How to fix covered bonds

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  1. I am not an expert on this subject, more of a learning curve for me but who are the unsecured lenders/depositors? are they you and me with our savings?

    Also, I would like to know who is a good bank to go with or credit union. Currently my money is in Mega Bank and I don’t believe the markets in the EU are safe and I think with a euro crash our property markets will get smashed with a big impact on Mega Bank so I want to move what small savings I have out to a bank or credit union that is not so exposed if there is such a thing

    • who are the unsecured lenders/depositors? are they you and me with our savings?

      Yes, as depositors. Unsecured lenders are those who purchased vanilla bonds issued by the banks. (Equity – i.e., shareholders – is/are the last in line)

      I would like to know who is a good bank to go with or credit union.

      There’s a legal disclaimer attached to most posts here that this is general advice only and your personal circumstances may be different – read that first. Then consider it this way: are you concerned with safety of access to your savings? Go with the branch of MegaBank offering you the highest return on your savings, because they definitely fall in the too-big-to-fail bucket, and the Govt. will do whatever it takes to prop up the pillars. Going for a credit union or smaller bank such as Bendigo is a very, very slightly higher risk – short of the real estate market deteriorating by 20+% over a year, you’d be fairly safe with any ADI.

      (Anyone else, feel free to correct or add your view here…)

    • If they want to “level the playing field” between megabank and the smaller banks wouldn’t a good start be to stop megabank from using the IRB method and use the accounting system that the others have to use, which I think I read here sometime back is more conservative in capital requirements.

  2. Aaaah, unintended consequences. So basically the risks have gone up for unsecured creditors(you and me with our savings) while pushing up the interest rates on normal bonds, while simultaeneously leveraging risk to residential property prices in OZ. Did we even need them in the first place?(covered bonds)
    The following saying comes to mind-‘if you think the problems govts create are bad, just wait for the solution’
    Thanks DeepT, very interesting, encore.

  3. Firstly, thank you for clearing up the issue re. BoQ residential lending impairments. I was involved in that debate and it was very frustrating to be having to argue a position that I knew would be correct (confirmed the next day via the Merrill Lynch report)

    I also agree re the possibility of greater than declared retail impairments in areas such as the Gold Coast, but lets leave it at that in this thread.

    Moving on – the information on covered bonds is most welcome. I wasn’t aware that it would impact on reserve requirements in this way.

    If the terms remain unchanged, how long will it be before it impacts severely on our banks ability to raise capital, and when do the first issues need to be refinanced?

    • Hi Peter, forgive my ignorance but when you say re ability to raise capital, do you mean they wont be able to raise the capital(is that possible) or they will always be able to raise capital- it will just cost alot more? ie higher interest rates.

      • Hi vortex, well it may or it may not, so I was asking DT a question in a similar vein.

        We should wait for that answer.


    • PF and others

      The most important part of Mega Bank’s funding is being able to raise long term funds in the US and Europe. Huge issues were apparent in December and January but theese have eased considerably due to the ECB’s LTRO program which provided large liquidity to European baks which allowed investment into Australian bank covered bonds at reasonable rates.

      The effect of LTRO will wear off and scarcity of funds will reoccur in the coming months. As the housing market deteriorates offshore investors in Australia and Mega Bank will be looking very closely at whether to roll over maturing debt and the cost but the blow torch may be applied very slow.

      Also, I have to declare that I do not deposit funds with Mega Bank

      • Thank you for the reply. Loved the disclaimer.

        Yes I would agree with all of that, but I do think that now that they have dusted off the excel version of the Guttenberg, we are in for an extended period of cash at low rates hoping for the miracle of inflation to eat the debts away.

        Thank you for the reply.

        If I can add my own disclaimer for all of those who follow me around asking for data – I don’t have any data on expressed opinions of what I think may happen in the future.

      • I keep on thinking of LTRO as similar to the QE1 and 2 operations in the US and if the outcome is the same we end up with an increasingly well capitalised banking system that will have no issues funding itself after 2 or 3 years of low rates and positive carry. The size of the LTRO looks like it is targetting all of the refinancing requirements of Euro banks for 1 year ie if they even get a fraction of maturing bonds refinanced, they are awash in cash

  4. If they want to “level the playing field” between MegaBank and the smaller banks wouldn’t a good start be to stop MegaBank from using the Basel II IRB method and use the accounting system that the others have to use, which I think I read here sometime back is more conservative in capital requirements.

  5. Diogenes the CynicMEMBER

    Good article. Regulators are either asleep at the wheel or totally complicit. Either way Megabank and Aussie taxpayers are in for a world of hurt if this continues.

  6. Mitigators are
    -the covered bonds are limited to 8% of assets and as RBA governor De Belle pointed out, the banks will leave some margin of error so they wont get there
    -It hasn’t changed the ratings agencies views which in the Australian case are heavily influenced by their size and the implicit and explicit government support that will ensue when systemic crisis hit. ie debt doesn’t get hit
    – Even in GFC times (although I seem to remember something nasty in Denmark)no senior lenders (either secured or unsecured) were asked to burden share
    -Even if you go through the academic exercise where things are so bad that half of the over collaterallisation is used for the covered bonds,this only reduces the recovery rate for the next layer down by 2 or 3%. Country is stuffed and you probably wont have a job but theoretically you still get most of your money back.
    Agree entirely with the sentiments and we can only hope it doesnt become as bad as Europe where to collateralise LTRO borrowings enormous amounts of assets are being pledged to central banks. Thats when senior migrates down to subordinate

  7. rob barrattMEMBER

    “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”

    Assuming inevitable Greek default, domino effect on rest of PIIGS etc – Is it pull the cash & off to the Perth mint ASAP? – Any opinion considered…

  8. I say bring in Basel III
    Enhanced Basel II + Macroprudential overlay = Basel III
    We need enhanced Risk Management and DISCLOSURE, something Advanced IRB does not provide.

    I believe Mega Bank uses Advanced IRB…and MEGA BANKS only disclosure is with APRA…Please correct me if I am wrong.

    • The Pillar 3 reports give an OK level of disclosure. Read one of them and see what else you need to analyse the creditworthiness of the banks

    • Mega Bank does use AIRB (Advanced IRB) but not necessarily for its full loan book. CBA with BankWest and NAB with Challenger were not able to use AIRB for their acquired loans for some time – until the acquired subsidiary’s systems were fully integrated into the parent bank’s APRA-approved risk management systems.

      While Basel III may provide some additional safety – the requirement to hold government bonds does not inspire confidence given what has been happening with European banks and sovereign debt in recent months.

  9. “I do not understand the logic of a regulator treating Mega Bank’s capital requirements the same after the issue of covered bonds.”

    I do not see it as the regulators role to define capital requirements based on a liability structure. It is in fact role of the regulator role to define capital requirements based on the asset portfolio.

    Ideally, market pricing for the various components of the liability portfolio (term secured/unsecured debt, short term retail/wholesale deposits, equity etc) based will define the risk vs return equation.

    And if current market pricing is anything to go by, there is a definite tiering between the various forms of liabilities issued by any credit institution in Australia.

    The point about overcollateralisation is quite correct – but the market is reflecting this in the relative pricing between [wholesale] liabilities.

    • Hmmm. I think they have always considered liability structures in their assessment of banks. Since Basel 2 this has been caught up in Pillar 2 and pre Basel 2 it was in the Pillar 2 type discussions that took place between the banks and RBA/APRA.
      And I’m not sure that the bank bond offering documents a few years ago included the caveat that there would be a new level of super security that arises from the issuance of covered bonds. And all the sounds coming from regulators at that time was that covered bonds would occur over their dead bodies

  10. Liability structures were important when depositor preference was in place. Now that depositor preference has been modified (weakened) this is less the case. There clearly are constraints in place for liability structures (the limits on covereds come to mind, also the balancing act in place between LCR and NSFR and the short/long term retail/wholesale balance).

    The question however, was about capital requirements and how these are impacted by liability structures. At best, there are secondary/tertiary effects from the influences (and others) mentioned. That is liability structure may influence asset composition, which in turn influences capital requirements. But in my thinking, liability structures are not a primary determinant.

    • Well, if I was a regulator I would suspect that liability structure would increase the chance of default in exactly the same way that asset structure would. The GFC is a prime example of liability structures inducing default. You could use exactly the same calculation (PD x LGD equivalent) for liability structures to calculate the extra capital required for any given liability structure. Too difficult to do so thats why its parcelled up in Pillar 2. The alternataive is to be indifferent to liability structures and that plain stupid. Well above secondary or tertiary effects
      I was also under the impression that there was already a tiering of liabilities with deposits ranking ahead of non deposits eg bank bills, MTN’s etc etc