Australia: Are covered bonds the new black?
Banking and Finance Update

The Federal Government's proposed banking reforms announced on 12 December 2010 placed covered bonds back on the Australian agenda as a more transparent and reliable source of debt funding for Approved Deposit Institutions (ADIs).

While not currently used as a source of funding in Australia, covered bonds have been used widely in European markets and more recently in Asia in the face of the global liquidity crisis.

What are covered bonds?

Covered bonds are secured debt instruments which provide investors with the ability to claim against both the issuer and a particular set of assets (the Cover Pool) in a default situation.

In the past, arguments against the use of covered bonds in Australia have been expressed by the Australian Prudential Regulation Authority (APRA) on the basis that Cover Pool assets potentially leave ADIs without the means to meet liabilities owed to depositors, in contravention of depositor preference obligations under section 13A(3) of the Banking Act 1959, and potentially place stress on the asset base of Australian ADIs.

While the establishment of a covered bonds market in Australia will involve amendment to the traditional depositor preference provisions contained in the Banking Act 1959, the Government has been quick to reiterate the value of depositor protection arrangements contained in the financial claims scheme as well as the supervisory role of APRA.

Characteristics

We can expect to see the following characteristics in an Australian covered bond market:

1. Any issue will be secured by the Cover Pool, which will comprise assets which are segregated or 'ring-fenced' from the other assets of the issuing entity.
2. The value of the Cover Pool must, depending on the terms of issue, be at least equal to the face value of the bonds issued (the Asset Coverage Test).
3. Underperforming assets in the Cover Pool will be replaced with a better quality of asset or the Cover Pool may be topped up with additional assets, providing accountability for investors and an incentive for the issuer to ensure the quality of the underlying assets.
4. If the Cover Pool is insufficient to meet the liabilities owed to investors, investors can take action against the issuer itself. This is in contrast to securitisation arrangements where investors do not have recourse against the sponsor.
5. The adequacy of the Cover Pool will be supervised by a third party (which would most likely be APRA).
6. The Cover Pool will be protected from unsecured creditor claims and investors will have preference to the Cover Pool in the winding up of the issuer or in a default event.
7. The Cover Pool remains on the issuer's balance sheet providing transparency for investors and regulators.

Change for Australia

We expect to see specific regulation in any new covered bond framework dealing with the adequacy of Cover Pool assets as well as potential waterfall provisions in an insolvency or default event.

The Treasurer has begun discussions around the framework of this new market by suggesting a cap on covered bonds at a limit of 5 per cent of the total assets of an issuer. However, it may be the case that after discussion with industry, different caps apply to different ADIs.

Westpac New Zealand recently issued €1 billion of AAA rated covered bonds with a cover pool made up of NZ$2.7 billion of residential mortgage assets. The Reserve Bank of New Zealand has capped issues by NZ entities at 10 per cent of total assets. This issue by Westpac New Zealand will be a good case study for the emerging Australian market.

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