The Raw Prawn

There’s been some discussion on the Mule Stable about covered bonds and who may or may not be disadvantaged by them, so I thought I’d post a (very) simplified example of how they would work compared to the alternatives of standard financing or securitisation.

The first (sometimes confusing) thing to remember is that loans are a banks assets and deposits are their liabilities, as are their other sources of funds such as bonds issued by the banks. Imagine a bank has $100 million of assets and, to make life easy, we’ll assume they’re all home loans. Bank capital requirements mean that the bank has a minimum capital requirement of 8% of “risk-weighted assets”. I’ll ignore the technicalities of risk-weighting and assume that the home loans are 100% risk-weighted (in fact they’d be less that this, but other loans would have higher weights), which means that the bank must have at least $8 million of capital. Again, in the interests of simplicity, I’ll assume that this is all in the form of equity. The remaining $92 million I’ll assume to be made up of $52 million in deposits and $40 million raised by issuing bonds which have been bought by superannuation funds (i.e. pension funds).

So, here’s the bank’s balance sheet:

Home Loans $100m

Deposits $52m

Wholesale borrowing (bonds) $40m

Shares $8m

In a moment, I’m going to imagine that the property market collapses and the portfolio of home loans loses 50% of its value. But before that, $5m of the bonds are due to be repaid and the bank has to decide how to refinance them. The options being considered are

1. Issue $5m more bonds
2. Issue $5m in covered bonds, pledging $5m of the home loans as collateral
3. Securitising $5m of the home loans.

Now disaster strikes and the loan porfolio halves in value across the board. What happens in each case? Keep in mind that depositors rank first in their claims on the bank, so they are the last to lose money, except where assets have been explicitly pledged as in the case of covered bonds.

Case 1. The loan portfolio falls to $50m. Shareholders lose everything, wholesale borrowers lose everything and the depositors lose $2m, a 4% loss.

Case 2. Again, the loan portfolio falls to $50 and shareholders lose everything. This time, however, the covered bond investors have a claim on the loans securing their bonds, which are now worth $2.5m and so they lose 50% of their investment, while the other bond holders still lose everything. Since the depositors don’t have the benefit of the $2.5m that was pledged to the covered bond investors, they now lose $4.5m or 9%.

Case 3. The outcome is the same as case 2.

So, in this scenario, the outcome is the same whether the bank issued covered bonds or securitised. Depositors would be better off if the bank were to simply borrow from the wholesale markets for their funding. Both covered bond funding and securitisation leave them worse off.

Now imagine a slightly more modest collapse in the portfolio value. This time, they lose 20% of their value. Running through the scenarios again we have

So the outcome this time is a little better for other bondholders when the bank goes down the route of covered bonds rather than securitisation.

This raises the question why has the regulator (APRA) been happy in the past to allow securitisation but not covered bonds? I believe it is a matter of transparency. In the case of securitisation, if you look at the bank’s balance sheet, it’s clear that there are only assets worth $95m. When the bank uses covered bond, it appears as though depositors have the benefit of a full $100m, when in fact $5m is pledged to the covered bond investors. While a bank would have to make a note to their accounts to this effect, it may be harder to people to understand.

There’s been some discussion on the Mule Stable about covered bonds and who may or may not be disadvantaged by them, so I thought I’d post a (very) simplified example of how they would work compared to the alternatives of standard financing or securitisation.

The first (sometimes confusing) thing to remember is that loans are a banks assets and deposits are their liabilities, as are their other sources of funds such as bonds issued by the banks. Imagine a bank has $100 million of assets and, to make life easy, we’ll assume they’re all home loans. Bank capital requirements mean that the bank has a minimum capital requirement of 8% of “risk-weighted assets”. I’ll ignore the technicalities of risk-weighting and assume that the home loans are 100% risk-weighted (in fact they’d be less that this, but other loans would have higher weights), which means that the bank must have at least $8 million of capital. Again, in the interests of simplicity, I’ll assume that this is all in the form of equity. The remaining $92 million I’ll assume to be made up of $52 million in deposits and $40 million raised by issuing bonds which have been bought by superannuation funds (i.e. pension funds).

So, here’s the bank’s balance sheet:

Home Loans $100m

Deposits $52m

Wholesale borrowing (bonds) $40m

Shares $8m

In a moment, I’m going to imagine that the property market collapses and the portfolio of home loans loses 50% of its value. But before that, $5m of the bonds are due to be repaid and the bank has to decide how to refinance them. The options being considered are

1. Issue $5m more bonds
2. Issue $5m in covered bonds, pledging $5m of the home loans as collateral
3. Securitising $5m of the home loans.

Now disaster strikes and the loan porfolio halves in value across the board. What happens in each case? Keep in mind that depositors rank first in their claims on the bank, so they are the last to lose money, except where assets have been explicitly pledged as in the case of covered bonds.

Case 1. The loan portfolio falls to $50m. Shareholders lose everything, wholesale borrowers lose everything and the depositors lose $2m, a 4% loss.

Case 2. Again, the loan portfolio falls to $50 and shareholders lose everything. This time, however, the covered bond investors have a claim on the loans securing their bonds, which are now worth $2.5m and so they lose 50% of their investment, while the other bond holders still lose everything. Since the depositors don’t have the benefit of the $2.5m that was pledged to the covered bond investors, they now lose $4.5m or 9%.

Case 3. The outcome is the same as case 2.

So, in this scenario, the outcome is the same whether the bank issued covered bonds or securitised. Depositors would be better off if the bank were to simply borrow from the wholesale markets for their funding. Both covered bond funding and securitisation leave them worse off.

Now imagine a slightly more modest collapse in the portfolio value. This time, they lose 20% of their value. Running through the scenarios again we have

So the outcome this time is a little better for other bondholders when the bank goes down the route of covered bonds rather than securitisation.

This raises the question why has the regulator (APRA) been happy in the past to allow securitisation but not covered bonds? I believe it is a matter of transparency. In the case of securitisation, if you look at the bank’s balance sheet, it’s clear that there are only assets worth $95m. When the bank uses covered bond, it appears as though depositors have the benefit of a full $100m, when in fact $5m is pledged to the covered bond investors. While a bank would have to make a note to their accounts to this effect, it may be harder to people to understand.

There’s been some discussion on the Mule Stable about covered bonds and who may or may not be disadvantaged by them, so I thought I’d post a (very) simplified example of how they would work compared to the alternatives of standard financing or securitisation.

The first (sometimes confusing) thing to remember is that loans are a banks assets and deposits are their liabilities, as are their other sources of funds such as bonds issued by the banks. Imagine a bank has $100 million of assets and, to make life easy, we’ll assume they’re all home loans. Bank capital requirements mean that the bank has a minimum capital requirement of 8% of “risk-weighted assets”. I’ll ignore the technicalities of risk-weighting and assume that the home loans are 100% risk-weighted (in fact they’d be less that this, but other loans would have higher weights), which means that the bank must have at least $8 million of capital. Again, in the interests of simplicity, I’ll assume that this is all in the form of equity. The remaining $92 million I’ll assume to be made up of $52 million in deposits and $40 million raised by issuing bonds which have been bought by superannuation funds (i.e. pension funds).

So, here’s the bank’s balance sheet:

Home Loans $100m

Deposits $52m

Wholesale borrowing (bonds) $40m

Shares $8m

In a moment, I’m going to imagine that the property market collapses and the portfolio of home loans loses 50% of its value. But before that, $5m of the bonds are due to be repaid and the bank has to decide how to refinance them. The options being considered are

1. Issue $5m more bonds
2. Issue $5m in covered bonds, pledging $5m of the home loans as collateral
3. Securitising $5m of the home loans.

Now disaster strikes and the loan porfolio halves in value across the board. What happens in each case? Keep in mind that depositors rank first in their claims on the bank, so they are the last to lose money, except where assets have been explicitly pledged as in the case of covered bonds.

Case 1. The loan portfolio falls to $50m. Shareholders lose everything, wholesale borrowers lose everything and the depositors lose $2m, a 4% loss.

Case 2. Again, the loan portfolio falls to $50 and shareholders lose everything. This time, however, the covered bond investors have a claim on the loans securing their bonds, which are now worth $2.5m and so they lose 50% of their investment, while the other bond holders still lose everything. Since the depositors don’t have the benefit of the $2.5m that was pledged to the covered bond investors, they now lose $4.5m or 9%.

Case 3. The outcome is the same as case 2.

So, in this scenario, the outcome is the same whether the bank issued covered bonds or securitised. Depositors would be better off if the bank were to simply borrow from the wholesale markets for their funding. Both covered bond funding and securitisation leave them worse off.

Now imagine a slightly more modest collapse in the portfolio value. This time, they lose 20% of their value. Running through the scenarios again we have

So the outcome this time is a little better for other bondholders when the bank goes down the route of covered bonds rather than securitisation.

This raises the question why has the regulator (APRA) been happy in the past to allow securitisation but not covered bonds? I believe it is a matter of transparency. In the case of securitisation, if you look at the bank’s balance sheet, it’s clear that there are only assets worth $95m. When the bank uses covered bond, it appears as though depositors have the benefit of a full $100m, when in fact $5m is pledged to the covered bond investors. While a bank would have to make a note to their accounts to this effect, it may be harder to people to understand.

Last night @randomphrase asked on Twitter about a long term chart of the spread of bank mortgage rates against the RBA cash rate. Fortunately, the RBA publishes quite a bit of interest rate data, including mortgage rates and their own cash rate.

So here is a chart:

Of course, every bank offers slightly different rates, not to mention a slew of discounted and fixed rate options. So, to be clear what we’re looking at, here is

‘Housing loan’ rates are those quoted for loans to owner-occupiers; in most cases, the same rates also apply to investment housing. Rates for ‘Banks’ and ‘Mortgage managers’ are the average rates of large lenders in each group. ‘Standard’ rates apply to housing loans with facilities such as the option to redraw or make early repayments.

The mortgage rate I have used is the ‘Standard’ rate for ‘Banks’, so it should just be a simple average (i.e. not market share-weighted or anything) of the rates from the big four.

It’s probably also worth noting that this spread does not necessarily give a great indication of the banks’ profit margins on mortgages because (i) the cash rate is a very visible rate, but longer-term rates (say 30 day to 90 day bill rates) are a better indication of the primary component of bank funding costs and (ii) on their long-dated wholesale borrowing, both domestically and offshore, they also pay a margin which is higher today than it was five years ago.

Sean Carmody