Covered bond opponent urges Parliament to 'face down the banking lobby and ban these bonds' in select committee submission

Covered bond opponent urges Parliament to 'face down the banking lobby and ban these bonds' in select committee submission

By Gareth Vaughan

The fact a bill establishing a legislative basis for covered bonds is before Parliament shows "regulatory capture" of the Reserve Bank by the banking industry given covered bonds should explicitly be prohibited by law, says a submitter to the Select Committee considering the Bill.

Geoff Bertram, formerly a senior lecturer in economics at Victoria University and now a senior associate at Victoria's Institute of Policy Studies, says in a submission to Parliament's Finance and Expenditure Select Committee on the the Reserve Bank of New Zealand (Covered Bonds) Amendment Bill, that the purpose of covered bonds is no mystery.

"The New Zealand banking sector, in common with its Australian counterpart (and dominant owner) has for over a decade now been engaged in the profitable business of funding its local credit expansion in New Zealand dollars by means of offshore funding - selling bonds denominated in overseas currency," says Bertram.

"The result has been a massive and worsening currency mis-match in the banks’ balance sheets which has greatly increased the riskiness of the industry while fattening its bottom line and increasing the New Zealand economy’s aggregate foreign-currency indebtedness and exposure to global financial instability."

Finance Minister Bill English introduced the  Reserve Bank of New Zealand (Covered Bonds) Amendment Bill to Parliament in May. English said the Bill would provide greater legal certainty for investors in the unlikely event of a bank defaulting. He also said covered bonds offered significant benefits for banks as a long-term source of relatively stable finance. The Bill is now before the Finance and Expenditure Select Committee with the deadline for submissions having closed on July 3.


Bertram notes covered bonds are mortgage-backed securities packaged together and sold to investors with AAA ratings from major credit rating agencies, along similar lines to many of the toxic assets in the 2008 global financial crash. They carve off some of the banks' assets for the benefit of covered bondholders - in the event of a bank default - meaning bank depositors' claims are diluted. This aspect meant covered bonds were banned in Australia by the Australian Prudential Regulation Authority until last year when the Government, after lobbying by the major banks, bypassed APRA's concerns and enacted legislation allowing covered bonds.

Meanwhile the Bill has been compared with the Prostitution Law Reform Bill by Labour Party Economic Development and Associate Finance spokesman, David Cunliffe, and covered bonds themselves with "a drug that you don't go on unless you seriously need to," by ANZ Banking Group CEO Mike Smith. See more on Cunliffe & Smith's comments, and what covered bonds mean for both borrowers and savers here.

Bertram argues the best assets in the bank’s portfolio (some of its residential mortgages) are removed from the reach of a liquidator and placed in a separate cover pool devoted solely to providing strong backing for bonds issued and sold to institutional investors, most of whom will be overseas. This leaves unsecured creditors, including regular depositors, exposed to greater risk of loss, given the bank uses its more risky and lower-quality assets to match its deposit liabilities.

"This arrangement is corrosive of the incentives that governments the world over acknowledge are needed to reduce the risk of future banking crises. It works to undermine the Reserve Bank’s core funding requirement, and potentially enables the banks’ shareholders to mitigate their losses in the event of bank failure by holding covered bonds in their own institution," says Bertram.

'Ban them'

Ideally covered bonds ought to be "explicitly prohibited" by legislation, and and the Select Committee should recommend accordingly. The near NZ$10 billion of covered bonds already issued by the big four banks - ANZ New Zealand, ASB, BNZ and Westpac New Zealand - could remain on the existing contract basis with no legislative status, and would be allowed to expire without replacement, says Bertram.

However, if the Select Committee is unable to "face down the banking lobby and ban these bonds," Bertram suggests its members should demand much stronger safeguards and restrictions than the Reserve Bank is proposing.

These include banning the issue of covered bonds in foreign currencies, reducing the ceiling of 10% of the issuer's assets allowed to be used as collateral for covered bonds to 4%, and prohibiting associated parties of an issuing bank from purchasing, holding or trading in the covered bonds issued by the bank they are associated with.

If this last safeguard isn't introduced Bertram warns covered bonds simply become a means for converting a large chunk of the NZ$45 billion of unsecured “funding from associates” in the New Zealand banks into protected preferential claims over the prime assets in the event of liquidation.

Furthermore, he argues New Zealand-originated loans that have been transferred to a bank’s parent should be deducted from the asset pool available to support covered bonds, in order to pre-empt possible asset-stripping of New Zealand banks by their parents. And, all bank loans tied up in repo transactions at any time should be deducted from the asset pool when calculating the limit on covered bond issue. This, he argues, is because in the event of bank failure, the repo counter parties could sell off the loans they hold as security, removing them from the reach of any liquidator.

"As an ordinary depositor with two of the New Zealand banks, I regard this (the Reserve Bank allowing covered bonds) as regulatory capture by the banking industry, which will put at increased risk the savings of myself and other ordinary New Zealanders in a similar position," Bertram says.

"I am unmoved by Reserve Bank speculation that diversifying the banks’ funding by the device of covered bonds 'may' benefit me and other depositors because it 'can potentially reduce the probability of a (bank) failure occurring'."

"The exchange of a clear and present watering down of the security of my deposits for an untested and hypothetical reduction of the probability of bank failure does not, in my submission, pass the most rudimentary cost-benefit test," adds Bertram.

What they are

Covered bonds are dual-recourse securities, issued for anywhere from three to 10 years, through which bondholders have both an unsecured claim on the issuing bank (should it default on the bonds) and hold a secured interest over a specific pool of assets - generally residential mortgages - called the cover pool.

Covered bonds are different to senior unsecured debt instruments issued by banks, where the bondholder is simply an unsecured creditor of the bank, and also from mortgage-backed securities, where the bondholder has a secured interest in the cover pool but has no claim on the issuing bank.

Due to their dual recourse security, covered bonds generally attract the highest possible AAA credit rating (which is higher than the bank issuer's own ratings) and are therefore a cheaper form of funding for banks than standard bank bonds.

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Good to see others noticing the farce of securitization of assets funded by RP as the shell game it inevitably is. Bravo Mr Bertram.
"I am unmoved by Reserve Bank speculation that diversifying the banks’ funding by the device of covered bonds 'may' benefit me and other depositors because it 'can potentially reduce the probability of a (bank) failure occurring'."
Well that's as close as one gets to impugning the character of RBNZ management - it was a backward step allowing the egregious actions of the Renumeration Authority to pay extravagant sums to civil servants which gives respectable citizens cause to question the impartiality of decisions made.

English said the Bill would provide greater legal certainty for investors in the unlikely event of a bank defaulting.
Unlikely - yeah right.

What more certainty that if you're an investor you go to the top of the list, and more certainty for depositors that you will be screwed for sure, in that "unlikely" event.

Winners and losers
3 cheers for Geoff!  Never even thought about related party covered bond buying.
Are you a tax payer? Don't wory about foreign currency covered bonds leading to tax funded bailouts. OBR will protect you  - but maybe not -
Are you a bank bonus or profit seeker or a bank employee ( short term horizons only please )?  Yes lower cost funding should get even more profit from the most profitable banking industry in the developed world - means more cash for you for some time anyway.
Are you governing? Great - easier funding means you can get the banks to meet more stringent asset targets and lets face it deadlines have slipped a bit so far. And you don't have to cause a retail deposit war to do it.
Are you a borrower? Oodles of cash to lend here though ownership of your obligations may change - down the line of course.
Are you a retail depositor? Tough. OK rates are not great but you can always move to a bank which doesn't have any covered bond funds yet. Buy gold or oh yes - buy a rental, or something.

The official line from the NY FED in this excerpt from their Shadow Banking doc goes like this:
The development of the GSEs’ activities described above has been mirrored by the evolution of a full-fledged shadow banking system over the past 30 years.
The shadow banking system emerged from the transformation of the largest banks from low return on-equity (RoE) utilities that originate loans and hold and fund them until maturity with deposits, to high RoE entities that originate loans in order to warehouse and later securitize and distribute them, or retain securitized loans through off-balance sheet asset management vehicles.
In conjunction with this transformation, the nature of banking has changed from a credit-risk intensive, deposit-funded, spread-based process, to a less credit-risk intensive, but more market-risk intensive, wholesale funded, fee-based process.
The vertical and horizontal slicing of credit intermediation is conducted through the application of a range of off-balance sheet securitization and asset management techniques (see Exhibit 5), which enable FHC-affiliated banks to conduct lending with less capital than if they had retained loans on their balance sheets.
This process enhances the RoE of banks, or more precisely, the RoE of their holding companies.

Tried to buy some? - if so from whom?

Sorry do you mind going back, this is 1st class, its nothing persional its just that we are better than you...

I vote for Geoff Bertram to be the next reserve Bank Governor! Well done!
Unfortunately I suspect that his opposition will be "noted" and then ignored.
As a deposit holder I'm petrified, but if I was a non-covered-bond bond-holder I'd be very worried by this move as well. Presumably the credit rating of the bank drops for these bonds.
Oh well, musn't be greedy. Next time I'll trot along to the Public Trust.....

@Uninterested : Next time I'll trot along to the Public Trust.....
You will be shocked at the derisory level of rates on offer.
Mr English is always busy dutifully corralling citizen investors to the most high risk investments offered by our banks and other investment touting institutions.
You'd think he would be embarrassed penalising the elderly and infirm since he and his cohorts enjoy a handsome living off the public purse. They have no shame and it is our duty to endeavour to shame them while they act as though they are carnival barkers for hucksters rather than ministers of the crown.

Of course this current government is changing the law to allow it, what else would you expect from John Key the King of the muppets, and his main muppet English.
Even though Key was a banker himself he has somehow missed what caused the second biggest financial crisis in US history, and wants to change the law here so we can get some of that too.

Seems censorship has a place in the big SCHEME of things.
Seems that we must all toe the Party Line.
Seems that some people do not like some peoples version of the truth.
Seems some people would not know the truth if they fell over it.
Seems some people only like their own view forwards and back.
Some people think that scamming other people out of their money is the way forward.
When there is no actual...honest way back, cos someone is gonna pay and it does not pay to be honest.

What a load of............The RBNZ does what it is told to do by the parasite's bosses but is allowed to spin the blather about being rubbish.
Most Kiwi peasants are either too stupid to know how the scam operates or couldn't give a dam. Very few know how the rort is run.
As for comments by any of the faces in the Beehive....just so much BS.
Rename it the  'Banking Regulatory Farce'
Simple not deposit your savings with a bank that puts your savings at greater risk than normal by flogging 'covered bond filth'....normal is bad enough...why be a fool.

"Simple not deposit your savings with a bank that puts your savings at greater risk than normal by flogging 'covered bond filth'....normal is bad enough...why be a fool."
But then where do you deposit the funds, Wolly?  I think that is the point this chap is making.
Forced by regulation to take a risk that most don't know anything about.  Of course you could always deal in cash, because you don't like the risk posed by covered bonds in bank deposits. But this draws all sorts of unwanted attention.
Tried paying for a house with a suitcase full of cash, these days?
Good chance you will end up in Hotel Guantanamo, waterboarding optional, but highly recommended by the staff.

Russell Norman appears to think it would be good for the RBNZ to regulate the covered bond market, must be part of some communist plot, I am sure he actually wants the government to bail out the covered bond market somewhere down the track.
Seems the government however rather more enamoured with letting the financials do its own thing in the most 'efficient' way possible.

I think the NZRB can and is....I thought hey had limited it to10% max?
Listening to this piece RN wants the opposite, and yes it takes it out of teh RB's hands, think thats wrong, just look at moodies etc.

There is some oversight, like an upper limit, but there is limited oversight in the current reading of the regulation. I think Wolly finds the RBNZ is a good target to distract from the fact that the National government is legalising this banking practise. Seems to me he could be more independent himself.

Interest rates being more or less equal, you'd want your money in the most profitable bank rather than the least profitable one wouldn'y you?
Having said that Bertram has an excellent point about associated parties of a bank selling covered bonds, being allowed to buy the bonds. That is just a way of them elevating their shareholder funds above unsecured or lesser secured creditors and if push ever really does come to shove, bailing out painlessly and leaving New Zealanders lamenting. That really should be illegal and the law ought to allow a banking undertaker to set aside those transactions.

if you ignore risk yes....are you telling me your outlook is so simple you dont consider such things? in that case why not bank at TAB?

That's my point really. If a bank can lower its overall cost of funding while still paying competitive retail deposit rates its competitive position is stronger and the risk of banking there is lower. I realise deposits would have a worsened security position by letting covered bond holders have a priority position but you are still better to have a weaker security position in a solvent institution than a stonger one in an institution that is collapsing.

Good on Geoff Bertram - so where's the rest of academia?  One wonders whether any of those not-yet-retired have submitted as well?
Are all the submissions posted somewhere publicly, Bernard?  Had a quick look at the parliament site and couldn't find them.

All submissions on the bill should eventually appear here -

thanks, have bookmarked.

 Covered bonds are a back door bailout of the banking system, at the expense of savers, which is all part of Bernards recent personal revelation that this is part of government policy.
Interest rates will be lower, debtors will have a better chance of getting thru this very long crisis with no end in sight yet and savers will get devalued.   If debtors were wiped out then so must the savers be wiped out.   The fact is many debtors are still going to be wiped out by the time this is all over in many years time.  

"The result has been a massive and worsening currency mis-match in the banks’ balance sheets which has greatly increased the riskiness of the industry while fattening its bottom line and increasing the New Zealand economy’s aggregate foreign-currency indebtedness and exposure to global financial instability."
I take it from this that our major (Aussie) banks hold the foreign exchange risk with the covered bonds; such that if there were say a devaluation of the magnitude that the IMF says is necessary- 20%- then our banks would take a 20% hit on their covered bonds. If there are $10 billion out there, then a $2 billion hit.
So apart from what seems Bertram's main concern , of regular depositiors being dropped back in the queue in the event of a default, the banks have a massive self inerest in perpetuating a currency that is overvalued- at the cost of our exporters, manufacturers, tourist industry- and through them, our future generations who will be saddled with the debt and non onwership of anything when the music actually stops.
It would seem best to insist that the banks assets are in fact currency matched; or to the extent they are not, that that be approved by the Reserve Bank, with a view to a balanced current account.

Not quite true - the banks exchange the foreign currency proceeds of longer tenor covered bond issuance for NZD through the cross currency basis swap market. Physical exchanges take place at pre-arranged prices and times, so counterparty risk is an issue during and at the end of the swap.  Our local banks can only redeem their foreign liabilities when the currency exchange is unwound.  This is referred to as hedged borrowing.