How Australian Banks Use Covered Bonds to Play a Dangerous Game

When Kevin Rudd’s political obituary is written – perhaps as soon as today – a great deal of focus will be on the coup that deposed him as prime minister and the coup de grace that ended the political misery of the Labor party. For anyone interested in Rudd’s biggest impact on Australian life, the focus should be on how he encouraged tens of thousands of Australians to take on crippling debt and bet on higher house prices.

The First Home Owners Grant (FHOG) of 2008 was Rudd’s reaction to the Global Financial Crisis. The basic thrust of the response was this: borrow more and everything will turn out just fine. The government doubled the grant on existing homes from $7,000 to $14,000. It tripled the grant on new homes to first-time buyers to $21,000. The Big Four Australian banks have increased their share of the mortgage market to 86% since the FHOG was first introduced and then extended.

Rudd’s response was straight out of the Keynesian playbook. In Europe and the US and Japan, government borrowing increased in an attempt to stave off the end of the credit boom. Rudd followed suit there, too. Australia turned a $20 billion surplus into a quick annual deficit. That deficit has grown into a formidable $200 billion debt since. It shows no signs of getting smaller.

Australia survives the GFC by loading up on debt

Australia survives the GFC by loading up on debt

Rudd’s only particular twist on the Keynesian playbook was the FHOG. He wasn’t content with blowing up the government’s balance sheet. He set charges and the fuse under the entire private sector housing market. The bizarre result, as our friend Dr. Steve Keen has pointed out, is that Australia spent the Global Financial Crisis doubling down on housing and extending the household debt-to-GDP ratio to 150% – the highest level in the Western world.

No matter what happens to Rudd today, his financial legacy is already written in years of red ink. The story won’t end with his relegation to the backwoods of the Labor party. Australia’s banks are labouring under the global impression that they’re exposed to a housing crash. One particular solution to the bank’s “funding crisis” isn’t turning out the way anyone expected.

Ratings agency Fitch downgraded Commonwealth Bank, NAB, and Westpac to AA – from AA on Friday. Fitch’s move wasn’t groundbreaking. S&P downgraded the Aussie banks in November. But Fitch did add this bit:
A high reliance on wholesale funding makes maintaining investor confidence key. Factors such as Australia’s high household debt levels, elevated house prices and increasing reliance on Asia for trade may all impact this confidence, particularly if economic conditions in the region were to deteriorate significantly.

This is a mixed message. Australian banks rely on off-shore debt markets for 40% of the funding they need to make loans. It DOES sound confusing that a bank has to borrow money in order to loan it. Banks have to get their money from somewhere too, even with fractional reserve lending. It’s more expensive to get that money.

Deposits have grown at Aussie banks since financial markets tanked in 2009. That’s mostly thanks to high interest rates on bank savings accounts and an aversion to the stock market. But banks still need to refinance $90 billion in loans this year – without the benefit of a government guarantee. That’s not just pocket change.

Which brings us to the covered bond market. Covered bonds were cooked up last year by the banking sector and Treasurer Wayne Swan as a way for banks to secure access to more funding if global credit markets break down. Actually, that’s not fair. Covered bonds have been around in Europe for quite awhile. They ARE new to Australia though.

How a Covered Bond Works

The premise behind a covered bond is that it’s a secure debt. If you buy a bond from the bank – which is to say if you loan money to the bank – the bank pledges you collateral as security. As a secured creditor, you get first dibs on that collateral if the bank should ever run into a catastrophic event (that never happens in the banking sector, though).

The covered bond market was supposed to open up a new source of funding for Australian banks by “unlocking” their balance sheets. Banks are allowed to use different pools of assets to pledge as collateral for the bonds. The main two pools of assets are depositor funds (your money) and home mortgages (your house).

A funny thing has happened on the way to lower funding costs through covered bonds. They didn’t lower costs. The introduction of the covered bonds has actually shifted all borrowing costs higher for Australian banks. It’s created a new class system within the capital structure of a company, which is so exciting we’ll get to it shortly.

This all started to become clear when Westpac and Commonwealth Bank sold a combined $6.6 billion worth of covered bonds in January. The trouble was that both had to pay a higher interest rate than they expected. Without getting too complicated, the rate of interest on a covered bond is usually at a premium to a swap rate (which we won’t get into here). Westpac and CBA paid premiums much higher than they expected.

This has immediate consequences for other bonds issued by banks. “The high spread at which the covered bonds were issued effectively means investors in all other bank securities need to be paid a greater premium,” said Andrew Gordon at FIIG Securities Ltd in Sydney. In other words, the covered bonds are dragging yields on other bank debt up because covered bonds are secured and other bank debt is not.

The spread between the interest rate on covered bonds and the swap rate varies. Sometimes it’s bigger. Sometimes it’s smaller. The size of the premium depends on investor confidence and global credit markets.

But when you sift through all the financial details you see that Australia’s banks are playing a dangerous game. The assets of the big four – $932.5 billion in housing loans – are secured by Aussie houses. Assets can change in value, especially when house prices fall, like they did last year in the biggest calendar year drop on record, according to Bloomberg. Meanwhile, the banks are incurring new debts via the covered bond market, using the same assets as collateral.

In the class system emerging in financial markets, bank depositors are proletarians. Secured and unsecured bondholders can probably sleep well at night. If the bank can’t pay back its debts, creditors have first recourse to the bank’s assets (your house, your deposits). Equity investors should probably take a cold shower after reading this and ask themselves why you’d want to be at the bottom of the capital structure in the event of a liquidation of a bank.

The even better question is why you’d want to invest in a business whose earnings growth is dependent on the expansion of debt…when the world is in the throes of a credit depression? You’ll be swimming upstream for several years.

Of course the whole issue of who gets paid what in the event of liquidation only matters if the bank fails. And from a political perspective, it’s unlikely an Australian bank would ever be allowed to fail. Depositors would be bailed out via the Financial Claims Scheme. Everyone else – the secured creditors, the unsecured creditors, and the equity investors – would fight over scraps based on legal hierarchy.

None of that will ever happen, though, because Australia’s housing market could never crash. Even if homes are severely unaffordable…and even if the global credit crunch is driving up borrowing costs…and even if Aussie banks are having resort to more convoluted ways to borrow money…Aussie house prices will be just fine, which means bank assets will be just fine, which means everything will be fine.

Tomorrow…why everything may not be fine after all.


Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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17 Comments on "How Australian Banks Use Covered Bonds to Play a Dangerous Game"

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When they started selling covered bonds I started pulling cash out and putting it into gold.

Dan Denning Have been wondering for some time about covered bonds. Questioned pre Christmas Westpac (my bank) at length about the security of money on deposit (both term depsoit and normal bank acct.) What happens in case of a bank failure etc.? they rabbitted on about the changes to the Govt. Guarantee. What I was never able to get from them was whether or not my “funds” on deposit was in full or part subordinated because of the covered bonds they had issued. Whilst I can, in a vague sense,understand that home mortgages can be subordinated on the basis that… Read more »

Dan, that is an interesting take on things. End game in the making?

Peter, don’t worry! I’m sure the politicians and fat cats will be well taken care of in the event of some calamity befalling the banking system. While the depositors may get very little, they will still collect their generous superannuation and other benefits.

After all, we are all equals – apart from that group which is more equal than you and me.


Good one Dan and good one Peter. I want to see Dan or other writers investigate covered bonds more fully too.

A Covered Bond is as simple as; “The premise behind a covered bond is that it’s a secure debt. If you buy a bond from the bank – which is to say if you loan money to the bank – the bank pledges you collateral as security. As a secured creditor, you get first dibs on that collateral if the bank should ever run into a catastrophic event (that never happens in the banking sector, though).”; Because; “In the class system emerging in financial markets, bank depositors are proletarians. Secured and unsecured bondholders can probably sleep well at night. If… Read more »
Some OK points here, but people getting a bit mixed with some of the terms used I think. Some points to keep in mind: * Covered bonds can only take up around 8% of the assets of the bank I believe. * Covered bonds are indeed secured against the mortgages in the mortage pool, but NOT secured by the deposits. Keep in mind that a mortgage is an asset of the bank, whereas a deposit is a liability of the bank – it is not used as security as mentioned in the article. A covered bond holder cannot take your… Read more »
Richo (the second)
…but an equity investor probably has a market with greater liquidity to dispose of shares v a covered bond holder where there is not much of a market for liquidity. (referenced from a good article in the Sunday Age by Andrew Potts last weekend). Plus the equity holder can hedge with put options or CFDs. I was thinking of getting into covered bonds as a bit of diversity but decisded to be content with a mix of RBA Bonds, cash and shares. Even if covered bonds do provide cover in the event of bankruptcy by the time the liqudators take… Read more »
Peter 27 Feb 12
The follow up. We all genuinly need help to understand the reality of the issue of Covered Bonds means. Let’s be clear The challenge for you or the written media. Is that someone with a full understanding what is going on provide an explanation. Still hoping Dan takes up the challenge with his skills to write a simple factural article about Australian Government Legislation that has allows the majority of banking institutions to issue covered bonds. How they affect the security of existing bank stakeholders/customers, share holders, depositors and borrowers. I guess that I and the vast majority are the… Read more »

the next step in the debate is for someone to qualify their assertions with some relative documentation

Peter' 2 March 2012
Lachlan 28/02/2012 “the next step in the debate is for someone to qualify their assertions with some relative documentation”. I am not sure if this is the information you are seeking. I have an email from a Senior Westpac Executive that states in his words not mine in it’s closing as following:- “As to your question of your funds on term deposit being subordinated to holders of covered bonds; through a sequence of very remote and unlikely circumstances, that is correct. In context, the covered bonds represent only 0.5% of assets, and the assets of Westpac in Australia are fully… Read more »

Don’t our deposits become mortgages when lent out.

At the end of the day, the banks really don’t give a shit about its small fry depositors, as deposits are a ‘liability’. Best not to expose yourselves too much too this unknown potential ‘covered bonds’ issue. All the banks are interested in is looking after capitalist fatcat big players first and foremost, and making the biggest returns (profits) possible while playing the age old PR game. The game of having mum and dad depositors and homeloanees think they are getting better interest rates, and having ‘security’ with that particular institution ,who, by the way, give paltry interest returns on… Read more »
It goes somewhat like this: The bank does not own your deposited money,as Laks correctly states. Let’s say you deposit $100,000 with the bank. The bank owes it to you (as a liability). It then lends it out to X. secured by a mortgage over his home. owes the bank $100,000 plus interest (say 5% p.a. i.e. $105,000) at the end of 1 year. That debt, which is owed to the bank, is an asset of the bank. Now multiply this by 1000 (borrowers) for the purpose of this example. The bank’s assets are then $105,000,000 (which is owed… Read more »
Graham Paterson
One question Frank – can you give me any evidence of one single depositor who has had his/her balance reduced because it has been lent out? If you have never heard of the fractional reserve system used by all the banks, it may pay to do a bit of research. Here are a couple of explanations from banking authorities going back over the years – The way private banks operate is well documented, such as the 1924 confirmation from Mr. McKenna, the Chairman of the Midland Bank in the UK. He explained, ‘Every bank loan and every purchase of securities… Read more »
Worked examples by Frank is interesting. But there are some overlooked assumptions. Firstly, Bank will never fail ( or allowed to fail ). Secondly, the printing press will never break down. Thirdly, because of first and second assumptions, house prices will never fall. So the original figures would be preserved. Every one involved would not suffer in terms of the existing figures of their investments or deposits. For all we know, there might not be a 20% depreciated price for the house prices but a 20% upwards increase. The bank assets likewise will be similarly compensated as an increase. The… Read more »

It has ever been thus, Ron. My grandmother noted that a loaf of bread cost one farthing (a quarter penny) in London, back in ’84.

(Let’s see if something _this_ innocuous gets posted! :D )

It seems to me that the Banks are only interested in moving overpriced houses off their books, and passing the problem on to someone else via covered bonds. The really scary thing is that if the Bank decides not to pay the bond holders, then the bond holders could sell your home even though you have never missed a mortgage payment. At least that’s how I read it. I does not seem to require the failure of the bank, just a default by the bank to pay the bond holders. It appears to me that covered bonds are a simple… Read more »
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