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By Gareth Vaughan
So you finally found your dream home, and with the help of a loan from your friendly banker, you even managed to buy it.
When taking out your mortgage you may have punted for a floating mortgage rate, or perhaps you wanted more certainty and went for a fixed-term (such as two-year) interest rate. Other than that, and making sure you meet your interest and principal repayments, you'll probably give little further thought to your mortgage.
But if your mortgage is with one of the big four banks - ANZ, ASB, BNZ or Westpac - it just may have been transferred by the bank into a separate legal entity known as a special purpose vehicle (SPV), which is majority owned by a trustee company. This is most likely to be the Public Trust, although others, probably best known to you as the former trustees of failed finance companies, could come into play. If this is your mortgage's destiny then it's now also part of what's known as a cover pool, where it'll have a pool monitor in the shape of an auditor.
Your mortgage, and thousands of others written - and owned - by your bank are in this cover pool as security to investors - probably institutional, or professional ones, based in a plush office somewhere in Europe such as Munich, Amsterdam or London, who have loaned money to your bank. Their loans have come through what's known as covered bonds issued by your bank.
So what does this mean?
What all this means is if your bank should default on its covered bonds, that investor in Munich, Amsterdam or London has first dibs on your mortgage. And if you also have invested some hard earned savings via a deposit with your bank, the value of assets available to repay you, and other unsecured creditors, in the event of bank failure, has been reduced. More on this later.
Should your bank default on its covered bonds, the legal title to your mortgage will move from your bank to the SPV, which that European investor has legal rights to as security for his loan to the bank. The SPV will then have to find another party, other than your bank, to collect your repayments. That means you'll now be making your principal repayments, and weighty interest payments, not to your bank but to a different entity.
Who this ultimately becomes is a moot point as, if your bank were to become insolvent, your mortgage may be sold, along with some of the bank's other assets.
Now, I don't want to be accused of scare mongering so let me say here and now that New Zealand's major banks are currently all in vigorously healthy financial shape and long may they remain so.
However, those with a few grey hairs and good memories will recall the Government rescuing BNZ with NZ$620 million of taxpayers' money in 1990. See more here in this Reserve Bank article on New Zealand banking crises.
And those of you who keep up with international news know what happened to Iceland's banks, plus the likes of Northern Rock, Bank of Scotland and Lehman Brothers. You're probably also aware that global financial markets are currently spooked by sovereign debt levels and the strength of banks in European countries referred to as "PIIGS" (Portugal, Ireland, Italy, Greece and Spain).
Thus far our banks have managed to navigate this turbulent modern world very successfully (see more on this here), but we do live in uncertain times.
About NZ$9.2 billion worth already on issue
Although New Zealand banks have been issuing covered bonds since 2010, and the big four banks have already borrowed about NZ$9.2 billion through issuing them over terms ranging from three to eight years, a bill - the Reserve Bank of New Zealand (Covered Bonds) Amendment Bill - is currently before Parliament as the Government strives to establish a legal framework for them. The aim of this bill is to help local banks secure stable long-term funding in an uncertain world, and to provide overseas investors with certainty.
For the banks, covered bond borrowings can come cheap, not withstanding they have to convert money raised overseas into New Zealand dollars, because covered bonds generally attract the highest possible credit ratings from international credit rating agencies Fitch and Moody's being AAA and Aaa, respectively.
That's higher than the banks' own AA- rating from Fitch and Aa3 from Moody's and comes because these bonds are deemed to be of low risk to investors because covered bond holders have both an unsecured claim on the issuing bank and the aforementioned secured interest over the cover pool. (The third major credit rating agency Standard & Poor's hasn't yet rated any New Zealand bank covered bonds but rates the banks themselves AA-).
The Reserve Bank, the banks' regulator, says banks are allowed to use up to 10% of their total assets as collateral for covered bonds. It expects this means they won't actually go above 8% so as to be extra careful not to inadvertently breach the regulatory limit.
So far BNZ has issued covered bonds worth more than twice as much as any other New Zealand bank at NZ$4.4 billion, reaching 6.1% of its NZ$71.7 billion worth of total assets. Westpac has issued just under NZ$2.2 billion worth of covered bonds, which is 3.2% of its NZ$67.1 billion of assets. ANZ has issued about NZ$1.9 billion worth of covered bonds, or 1.5% of its NZ$124.7 billion of assets including those held by the National Bank. ASB has issued NZ$780 million worth of covered bonds, or about 1.2% of its NZ$64.4 billion of assets.
Is your mortgage in a cover pool?
So what are the chances of your mortgage ending up in a cover pool? And just how big are the cover pools? The banks are likely to use higher quality mortgages in their cover pools, ie. probably not those with 95% loan-to-valuation ratios (LVRs), although the proposed legislation doesn't specify limits on LVRs. And if you've had trouble with repayments, your mortgage probably won't be sought out for a cover pool.
In its latest general disclosure statement BNZ says the BNZ Covered Bond Trust held housing loans valued at NZ$5.38 billion as of March 31, with collateral for the guarantees provided by the Trust put at NZ$5.4 billion.
In a credit rating report Fitch noted that as of December 31, ASB's cover pool consisted of 24,746 loans secured by first-ranking mortgages over New Zealand residential properties with a total outstanding balance of NZ$3.622 billion. It said the portfolio was wholly made up of full documentation loans with a weighted average current loan-to-valuation ratio of 49.2%, and a weighted average seasoning - or length of time they've been running - of 3.5 years. Fixed-term loans represented 48.8% of the cover pool, Fitch says.
In a separate report Fitch broke down the geographical spread of an ANZ cover pool consisting of 20,567 loans. In terms of main population centres, it said 41.9% of the mortgages were in Auckland, 8.8% in Canterbury centred on Christchurch, 9.8% in the Waikato, and 15.8% in Wellington.
If they need to, such as when a mortgage customer moves their business to another bank, or after the devastating February earthquake in Christchurch last year, the banks can remove mortgages from their cover pool and replace them. Westpac pulled between NZ$60 million and NZ$80 million worth of Christchurch residential mortgages out of the its cover pool after the quake, or about 4% of the total mortgages in the pool based on postal codes, replacing them with others.
Covered bonds have a long history, apparently dating back to Prussia in 1769. They are most popular in Europe and there are said to be about €2 trillion (about NZ$3.34
billion trillion) worth on issue globally.
Drugs & prostitution
Covered bonds are certainly controversial. Because they carve off some of the banks' assets for the benefit of covered bond holders in the event of a bank default, bank depositors' claims are diluted. This aspect meant covered bonds were banned in Australia by the Australian Prudential Regulation Authority (APRA) until last year when the Government, after lobbying by the major banks, bypassed APRA's concerns and passed legislation to allow covered bonds.
And even in the banking industry not everyone is enamoured with covered bonds. Speaking to interest.co.nz in March last year, ANZ Banking Group CEO Mike Smith (see the full story and video here) described covered bonds as a drug.
"Covered bonds are basically an enriched type of securitisation. I actually think that that's a drug that you don't go on unless you seriously need to," Smith said.
Speaking in Parliament following the introduction of the Reserve Bank of New Zealand (Covered Bonds) Amendment Bill, the Labour Party's Economic Development and Associate Finance spokesman, David Cunliffe, said the Bill reminded him "rather a lot" of the Prostitution Law Reform Bill. See Cunliffe speaking about covered bonds in Parliament on video here.
"The issue with this bill is similar. There is a practice in the market place that many New Zealanders feel uncomfortable about. In this case it is covered bonds," Cunliffe said.
'A queue jumping mechanism'
Here's more from Cunliffe.
"Let us be clear about what a covered bond is. A covered bond is a vehicle by which large, wealthy institutional investors get themselves to the top of the security queue and mum and dad investors go to the bottom because they do not participate in the special purpose vehicle which extends the guarantee to the investor. So this is a queue jumping mechanism."
"And like prostitution the issue here is whether it is better because it exists to legalise it and regulate it, or to pretend it does not exist," Cunliffe added.
He said the Labour caucus had quite an active debate about how to handle the Bill "because as a starting point we are not enamoured of covered bonds."
"Covered bonds are not good for small investors at a time when we are trying to encourage mum and dad kiwi to put their hard earned savings, if they can afford any, into the banking system to build up national savings. We ought not do anything that would undermine that."
"There is a counter argument. Covered bonds can extend the access of major banks to lower cost offshore finance, which might a) lower retail interest rates in New Zealand by passing on those lower costs which would be a good thing for borrowers, or b) might increase the margins of the bank which would be a good thing for the bank's shareholders. But if the price of that is that mum and dad kiwi face higher risk because they go to the bottom of the queue, their debt is overtaken by the security ranking of the guarantees to the special purpose vehicle, then there is a potential equity issue," Cunliffe added.
He said Labour would support the Bill to select committee stage but hadn't decided whether to support it beyond that and encouraged consumers and savers to send submissions in to the Finance and Expenditure Select Committee.
What the banks have to say: Can you find out if your mortgage is in a cover pool? And what does it mean if it is?
The banks are under no legal obligation to tell a customer if his or her mortgage has been placed in a covered bond cover pool. However, interest.co.nz asked the big four if they would be prepared to do so if asked by a customer. ANZ and BNZ said yes, they would.
We further asked the banks if a customer requested their mortgage not be placed in a cover bond cover pool, or asked for it to be removed if it was in one, would they be prepared to do this?
To this ANZ replied: "Once a loan is in the covered bond cover pool, there are very limited circumstances under which ANZ can remove loans from the cover pool."
BNZ said: "No. What’s important to clarify here is that what is sold to the covered bond guarantor are the bank's rights in the mortgage loan, eg the right to receive repayment of the amounts the bank has lent to the customer. These rights are assets of the bank and the bank is legally entitled to deal with those rights, including by transferring them to a covered bond guarantor. Any obligations that the bank has in relation to the customer, such as to provide an additional loan, all queries regarding servicing of the mortgages remain with the bank ensuring we maintain a strong relationship with our customers."
Meanwhile, ASB's response to the two questions was: "There would be no practical impact on customers if their mortgage was part of a covered bond cover pool, as we continue to offer the same service to all of our mortgage customers. Should a customer contact us we would be happy to discuss this with them."
And Westpac said: "A customer can expect no changes to the manner in which a loan is managed as part of a covered bond pool as the loan servicing is still managed by Westpac, and it is only the beneficial ownership which has changed. There is no impact on the terms and conditions of the loan. Under our standard documentation Westpac has the right to transfer or assign the loan to someone else, including for the purpose of securitisation. It is not a requirement of the loan agreement that Westpac notify the borrower (or our normal practise) of a transfer."