Focus: New legislation will impact on covered bonds
24 March 2011
In brief: The Federal Government today released its exposure draft legislation relating to the issue by authorised deposit-taking institutions of covered bonds. Partners Matthew Allchurch and David Clifford (view CV) outline the proposed legislative regime and comment on its implications.
- What is a covered bond?
- Cap on issuance
- Make up of the cover pool
- Maintenance of cover pool
- Role of the Cover Pool Monitor
- Pooling and aggregation arrangements
- What it means for you
How does it affect you?
- If enacted, the legislation will give authorised deposit taking institutions (ADIs) access to an alternative source of funding which is expected to be significantly more cost effective than traditional securitisation.
- It may also provide opportunities for the development of a new class of asset backed or repackaged securities, through the pooling and aggregation provisions contemplated by the draft legislation.
A covered bond has three key characteristics:
- it is issued by an ADI;
- it is secured against a cover pool of assets owned by a special purpose vehicle (SPV); and
- the debt owed to the holder of the covered bond is recoverable from the ADI if the assets in the cover pool are insufficient to satisfy the debt.
In essence, the legislation (Exposure Draft Banking Amendment (Coverd Bonds) Bill (No 1) 2011) contemplates that a covered bond will effectively be a securitised bond with a fall-back credit enhancement in the form of a personal covenant from the ADI.
The new legislation, if enacted, means the cumulative amount of covered bonds an ADI will be able to issue will be capped. The ADI will only be able to issue covered bonds if the total value of assets in all cover pools maintained by that ADI does not exceed 8 per cent of the value of the ADI's assets in Australia at the time of issuance. The 8 per cent may be varied by regulation.
It is initially proposed that the assets that may be included in a cover pool will be limited to:
- government debt securities (provided they are no more than 20 per cent of the value of all assets in the cover pool);
- loans secured by first ranking mortgages over residential property, provided that at the time of origination, the loans had a loan-to-value ratio not exceeding 80 per cent;
- loans secured by first ranking mortgages over commercial property, provided that at the time of origination, the loans had a loan-to-value ratio not exceeding 60 per cent;
- derivatives, but only to the extent that they hedge movements in currency or interest rates relating to the SPV's assets or liabilities (eg, interest rate swaps hedging fixed rate mortgage loans in the cover pool against floating rate covered bonds).
The draft legislation contemplates that other categories of asset may be prescribed by regulation.
The ADI must ensure that the value of the assets in the cover pool is at all times adequate to meet the liabilities under the covered bonds and all other costs of the structure. These will include the costs of the special purpose vehicle, and the fees and expenses of the Cover Pool Monitor (see below) and other service providers to the structure (eg trustees and security trustees).
The value of the assets in the cover pool are to be determined by a Cover Pool Monitor. The Cover Pool Monitor must hold an Australian Financial Services Licence, and must not be an associate of the ADI. 'Associate' is widely defined.
The Cover Pool Monitor is required to perform a number of functions, including:
- establishing and maintaining a register of the assets in the cover pool;
- monitoring compliance with the Banking Act 1959 (Cth)and any prudential requirement regulations or prudential standards in relation to:
- the nature of the assets in the cover pool; and
- the maintenance of the value of the cover pool;
- determining the value of the assets in the cover pool and the liabilities secured against those assets; and
- providing reports requested by APRA.
These functions can also be changed by regulation.
The draft legislation contemplates that ADIs may enter into two sorts of pooling or aggregation arrangements. The first involves the creation of a new, specially formed ADI that has been licensed by APRA to conduct banking business limited to activities associated with issuing covered bonds. The new ADI may purchase qualifying assets from other ADIs and then issue covered bonds backed by a cover pool made up of those assets.
The second involves two or more ADIs entering into arrangements with another entity (referred to as an aggregating entity) under which the aggregating entity issues asset-backed securities backed by covered bonds issued by those ADIs (similar to a traditional securitisation asset repackaging vehicle).
The draft legislative regime is to be welcomed as the first concrete step in the development of a statutory regime permitting the issuance of covered bonds by Australian ADIs. However, there are a number of issues arising from the draft that merit further consideration and discussion. In particular:
- some ADIs may be disappointed with the 8 per cent cap, although others may be pleased that the Government has moved from its previously indicated position of 5 per cent;
- the 8 per cent cap is to be tested at the time of issuance against the value of the ADIs as set in Australia at that time. It is not clear whether this means that an ADI will need to revalue all of its assets each time it issues a covered bond but this is what the drafting suggests;
- the attractiveness of the proposed regime to smaller ADIs may be limited by the relationship between the 8 per cent cap and the provisions of the Banking Act requiring an ADI to hold assets in Australia of a value that is equal to or greater than the total amount of its deposit liabilities in Australia (unless otherwise authorised by APRA). APRA will retain a wide discretion as to whether or not to authorise the holding of assets of a lesser value;
- the role of the cover pool monitor is significant and potentially burdensome. It may carry with it significant risks, which will affect the willingness of parties to assume the role and its costs. It is not clear how frequently assets in the cover pool will need to be valued or on what basis. Further, the requirement to monitor compliance with the Banking Act and the interaction between the specific covered bond provisions and the asset maintenance provisions (section 13A(4)) may involve significant, ongoing work from the cover pool monitor, the cost of which will need to be met out of the structure. Again, the burden of this may be felt disproportionately by smaller ADIs;
- the draft legislation is only one part of the regulatory response. It expressly authorises APRA to determine prudential standards relating to the whole covered bond regime, and confers wide discretions on APRA in relation to the application and enforcement of the provisions. The way in which covered bonds are structured, and their attractiveness to ADIs as a potential funding source will depend to a large extent on the way APRA exercises these powers and discretions, particularly with regard to the determination and day-to-day application of Australian Prudential Standards;
- the proposed statutory regime contemplates a highly structured solution for covered bonds. The techniques to be used in the structures as they are developed are likely to be drawn from those involved in securitisation, but they will need to be thought through and developed in the context of the new regime. This will require careful structuring and may involve significant negotiation as the roles of the various parties, particularly the Cover Pool Monitor, are worked out; and
- the workability of the aggregation and pooling mechanisms is open to question. The special purpose ADI option will presumably require significant capital. The repackaging option may involve significant costs, both in terms of establishment and ongoing administration it will require each participating ADI to create its own covered bond structure with its own Cover Pool Monitor, which will then feed into the repackaging structure created by the aggregating entity.
- David CliffordPartner,
Ph: +61 2 9230 4975
- James DarcyPartner,
Ph: +61 3 9613 8516
- Nicky AndrewsPartner,
Ph: +61 2 9230 4947
- Tom HighnamPartner,
Ph: +61 2 9230 4009
- Stephen SpargoPartner,
Ph: +61 3 9613 8861