The next installment of working through the detail on how Mega Bank operates and is regulated is how covered bonds work. I have posted on this topic but its well worth revisiting and adding solutions for how both APRA and the RBA both could minimize a very risky situation. Why are they being issued and bought in such numbers and why has the baby has been thrown out with the bath water?
But first I’d like to make a quick observation on this week’s announcement of a loss and a capital raising by Bank of QLD which was the subject of some debate on MB. Prima facie the loss was caused by the drop in the value of property supporting non performing commercial loans secured against mostly development sites and had little directly to do with residential mortgages. Retail arrears and defaults did not change significantly. However, not enough information was released concerning the effect of the “borrower assist” program which allows a borrower with genuine hardship to defer payments for up to 12 months to be able to understand the real residential mortgage arrears position. The investor presentation did however refer to significant house price decreases on the Gold Coast.
My considered opinion is that the capital raising is something that has been strongly suggested by APRA to strengthen a weakening balance sheet before the situation deteriorates further. Although BOQ uses the standard approach and not an IRB approach, any deterioration in the value of security must be taken into account in the minimum capital allocation. Required or not, the question which is put to all referees is, how consistent is APRA going to be in enforcing banks to increase capital ratios and calculations of risk weighted assets? Without consistency from APRA, how can BOQ be competitive?
But I digress. Mega Bank has issued around $20Bn of covered bonds since November 2011. To summarise, covered bonds are bonds issued by banks where the bonds are secured by a dedicated pool of loans rather than simply the bank’s balance sheet. The misunderstood issue with covered bonds is that risk position of lenders and the providers of capital to the bank change considerably under the issuance of covered bonds. As APRA has regulated that the capital requirements for an ADI issuing covered bonds remain unchanged, one could be forgiven for thinking that the risk position has not changed. The facts are, that in order to support the AAA rating of the $20Bn in covered bonds issued, pools totaling $24Bn of residential mortgages have been used as the secured collateral. The extra $4Bn of collateral is now no longer available to support unsecured lenders, only the original capital is available as risk support which amounts to about $384M or more than a 10th of the over-collateralization.
In addition, the overcollateralization level exceeding 20% is solely determined by the opinions of credit rating agencies which have no responsibility for anything other than a conservative opinion on an AAA rating for the covered bonds. With 20% overcollateralization determined by CRAs and 1.6% capital allowed by APRA its not hard to understand that the more covered bonds that are issued, the less assets are available to support unsecured lenders, making this form of debt more expensive and more difficult to raise. The point must be reached where it may not be possible for Mega Bank or any other ADI to raise any long term unsecured funding. Many banks in Europe are now in this phase with little prospect of extracting themselves. The Australian bank babies, ie unsecured lenders both domestic and offshore, and depositors, are certainly being thrown out with the bath water of covered bond regulation.
To go over the point one more time. For every $1 of covered bonds that Mega Bank issues, a net 18.4 cents of security is extracted from the balance sheet that supports all unsecured lenders and depositors. This does have a significant effect on depositors because under the Banking Act, the government guarantee of deposits is not actually a legal guarantee but rather a make good claim for principal after the windup of the bank, which could take many years.
The Bank is also not incentivized to reduce or at least argue to reduce the amount sucked off the balance sheet ie the 18.4 cents. If APRA regulates that capital requirements will not change by issuing covered bonds and APRA wants Mega Bank to issue long term debt, then APRA gets what it wants no questions asked.
The counter argument is that so long as mortgage quality holds up to past performance, then covered bond investors will never use the over collateralization which in turn will always be available to unsecured lenders. Of course, if nothing ever goes wrong then the security is never used. As with all banking, so long as a bank can fund and asset quality remains strong then the dance will continue uninterrupted. However, the structure and regulation of Australian covered bonds sets up a dramatic feedback loop if and once asset quality starts to reduce even minimally.
If the performance of Mega Bank residential mortgages and the supporting collateral, ie house prices weakens, the unsecured lenders would be looking for more balance sheet support. At the same time the credit rating agencies will also be looking for more collateral to support the AAA rating of all the covered bonds that have been issued. This competition can only be won by the CRAs and the covered bond investors. Increasing over collateralization requirements must limit Mega Bank from raising funds to expand credit which in itself creates the positive feedback loop of lowering house prices and loan performance.
So is there an easy fix to this situation? Whilst there is no fix per se, there are things that both APRA and the RBA can do now to reduce the size of the positive feedback loop effect.
I do not understand the logic of a regulator treating Mega Bank’s capital requirements the same after the issue of covered bonds. Even APRA presumably understands the change in risk perspective of the unsecured lenders including depositors upon the issue of covered bonds. Regulation is primarily there to protect those lenders. As APRA allows Mega Bank to use the Basel II IRB approach to calculate capital weightings, surely it’s not that difficult for APRA to ask the banks to take account of the loss of assets supporting unsecured lenders when determining minimum capital requirements of the assets left on the balance sheet over time. The answer could never be zero, and it’s also Mega Bank’s responsibility to calculate the requirement. Not just an APRA directed capital allocation requirement. This type of approach would produce a hand break on both excessive covered bond issuance and the freedom of credit rating agencies to set overcollateralization amounts without reasoned argument.
At this point, many readers may be asking themselves, how is it possible for APRA to require 1.6% capital for perceived low risk residential mortgages and the CRAs to require over 20% support for their AAA rating opinions? It does not make sense. Well it doesn’t but there is an issue which significantly increases the overcollateralization requirements.
Covered bonds are primarily issued as bullet type bonds with principal repaid at maturity and not principal pass through like securitised RMBS. Therefore covered bonds suffer from refinance risk on maturity, especially when these bonds are backed by 30 year residential mortgages. The CRAs take this into account when determining the high level of over collateralization. The CRAs also take account of the ability of Mega Bank to use the RBA’s repo facility to repay the covered bond if it cannot be refinanced in the markets. Therefore, the terms of the RBA’s repo facility has a large effect on the CRA’s over collateralization requirements.
Now this is where the system is warped to the detriment of Mega Bank’s unsecured lenders and depositors. The RBA, aligning itself with APRA’s capital treatment that nothing has really changed with the issue of covered bonds, determines that covered bonds are just like any other ADI security for the purposes of repo eligibility and terms and conditions. This means that the haircut or discount requirements for Mega Bank covered bonds are the same as for its other unsecured securities. For example this means that a covered bond with a maturity of greater than 5 years is subject to a haircut of 6% in order to fund through the RBA’s repo facility and consequently the long term CLF as well. How is that justified when the CRA’s already impose a 20% collateralization buffer in order to get to a liquid AAA rating?
The whole structure of covered bonds and the unintended consequences have not been thought through by APRA or the RBA resulting in a large increase in risks for Mega Bank’s unsecured lenders and depositors which may be accelerated with falling house prices. The least the RBA could do to lessen this risk is to listen to the crying baby and allow repo eligibility of covered bonds with a 2% haircut as per government bonds. This action would certainly reduce CRA over collateralization requirements and go some way to lessening the balance sheet risk.