Behind the controversial new funding technique that is banned in Australia

Banks have started using a new way of raising money that shunts term depositors down the 'queue' in the event of liquidation, but which also could help strengthen and lengthen bank balance sheets. 

This new type of funding mechanism, known as issuing covered bonds, is banned in Australia, but is very popular with savers and banks alike in Europe. It also opens up a new type of investment, particularly for local KiwiSaver fund managers.

So what are covered bonds and why do they matter for both term depositors and the economy generally? 

Essentially, a covered bond is a type of bond issued by a bank that packages up the revenue or interest streams from mortgages it owns. The difference with securitised mortgages, which are widely used in America and to a lesser extent in Australia, is that with covered bonds the mortgages remain on the banks' balance sheets.  

Our Banking and Finance Editor Gareth Vaughan has reported in depth in recent weeks on banks' plans in New Zealand to issue as much as NZ$19 billion worth of covered bonds to domestic and foreign fund managers. This followed approval from the Reserve Bank of New Zealand to issue up to 5% of total assets.

BNZ was the first cab off the rank this week, issuing NZ$425 million of covered  bonds in two tranches to domestic fund managers. It sold NZ$175 million of five year covered bonds at 98 basis points over the wholesale swap rate and NZ$250 million of 7 year covered bonds at 112 basis points over the wholesale swap rate. This was slightly more costly than BNZ had originally expected, but slightly cheaper than issuing regular bonds to foreign institutional investors.

Westpac is also planning to issue these covered bonds and both ASB and ANZ are also expected to jump in too.

These bonds are controversial in Australia where the banking regulator, the Australian Prudential Regulatory Authority (APRA) has banned them on the grounds they break the law in the 1959 Australian Banking Act that says no other type of security can stand in line ahead of term depositors. Australia's banks are lobbying to change the law, but so far the regulator and the government have not budged.

This issue of 'prior charges' could prove controversial here too, particularly in the wake of various finance company collapses where vulture funds such as Fortress Capital and banks such as Bank of Scotland had lent money under 'prior charge' facilities which meant they received any monies recovered before debenture investors, despite advertisements describing the debentures as 'first ranking secured debentures'. South Canterbury Finance also has a 'prior charge' facility with Torchlight that stands in line ahead of term depositors, or in the current case, the government because of the deposit guarantee scheme.

The assumption in New Zealand banking circles is that term depositors would always get any money recovered first in the event of a collapse. The advent of covered bonds undermines that "Negative Pledge" assumption.

However, there are good reasons for the banks to start offering covered bonds and for the Reserve Bank to approve their issuance. They will help banks lengthen and strengthen their sources of funding. Up until late 2008 our banks were raising more than 40% of their funds from short term 'hot' money markets. These markets froze up after the collapse of Lehman Brothers, forcing the banks to find other sources of funding. At one stage the Reserve Bank had to help the banks raise funds to tide them over.

Now the Reserve Bank is pushing banks to lengthen and strengthen their funding by raising more funds locally and for longer terms offshore. The RBNZ has done this through its Core Funding Ratio, which is pushing the banks to raise more than 65% of their funds from local and long term sources. That ratio is expected to rise to 75% by April 2012.

Covered bonds help the banks do this, particularly with European fund managers who are very familiar with covered bonds. Even during the recent financial crisis in Europe, banks there were still able to issue more than 4 billion euros a week of covered bonds.

But there are some risks for the Reserve Bank and the economy. Banks could use covered bonds issued offshore to substitute for funds raised from local term depositors. That could reduce competition for term deposits here and therefore reduce interest rates, which have been relatively high lately because of the pressure for the banks to lift their Core Funding Ratio.

If these covered bonds were cheaper than local deposits, that could create the ugly situation the economy and the Reserve Bank faced between 2002 and 2008 when the banks were able to raise funds cheaply offshore and then offer low fixed mortgage rates which undermined the monetary policy power of the Reserve Bank. This helped power the housing boom and sucking in all that foreign money pushed up the New Zealand dollar and damaged our export sector.

However, the early signs are that these funds are still relatively expensive. Indeed, the surprisingly high price paid by BNZ may discourage some of the other banks from going too hard down this route. Also, the Reserve Bank has set a limit of 5% of total assets, which should keep things under control. 

The other danger is that the Australian banks, who are blocked from doing the same in Australia, could use New Zealand as a backdoor for issuing covered bonds, essentially engaging in regulatory arbitrage.

It's early days yet, but I doubt our Reserve Bank would allow or encourage that.

The other unspoken aspect here is that many term depositors don't believe one of the big four banks would ever be allowed to fail, either by our government or the Austarlian government behind their parents. That was proved, albeit temporarily, when both governments offered government guarantees for such deposits. They expire in New Zealand at the end of October. 

Your views? I welcome your thoughts below. I also spoke above to TVNZ's Business programme yesterday morning with Corin Dann about this. You can see the video above.