The recent announcement by the federal governments that it will allow Australian banks to issue covered bonds was greeted with much joy by the banking industry. However, when something is good for a particular self-interest group, especially one with lots of other people’s money to spend on lobbying, it is inevitably bad for everyone else. Covered bonds are no exception.
Covered bonds are a effectively a securitised asset, but instead of being sold to third-party investors, they remain on the bank’s balance sheet. They are a little like the asset-back securities that caused problems for US banks during the GFC, the difference being, instead of being sold to an investment bank that then on-sells the instrument to investors, the financial institution keeps the liability on its balance sheet.
Covered bonds tend to receive a high credit rating, often AAA (but as we saw during the GFC, loans made to unemployed, illiterate alcoholics were once considered AAA). This is because in the event of an insolvency of the issuer, the investor in the asset will have direct recourse to the underlying asset in question, rather than being simply another creditor of the failed borrower.
That all sounds good and well. Covered bonds allow lenders to have peace of mind that their security is clear and legitimate, and would lead to lower costs for borrowers as the risk top investors is reduced.
Of course, when anything sounds too good to be true, it usually is — especially when it involves banks.
The first (and most obvious) problem with allowing current bonds is that ignores Australia’s already substantial (private) debt problem. While many are quick to point out Australia’s very low level of public debt, Australia actually has a mountainous level of private debt. Higher even than the US before its housing bubble popped. Australia’s massive debt has generally been used to prop up what is on some metrics, the world’s most expensive housing sector. Australia’s mortgage debt to GDP has rocketed from just over 20% in the late 1990s to about 90% now. Similarly, since 1994, the ratio of housing debt compared with housing assets has risen from 15.8% to 28.7%.
This extraordinary level of indebtedness has caused a problem for banks, especially the Big Four, which have needed to fund much of the borrowing from overseas. Because the cost of wholesale borrowing has increased in recent years, the banks need to find more money from other sources to allow Australia’s home-lending binge to continue. Covered bonds are one obvious way.
So instead of reducing lending to home buyers, covered bonds will be another way to actually lend more money to the residential housing sector. (In recent weeks, despite increasing mortgage delinquencies, the major banks increased their ‘loan-to-valuation ratios’, with Westpac now allowing home buyers to borrow 97 percent of the cost of the property).
This is where covered bonds may very well lead to a big problem. That’s because while the covered bonds themselves will be ring-fenced (such that lenders will have access to the specific collateral underlying the loan), the further increase in debt will lead to greater risk for banks’ other assets. Those other assets are owned by shareholders. The thing about banks though, is that they usually have only a sliver of equity (say $35 billion in the case of the Commonwealth Bank) and a huge amount of debt (CBA has about $600 billion). Thanks to Kevin Rudd and Wayne Swan, who took finance lessons from the Irish government, Australian taxpayers are now on the hook for the rest (to ensure that depositors are safe in the event of a collapse). That means, while covered bonds allow banks to borrow more, that will directly increase the risks faced by the banks’ current creditors and, of course, Australian taxpayers.
Basically, allowing covered bonds reduces the position of depositors in the order of priorities in the event of a bank collapse. Because depositors are now protected by taxpayers, in allowing covered bonds, the federal government is placing taxpayers further down the priority list in the event of a winding up. The irony shouldn’t be lost on anyone that the federal government is essentially charged with acting on taxpayers’ behalf.
And don’t be fooled by the limit imposed by federal government that covered bonds can be used for up to 8% of local assets. Given that banks operate on leverage of upwards of 20:1, that is actually an extraordinarily high figure, almost double the banks’ equity levels (depending on the ratio of local to international assets).
The second reason covered bonds are a bad idea is that they will serve to reinforce the funding disadvantages suffered by smaller financial institutions. Already hamstrung by the poorly devised government funding guarantee smaller institutions will also find it more difficult and expensive to issue covered bonds. As Karen Maley noted in Business Spectator, “foreign investors who are the likely buyers of the bonds will probably be drawn to the covered bonds issued by the big four banks, rather than bonds issued by smaller, less well-known institutions”.
Remarkably, the only person in parliament to fully grasp the issues with potential problems is Greens member Adam Bandt, who noted that “covered bonds may in fact entrench the large banks’ market dominance, as smaller banks are unlikely to be able to access the covered bond market on the same scale, if at all”.
Wayne Swan and the federal government should be doing everything they can to reduce the size of Australia’s big banks (which are all clearly now, too big to fail) and curtail their lending. Instead, they are doing the opposite. This is good news for bank executives and bad news for taxpayers.