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What anyone with a home loan and/or bank deposit needs to know about the bank bonds compared with drugs and prostitution

What anyone with a home loan and/or bank deposit needs to know about the bank bonds compared with drugs and prostitution

This article was first published in our email for paid subscribers this morning. See here for more details and to subscribe.

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 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, 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."

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What's Kiwibank's position on this?

They haven't issued any, nor established a programme to do so. But just before he stepped down as CEO in 2010, Sam Knowles said: “We’ll look at covered bonds long-term as well,” said Knowles. “We’ll look at all those things as would any prudent financial institution.”

"Prudent financial institution"?
Let's hope so. Why don't you put a call into Paul and ask him about his position?

Thanks for that interesting analysis.  I felt the same way hearing about covered bonds for the first time last year - as a saver I object to anything that reduces my primary claim on getting my deposits back.  
As mentioned above this swings things in favour of borrowers - banks giving lower interest rates as they can borrow money more cheaply, and away from savers - ditto.  
So why should I save with any of these banks?

Well, you dont have to....TSB, Kiwibank do not do it....also the % is factor that as a risk when you look at the deposit rate offered.
I see no problem as long as its in the open and you are free to move.....The good thing about deposits is Internet banksing, dont like whats happening, why transfer elsewhere....I'd suggest 3 banks...

Indeed - have been with kiwi and now co-op for some time.  
My beef is the constant chanting from the government that they want to reduce debt and increase savings - but their actions have the opposite effect. 
Yes debt reduction (both private and public) and increased savings both act to reduce top line growth.  But then using growth as the sole measure of how well the country is doing has always been a fools errand.

When the biggest slice of  your GDP has been allowed to become consumerism and property gambling then yes the Govn cant afforsd for us to start to save....or even pay back debt.

Lower borrowing rates come with a huge caveat, as did higher savings rates (see finance companies for details). 
When is this nonsense going to stop?

Not the same thing....

Got to look after those overseas banks, haven't we?

but its not hidden....and you are free to move your money out  to other banks that do not do it.
You know its business........funny that.

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) worth on issue globally.



Gareth........ Two trillion euros doesn't equal nz3.34 billion...... 

Indeed, thanks.

Excellent piece, Gareth.
It's a shame that most NZ borrowers and / or depositors, will not read and understand what it means.  Far too busy watching Shortland Street I suspect, but I'm sure the punters will appear on Close Up or Fair Go, one day in the future, bemoaning thier poor lot in life, and, perhaps quite rightly, expecting a bank deposit to be a simple transaction, where a customer puts thier funds in a bank, and it stays there until he / she decides to withdraw it.

I have to admit that until about 5 years ago I thought the same*  - that bank deposits were my money stored in the bank.  I knew they were 'used' but had the same general idea that the money was still mine and could always be taken out again.
Just renaming 'savings and deposits' as 'loans to the bank' changes your perspective.  You then start to ask questions like - how good a borrower is this organisation, are they more or less reliable than lending money to a guy down the pub, how well does the law protect my contract.  
Funny that when the bank lends you money they set the terms and conditions and interest rate, when you lend the bank money - they set the terms and conditions and interest rate.
* it never mattered much before that - being a debtor. 

Fair point on the capital positions of the banks. Although we do monitor them here - and I do include something in the general disclosure statement stories about the individual banks. But there's always scope for more coverage on their capital positions. Cheers.

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.
Gareth you should be held up and praised for raising the alarm - don't go coy on us now we are at a crisis point.   
The banking model as we have known it in this country since the BNZ collapsed is doing so again. New Zealand is highly indebted on a per capita basis which denies your claim that our banks are in a rude state of health.
Let's be clear, your article confirms our foreign creditors will not continue to make unsecured loans to enable our banks to fumble around in an overpriced and overgeared property market. 
Germany has just issued a two year zero interest rate note and 10 year government debt yield curves are collapsing - We are being engulfed by deflation and our foreign banking masters want their claims secured by land and property.
New Zealanders need to drop the mask of complancency and demand similar rights until our banks are separated into units that reflect a fair return to the creditors for the risk  undertaken.
Bank customers need to have tiered risk defined lending backed by similarly tiered risk defined deposits. Depositors should be able to choose their risk categories, as are the foreign covered bond lenders - they get seasoned low LVR loans as collateral not the 90% LVR junk that is indiscriminately assigned to co-mingled low level risk taking depositors. 
Depositors need to set up advocate bodies enshrined in law to negotiate terms with the banks. It will become increasingly clear once we head down this path of clarity that there is a small portion of the population holding the gun of default to the head of the majority and they need to be publicly held to account and segregated to allow for a stable banking system. 

We are being engulfed by deflation and our foreign banking masters want their claims secured by land and property.
Exactly.  Read it again and again and again until you get it.
Had a girlfriend in the States who had her mortgage sold 5 times inside 2 years in the lead up to the GFC.  She would get letters from these new institutions saying they now owned her mortgage - and she had to look each one up on the internet to find out who the heck they were and where they were domiciled.   Had never heard of any of them before.
When the GFC happened, she went underwater on the property loan - as did just about everyone in Phoenix Arizona - 40% valuation drops virtually overnight - and you couldn't even sell stuff at that kind of discounted price as the banks weren't lending.  
She was a registered property valuer and that type of work just dried up once the speculative bubble burst.  The bank holding her mortgage changed the terms of the mortgage within 5 weeks of the Lehman collapse.  It had been one of those flexible ones where you had a stated amount of "up to" borrowing secured (on purchase she put 30% down).  As soon as the GFC hit, they closed down the ability to draw down any further on the loan - and she put the house on the market.  Nothing was selling, not at ANY price and having lost her income ... well, the bank foreclosed on her some 18 months later ... before such time as Obama intervened to slow down the practise. 
The bank that had foreclosed on her bought her house at auction for the amount owing to them... poof... her original 30% deposit - gone. 
Same thing happened to miliions upon millions of Americans.
Don't for a minute think "it could never happen here".
Make a submission. The cynic in me says it won't make one iota of difference as JK's government will be diving headlong into this - but the more times it can be demonstrated to wider society that this government chooses to ignore the majority, the better.

PDK has been saying this for a long while...its a game of musical chairs when the music stops there will be a lot of ppl with no where to sit....All the fancy financial cr*p is under-written by it will cease to exist and when it comes "investors"  looking for assets to hold, and  those with debt go first.....and we both have been saying avoid debt.
Trouble is they are not really is is not....depositors can get out fast.....its your trump card hopefully.

Try substituting it then, Not only is this impossible but all other 'resources' depend on it

When bloggers like Denninger give Europeans advice like this, one has to wonder when its our turn?
Advice To Europeans: Get Your Money Now

no later after ppl are wiped is a protection against inflation, its not very good for deflation, but then this looks like an event without recidence so who can say for sure.

Agree in avoiding all debt. But since money is debt then I am not sure I agree with Steven. I have an interesting book out at the moment on Gold and despite it being written by people that likely profit from the trade of it, the book has a fairly no nonsense approach. There is complete disagreement with Steven on the issue of inflation however. Gold does well in extremes, when fear is a factor. It is also good in an environment when interest rates are low, or even negative as they pretty much are now. Reason being is that is not competing for yield.


It is a waste of time even thinking about this economy ever becoming on a par with that of Sweden or any other modern nation governed by prudent managers. We are trapped in the sick as a dog electoral farce that has driven the benefit welfare bureaucratic monster to where it is today.
At the heart of the disease is the control over the pollies held by the main parasites. The banks rule and the govt does what it is told.
So we have a bloated private sector debt situation whereby the parasites are able to skim the economy for billions every year...they are getting fat on credit they created and sold to stupid Kiwi for the sole aim of porking the property bubble.
And our stupid govt cannot understand why they are regarded as 'Lapdogs'
Instead of bashing the banks with regulations many years ago, the idiots in the Beehive opted to hand control to the very same swine....and so the savings habit of many lifetimes were eaten away until today, all that remains is a token effort.
No savings to speak of and a gargantuan splurge with created credit.....

I guess it's been a case of follow thy leader.

Sadly, however there are enough in here who we have pointed such things out to and still deny it.

double post

Sweden wolly has an even bigger welfare state.....Therefore its hard to argue its anything to do with welfare. Personally I think it has far more to do with ego-centric behavior and rogernomics being an utter failure....and bliinkered and inept pollies...The private sector does indeed have huge debt because thats a way to dodge tax....CGT 20 years ago was needed, at least 10.....that's Auntie H's mistake/failure....but then she was always second rate.
Dont blame them too much Wolly, we the voter wanted it like that....its our fault.

The banks borrow short term....its conceivanle that when and it is a when money runs for safe havens our banks and us will be toast.

What does it matter if your mortgage is in the cover pool.  It makes no difference whether you pay your installments to the bank or to the investor.

Matters not to the mortgagee as matters more to those who have bank deposits and a lot of [OAP] NZers do.....but its a small effect....
I assume Im in a pool, but the mortgage would simply be on sold if the bank failed, or I could move.......really if its that severe depositors face losing it all anyway.

So this is good news for interest rates on bank deposits yes. With the increased risk/lowered backing interest rates will go up.
tui for lunch?

Today Fitch (the rating agents) said the big 4 New Zealand banks could withstand a moderate correction in the residential market, it also said that if unemployment levels rose this could also put pressure on banks.
The Reserve Bank is suggesting we should make provision for a 30% correction in residential property.
If moderate is equal to somewhere between say 10% and 20% and Job numbers keep carry on the way they are going with DOC, Telecom etc, then I believe the combination of a moderate to large correction in property, and continued job losses,will destablise our banking system to the point that those with overseas ownership and covered bonds will find ways to secure the best loans etc for themselves, leaving us to fight over the crumbs