being productive – what % of super fund allocations to secondary global equity markets participates in new capital raisings? Not much. Is liquidity provision for traders supposed to be a solace to long-term investors?

            By all means, let our super monies fund new business opportunities and participate in productive enterprise – but do it via direct investment or venture capital funding. Yield-farming aside, I fail to see the long-term productive benefit of secondary markets for super funds given the attendant nuisance of their very public volatility.

            I don’t want to subsidise banks anymore than we already do, but I believe that as a country we could find more nationally beneficial investments for at least a portion of our super funds which are currently being unthinkingly funneled into global equity allocations, and not very productively at that.

          • What % of super fund allocations to secondary global equity markets participates in new capital raisings? Not much. Is liquidity provision for traders supposed to be a solace to long-term investors?

            By all means, let our super monies fund new business opportunities and participate in productive enterprise – but do it via direct investment or venture capital funding. Yield-farming aside, I fail to see the long-term productive benefit of secondary markets for super funds given the attendant nuisance of their very public volatility.

          • In 2006 BAC had a P/E of 14.8 @ a $54 price. Today @ 6.31 it looks overvalued.

            In 2 years the USA has added 2.28M jobs and has 140M employed.

            In that time National Debt has increased 25% or roughly $3Trillion.

            Thats just over $1M in debt for each job. Thats value?

          • Pithoneme,
            It sounds as though you want a single super fund with a prescribed investment allocation and limited investment options. You are pretty much against free markets and capitalism. Just because you don’t see the value of something, it does not mean that many others won’t.

            In either case, the things you suggest will never happen – at least if it did, then you would see a capital move out and super would become essentially a government run and controlled mechanism, which inevitably is inefficient and subject to political requirements. It just won’t work. In either case, the things you suggest are theoretical and are extremely unlikely to happen – unless the government ends up taking over super money for its own (aka Hungary scenario).

          • Macros
            You are extrapolating to a ludicrous degree.

            It is perfectly conceivable that such actions could exist within a broadly free market (and in fact, variants of them already do globally), but as usual in these discussions it really comes down to one’s views on how broad that freedom of capital and how restricted the pursuit of social goals by government should be. I bristle at the unthinking dogma that is perpetuated on both sides of the argument.

            There is no practical reasons why Super Funds could not play a bigger part in alleviating the funding costs for banks, and still participate in the economic growth of companies and relative value opportunities you describe. From a whole of portfolio perspective, this would not have to incur unreasonable distortions to risk capital.

          • pithoneme,

            We are clearly coming at this from two different perspectives and obviously will never come to an agreement. My main contention is simply that providing banks artificially cheap cost of capital is essentially an inefficient allocation of capital because it will alleviate any issues in the short-term, but it does not resolve the underlying problems – which are global. It is for this reason that I do not see any value in the type of system you describe.

            Now if we were starting from a stable base and we able to have rational social discussions for the nation-wide political system regarding how we want the banks to work in the system and how much social support they receive to match their social responsibilities, then it would make sense. Given the fact that I cannot ever see this happening this decade (if ever?), I just don’t see the point.

          • BAC was very good value in 2006 (if you ignored the likelihood of a housing correction).

            Current value is based on current situations.

            The current valuation model doesn’t account for changes in a global credit freeze, domestic credit tightening, house price correction, China correction etc.

            Waffling about value under ‘current conditions’ is waffle.

            Price in…a global credit freeze, domestic credit tightening, house price correction, China correction etc.

          • “Current value is based on current situations.”

            I couldn’t disagree more. Current value is based on expectations of events to come in the future.

            You don’t think other market participants are aware of those factors that you mention. What about if the tables turned and all of a sudden other factors were able to counter those conditions?

            If you have a look at the info I posted in the trading day thread above this one, I have developed an economic fair value model which suggests that we are now priced below fair value for the first time in years. Obviously things can change, but until they do I’ll go with the data that I see.

        • good questions – we’ve discuss this before at MB, at length. Check out the superannuation, investing category and use the search function at the top right to have a gander.

          I’ve come up with a possible solution instead of buying bank issued bonds, the government backs “research bonds” by paying the coupons, where the superannuants pool their resources for the initial capital. After 5 or 10 years, if the research yields no significant development opportunities, the government pays back the bond capital to the original investor, or it is rolled over and it keeps paying the coupons. See here for more info:

          • Now that is a good idea.
            It might actually lead to genuine improvements in wealth and productivity. Unfortunately the probability of an excellent idea being encouraged by the Government is inversely proportional to the greatness of the idea.
            (I’m sure I’m paraphrasing someone famous here)

  9. Is there any public record of which Aussie banks have sold how much in covered bonds?

    Otherwise, how do you reliably find this information?

    • You can find that info by looking at the bank websites, either in the investor centre or media releases. Westpac has a nice monthly investor report that summarises the covered bond programme.

      There have only been a few Aussie covered bond issues to date so its easy to track (from memory, ANZ had the first ~$1.25bn, Westpac second with a billion and now the CBA issue. NAB is about to get its first issue away).

      The NZ subsidiaries have launched a few more covered bond issues, and again that is available on the bank websites.

  10. I consider this to be great news. When the rubber hits the road this year, all the charade about how well-managed our banks are and how their reliance on offshore funding has come down, will end.
    The offshore market is sending the price signal that our banks are not as safe as being made out after all.
    Bear in mind, the big 4 banks have to roll over (forget raising fresh funds) $ ~150 billion .. so this is just the beginning.

  11. That price is pretty amazing…given that CBA is getting this away now they must be assuming that funding costs will be higher than that in the future (i dont believe they have an urgent funding need right now).

    We’re headed towards ZIRP and more RBA guaranteed funding methinks, which means havoc for the public balance sheet and a fair amount of hurt for the economy. I dont see how it can play out any other way, unless someone can explain how the EU can actually stop itself from imploding, or how China can replace hundreds of millions of wealthy Western consumers with Chinese peasants.

    • I agree, however EU can stop itself imploding. It already has with LTRO. I think this is much bigger than is widely thought. On 18 Jan the reserve ratio requirement is going to be just 1%. There is much they can do. However they want to have the perception that they are trying to be responsible.

      • Jan 18 is certainly a key date, and one I am waiting for. The reserve ratio change really is the biggest part of the ECB changes IMHO.

        Obviously the question still stands. What will they do with the excess reserves ?

        • DE,

          The Italian 2 year bond 7.66% on Nov 25 to 4.92% now. I’m pretty sure that is not all the heavy lifting of the ECB.

          The 10 year bond hasn’t improved, but that is to be expected with a 3 year facility.

          Surely it is the banks that are buying govt bonds through the carry trade, and are keeping funds with the ECB with fractional reserve. Is it not the case that 1% of the funds received by the banks must be kept as reserve and achieve up to 100 times leverage?

          I view this is a form of QE, without the same attention they would receive if they had called it QE.

  12. Hope this is not a silly question, but in the report it notes pricing was at 100 bps above midswaps, so how did you convert this to 220 bps above BBSW (in AUD)? Do you have a formula to share as im still trying to get my head around this. Thanks.

    • +100

      Price in a 20% housing correction and revalue them, then 30% etc.

      This valuation rubbish under current conditions is like saying; hmmm no cars have used this road in 5 hours, its 3AM and I might have a kip on it since its warm.