By Bernard Hickey
A major change in the relationship between savers and New Zealand banks is about to happen with little public debate.
This change also presents a real risk to New Zealand's economic rebirth as a nation of savers, investors and exporters from being a nation of consumers, borrowers and importers.
Yet again, there has been little public debate about a new policy that could derail the Government's and the Reserve Bank's hopes for transformation.
So let's start.
New Zealand's banks have launched a massive drive to borrow up to NZ$32 billion from mostly European investors through the issue of covered bonds. Legislation to back these covered bonds is about to go through parliament.
These covered bonds are new to the New Zealand banking landscape, but they have been around forever in Europe, where the European Central Bank estimates there were 2.4 trillion euros on issue at the end of 2008.
They allow banks to essentially carve off a bunch of mortgages on their balance sheet and sell them to investors. The interest payments are 'covered' by interest paid to the banks by home mortgage borrowers and the assets in the bonds are 'covered' by a pool of assets in the bank. They're a bit like securitised mortgages, also known as Residential Mortgage Backed Securities (RMBS), but the mortgages are written by the banks and stay on the balance sheets. These covered bonds often carry AAA credit ratings, which are higher than than banks' own ratings.
The key difference between covered bonds and any regular bond issue or RMBS is that covered bond holders move to the front of the queue in the event of any crisis at the bank. That's one reason why they carry higher credit ratings.
The Reserve Bank explains here in its public consultation paper issued in October how they work:
In broad terms, a covered bond is a similar instrument to an RMBS, but the primary difference between an RMBS and a covered bond is that covered bond holders have dual recourse to both the assets in the cover pool and to the issuer.
An RMBS only offers single recourse to the assets contained within the RMBS structure. With covered bonds, investors are protected by high quality collateral, over-collateralisation, and a preferential claim on the cover pool, and by an equal claim to any residual assets of the issuer.
The key phrase there is 'preferential claim'.
Queue jumping bond holders
This means the covered bond holders have jumped ahead of regular term depositors in the queue. This is the reason they have been banned in Australia, which has provisions in its Banking Act
to ensure regular term deposit savers are first in the queue. Although this week the Labor government in Australia signaled it would allow all banks, including the four pillars (ANZ, Westpac, NAB and CBA) to start offering covered bonds.
There is nothing specific in our legislation to stop our banks from issuing them. However, the Reserve Bank initially suggested banks not issue covered bonds worth more than 5% of their assets. Now the Reserve Bank is pushing to get legislation governing the issuance of these bonds and has proposed a doubling of that limit to 10%, which is worth NZ$32 billion. See more on that here from Gareth Vaughan, who has covered this subject extensively.
See all our articles on covered bonds here.
Bank of New Zealand was the first cab off the rank. It issued a 'test' issue of NZ$425 million worth of covered bonds to domestic institutions in June that cost over 6%, which wasn't much less than borrowing it from local 'Mum and Dad' investors. Then last month BNZ sold 1 billion euros (NZ$1.76 billion) of covered bonds to European investors at a base interest rate of 3.125%. Even after swapping the proceeds back into New Zealand dollars, the costs is significantly below the cost of raising funds here.
BNZ has initial plans to issue NZ$3 billion of these covered bonds to European investors and has said it may double the programme. See more here.
'Strong demand from a bombed out Europe'
Westpac New Zealand is also looking to get in on the act. Westpac has signaled plans for a 5 billion euro (NZ$8.8 billion) programme of issuance, starting in the first quarter of next year. See more here.
ANZ New Zealand has indicated it would probably issue covered bonds. See more here. ASB has also said it is open to the idea. See more here.
Part of the rush is due to strong demand from European investors worried about investing in their own debt as the European sovereign debt crisis rolls on. Putting money as far away from Europe as possible seems attractive, particularly when the story about New Zealand's connections with the Chinese-fueled Australian engine is emphasised.
From the banks' point of view it is the perfect combination. After more than two years of scrambling and paying high rates for lots of often small local term deposits, they can jump into the international markets and get hold of big dollops of cheap foreign funding.
Here's how the Reserve Bank describes it:
The primary attraction for issuers entering the covered bond market is the opportunity to gain access to relatively cheap longer term funding. Spreads between covered bonds and senior unsecured debts vary as market conditions change, but recent experience from overseas suggests that a double-A rated issuer might reasonably expect to save up to 50 basis points by developing a triple-A rated covered bond.
Cheaper, faster, deeper, wider, longer...and so seductive
The Reserve Bank has been attracted to the idea because it can help reduce the banks' vulnerability in a financial crisis like the one we saw in late 2008 and early 2009 after the collapse of Lehman Brothers. Until then the big banks obtained more than 65% of their foreign funding through short term 'commercial paper' issuance that rolled over in less than a year.
Rightly, the Reserve Bank wants the banks to extend the duration of their funding to reduce their vulnerability to another freeze.
The theory is that the banks will use the proceeds of these covered bond issues to refinance short term foreign borrowings.
But what if the banks choose to simply increase their ammunition pile of cheap foreign borrowing to go out and start lending heavily into the housing market again with low fixed mortgage rates?
All the Reserve Bank's good work in introducing the Core Funding Ratio to curb the 'Unbeatable' fixed mortgage rate campaigns will have been wasted. The extra potency given to monetary policy by a move into floating mortgages would be reversed. The upward pressure on term deposit rates, which encouraged saving and reduced borrowing, would be diluted.
It's been noticeable in recent weeks that the banks have started trimming their fixed mortgage rates, which has spurred some extra demand in the housing market. Mortgage approvals hit a record for 2010 last week of NZ$801.9 million. See more here. House prices have stabilised and are starting to heat up again in some areas, particularly those where richer buyers have just received their own dollops of tax cut cash to go on another borrowing spree. See more here.
And term deposit rates have started edging lower too as banks become more comfortable about borrowing offshore rather than from Mums and Dads at home. Remember, the Core Funding Ratio applies to both local funding and long term foreign funding. Covered bonds make it easier for the banks to meet their core funding requirements.
Looser credit criteria
It's also noticeable that many of the banks are slipping back into their old habits of offering 90% (Westpac) and 95% home loans (Kiwibank) along with discounts for legal fees and exemptions for application fees (ASB).
The rhetoric from the bank chief executives has clearly changed in the last two months. They are 'back in the game' as one CEO recently told us, referring to a new interest in growing lending and to offer home loans at up to 90% loan to value ratios.
Lending figures for the last two years show banks have continued growing lending against property, whether its in farms or in houses. Business lending has slumped. See more here.
This is exactly not what the government was hoping to achieve.
It wanted to discourage more borrowing against property and wanted to encourage more investment in productive business.
The problem with covered bonds is they risk derailing that grand economic strategy.
And they do it without compensating term depositors for being shunted back down the queue.
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