Reserve Bank outlines planned covered bond legislation 18 months after BNZ's first issue

By Gareth Vaughan

The Reserve Bank has outlined its plans for covered bond legislation 18 months after the first covered bond issue by a local bank and with more than NZ$6 billion worth of covered bonds now on issue.

But although the Reserve Bank's consultation paper, was only released on Friday afternoon outlining its proposed laws for covered bonds, there'll be few surprises in the plans for the big banks.

Covered bond legislation will effectively enshrine the rights of investors, mostly from overseas, to some of the residential mortgages written by New Zealand banks ahead of local bank depositors and give the big four banks carte blanche to issue covered bonds worth up to NZ$31.8 billion.

Any covered bond legislation is, however, still some way off with the Reserve Bank consultation, its second round on this subject, open for submissions until March 16 next year. See our story on the first consultation paper here.

The Reserve Bank says it won't legislate for covered bonds to be repo-eligible. However, a Reserve Bank spokesman says covered bonds are already deemed to be repo-eligible and some are being used in this manner by the banks already. Repo-eligible securities are ones the central bank accepts as collateral for loans.

What are they?

Covered bonds are senior debt instruments backed by a dedicated group of home loans assigned to provide security for the debt known as a “cover pool.” Popular in Western Europe, they are usually issued for terms of five to 10 years.

The way they're structured means if the issuing bank defaults, the assets in the cover pool are carved off - or ring fenced - from the bank 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 were banned by the Australian Prudential Regulation Authority as, in the event of a default by the bank issuer, depositors’ claims are diluted. However, the Australian government decided last December to change the law, and the Australian parents of New Zealand's big four banks are now issuing covered bonds.

Unlike with residential mortgage backed securities (RMBS), covered bond cashflows are funded by the issuer and not by the cashflows of the mortgage pool. Covered bond investors have dual recourse to the bank and mortgage pool collateral while senior bank bond investors can only claim on the bank, and RMBS investors can only claim on the collateral. Therefore covered bonds typically carry AAA credit ratings.

Westpac pulled up to NZ$80 million worth of Christchurch residential mortgages out of the pool used as collateral against its inaugural covered bond issue after the devastating February 22 earthquake.

'Access to stable funding in turbulent times'

Reserve Bank Deputy Governor Grant Spencer says the proposed legislative framework aims to provide investors with legal certainty on the treatment of cover pool assets in the "unlikely event" an issuing bank becomes insolvent. 

“Legislative frameworks exist in most other countries with covered bond markets,” says Spencer.

“Covered bonds can provide banks with access to a stable funding source, which helps support system stability during times of severe disruption in international markets."

Covered bonds are a cheaper source of funding for the banks than standard bonds because their high level of security means they're seen as lower risk by investors and credit rating agencies. ANZ's inaugural 500 million euro issue - in October amid the European sovereign debt crisis - is paying investors just 3% interest per annum. That's not the bank's total costs, however, with issuance costs and the price of converting the money raised into New Zealand dollars - from euros to the US dollar and then the kiwi - adding about another 100 basis points, the banks say.

Key aspects

The central bank says the key aspects of its proposed legislation is:

a. covered bond issues must be registered;

b. cover pool assets must be held by a special purpose vehicle (SPV);

c. an asset pool monitor must be appointed to monitor the cover pool;

d. legislative amendment to provide the SPV cannot be included in the statutory management of the issuing bank and that certain “moratorium provisions” of the statutory management and liquidation regimes will not prevent the SPV gaining full legal control of cover pool assets. Investors in covered bonds hold a secured interest over cover pool assets. Currently investors rely on contractual arrangements to provide them with priority to the cover pool.

The Reserve Bank says the regime it proposes provides a simple and low cost approach to regulating covered bonds, and it would apply both to New Zealand incorporated registered banks and New Zealand registered banks that are branches of overseas incorporated banks.

Banks not concerned about retrospective laws

Despite the fact the banks have issued more than NZ$6 billion worth of covered bonds before the Reserve Bank's laws around them are in place, the banks aren't concerned. BNZ Treasurer Tim Main, whose bank has issued NZ$3.47 billion worth of covered bonds which is more than the other banks combined, told interest.co.nz in June BNZ was relaxed about issuing covered bonds ahead of any legislation.

"They (the Reserve Bank) have said they'll grandfather existing issuances and we're confident that the legislation they come out with will be consistent with what we've been doing," Main said then.

The Reserve Bank says it wants the registration of covered bond issues to be mandatory with "transition rules" to be developed to allow pre-existing issues to be registered. As the proposed framework is intended to support existing commercial practice, the central bank expects existing issues to meet registration requirements. Conditions for registering an issue are set to include that the cover pool assets have been sold, assigned or otherwise transferred (including in equity) to an SPV that's a New Zealand registered company.

Meanwhile, the Reserve Bank wants changes to various laws so an SPV constituted under a registered covered bond programme couldn't be included in the statutory management of an issuing bank. The central bank says although it could charge banks a fee for registering of covered bonds, it's unlikely to do so.

Reserve Bank comfortable with programmes well in excess of 10% asset cap

In April the Reserve Bank imposed, as a condition of bank registration, that banks can't encumber - use as collateral - more than 10% of their total assets to support the covered bonds issuance. That means based on the big four banks' - ANZ, ASB, BNZ and Westpac's - total combined assets of NZ$318.692 billion, they can issue a total of NZ$31.8 billion worth of covered bonds. So far three - BNZ, Westpac and ANZ - have issued a combined total of just over NZ$6 billion worth with the bulk bought by Western European professional, or institutional, investors.

The Reserve Bank says the 10% cap addresses a key risk arising from covered bonds, namely that a bank’s unsecured creditors would be subordinated to covered bond holders in relation to cover pool assets in the event an issuing bank failed. However, both ASB, which has established a 7 billion euro (NZ$12.1 billion) covered bond programme, and Westpac which has a 5 billion euro (NZ$8.6 billion) one, have established programmes well in excess of 10% of their total assets.

ASB has NZ$63.254 billion worth of assets, meaning 10% worth is NZ$6.3 billion and Westpac NZ$56.887 billion putting 10% at NZ$5.68 billion. Both banks say the programmes, with numerous actual issues of covered bonds planned over a period of several years, allow for them to grow their asset bases.

And the Reserve Bank is happy with this, saying it's more efficient to register a single prospectus for one programme that has sufficient headroom to allow for any regulatory changes, changes in exchange rates, balance sheet growth, etc., than to constantly register and re-register as circumstances change. See more on this here.

(Updated to reflect the Reserve Bank's comments that covered bonds are already repo-eligible, thus it won't include repo-eligibility in any legislation).

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