By Gareth Vaughan
The Reserve Bank wants to introduce legislation that enshrines the rights of foreign covered bond investors to mortgages written by New Zealand banks ahead of local bank depositors and give the banks carte blanche to issue covered bonds worth more than NZ$32 billion.
In a consultation paper on covered bonds, the Reserve Bank says it would now be happy for banks to issue covered bonds worth up to 10% of their total assets, based on the value of assets securitised. This is up from its previous guideline of 5%. The central bank says it will review this limit within two years. The Reserve Bank also says it wants laws passed to enable banks to issue bonds backed by legislation to help attract overseas investors.
Based on the total assets of ASB, ANZ, BNZ, Westpac and Kiwibank at June 30, the five banks would be allowed to issue covered bonds worth up to NZ$32.1 billion of their combined NZ$321.05 billion of assets. That’s just half a billion dollars less than New Zealand’s NZ$32.6 billion of exports for the nine months to August and it’s equivalent to 59% of the sharemarket’s total capitalisation, which stood at about NZ$54 billion at the close of Friday’s trading.
Banned in Australia
Covered bonds are senior debt instruments issued by a bank, usually of five-to-ten year durations, and backed by a dedicated group of home loans known as a “cover pool.” If the issuing bank becomes insolvent, the assets in the cover pool are carved off from the issuer’s other assets solely for the benefit of the covered bondholders. This ring fencing of a chunk of a bank’s balance sheet is why covered bonds are banned by the Australian Prudential Regulation Authority as, in the event of a default by the bank issuer, depositors’ claims are diluted.
Overseas banks can, however, issue Australian dollar denominated covered bonds.
There’s nothing in the Reserve Bank’s prudential requirements or New Zealand law prohibiting or limiting the issue of covered bonds. With the Reserve Bank’s consent, the BNZ became the first New Zealand bank to issue covered bonds, issuing NZ$425 million worth to domestic institutional investors in June. Westpac’s chief financial officer Richard Jamieson told interest.co.nz in June that his bank also hoped to get a covered bond issue away during 2010.
At that stage the central bank had indicated it was comfortable with banks issuing covered bonds worth up to 5% of their total asset bases, but Jamieson said Westpac would like to see this lifted to 10%. On Friday a Westpac spokeswoman would only say the bank supported the active development of a covered bond market in New Zealand and the consultation document was an important step in this process.
Both ASB and ANZ have indicated they are also considering issuing covered bonds. And the recently departed CEO of Kiwibank, Sam Knowles said the state owned bank would also look at covered bonds. A spokesman said on Friday Kiwibank was supportive of the Reserve Bank advocating and encouraging development of covered bonds.
“We expect to make a submission on this subject but we will not be issuing this product in the near term,” the Kiwibank spokesman said.
Funding benefits to bank issuers
The Reserve Bank notes that covered bonds have significant benefits for issuers by lengthening the term structures of their funding, diversifying funding by providing access to new investors and enhancing domestic capital markets.
“This benefits the financial system by reducing the likelihood of liquidity problems affecting an issuer, and promoting the sound and efficient operation of the system.”
The central bank says the primary attraction for banks in issuing covered bonds is the chance to access relatively cheap long-term funding and that it has been concerned for a number of years about New Zealand bank’s over reliance on short term funding. This is something the banks are striving to overcome following the introduction of the Reserve Bank’s core funding ratio (CFR) on April 1. The CFR requires banks to source 65% of their funding from either retail deposits or long-term wholesale funding with maturities of more than one year.
The central bank aims to lift the CFR to 75% by mid-2012.
The Reserve Bank says the potential negative consequences that could arise from covered bonds don’t represent “a compelling argument” for prohibiting the issuance of covered bonds, so long as covered bond issuance is restricted to a conservative level. It notes that recent overseas experience shows an issuer with a AA credit rating could expect to save up to 50 basis points by developing a triple-A rated covered bond.
Covered bonds generally attract AAA credit ratings, giving them a higher credit rating than any of the AA rated ANZ, ASB, BNZ or National Bank and AA- rated Westpac.
They are generally issued at 50-60% of whatever the standard senior bond spread is. For example, if a bank issues five-year senior vanilla AA rated bonds at 100 basis points over the swap rate, it should be able to issue AAA covered bonds at 50-60 basis points over that swap rate. However, BNZ’s issue, comprising a five-year bond and seven-year bond, was priced at 98 basis points over the swap rate for the five-year and 112 basis points over the swap rate for the seven-year.
The consultation document notes there are two types of covered bonds; - legislatively backed ones and structured ones, such as those issued by BNZ. The latter, rely on contractual arrangements to protect bondholders’ rights, whereas legislatively backed bonds enshrine bondholders' interests in legislation. The Reserve Bank says that whilst discussions with market participants suggest some overseas investors would be willing to hold structured covered bonds issued by New Zealand banks, others were only willing to invest in legislatively backed bonds.
Furthermore, overseas benchmarks suggest a robust legislative framework could result in additional savings of 5 to 10 basis points compared to structured bonds with the same credit rating.
“The Reserve Bank’s initial view is that a legislative framework should be developed,” it says.
The central bank hopes to introduce a covered bonds register and for legislation to be introduced during 2011.
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