On 24 March 2011 the Australian Government released an exposure draft of the much anticipated Banking Amendment (Covered Bonds) Bill 2011 (the Draft Bill), which is intended to allow authorised deposit-talking institutions (ADIs) to issue covered bonds in Australia.
The issuance of the Draft Bill follows significant industry consultation in response to the Australian Government's announcements late last year that it intended to introduce covered bonds as a further funding tool for ADIs.
Recap: What is a covered bond?
Covered bonds are dual recourse debt instruments. They are typically issued by financial institutions and give covered bondholders recourse to the issuer on an unsecured basis, together with recourse to a 'cover pool' of assets that are specifically ring-fenced for the benefit of the covered bondholders.
One of the primary benefits to an issuer of a covered bond is that it allows the issue of bonds with a higher credit rating than if the issuer had issued a regular corporate bond. Covered bonds therefore have the potential to become a cheaper source of funding for issuers and also provide another means of diversifying an issuer's investor base. Covered bonds have been popular in a number of overseas jurisdictions, including Germany (where they are referred to as 'Pfandbriefe') and, since 2003, in the United Kingdom.
There have broadly been two types of covered bond structures that have been utilised in overseas jurisdictions.
One approach is the 'integrated' approach which is issued under a legal or statutory framework, which usually has the effect of amending insolvency laws and so allows the covered assets to remain on the balance sheet of the issuer (albeit that the covered assets are protected by statute from being available to creditors generally and are instead ring-fenced principally for the benefit of the covered bondholders). The integrated approach has been utilised in Germany for many years.
The second approach, is the 'segregated approach' under which the covered assets are ring-fenced by being transferred to a bankruptcy-remote special purpose vehicle (SPV). This is the approach that is taken in the United Kingdom and is also the approach proposed in Australia under the Draft Bill.
An example of this approach would involve:
- the issuer issuing a full recourse, unsecured, corporate bond to investors;
- the issuer transferring a cover pool to a newly established SPV in consideration for the creation of a subordinated debt owed by the SPV to the issuer;
- the SPV issuing a guarantee secured over the cover pool, principally for the benefit of the covered bondholders (together with other secured creditors, such as swap counterparties and service providers); and
- the transaction providing that if the assets in the cover pool are insufficient to repay the covered bondholders, then covered bondholders will have recourse to the issuer.
So what are the key points to note under the Draft Bill?
The Draft Bill sets out the basic framework which will allow ADIs to issue covered bonds. Some of the key features are as follows:
As mentioned above, the Draft Bill seeks to allow covered bonds which implement the 'segregated' approach, whereby the cover pool is transferred to an SPV which will provide a guarantee secured over the cover pool.
Cap on cover pool assets
The aggregate assets that an ADI may include in all cover pools relating to its covered bonds will be capped at 8% of the value of the ADI's assets in Australia. This figure is higher than the 5% which was initially proposed by the Government, but falls short of the 10% industry had requested. The Draft Bill states that this 8% figure is '8% or such other percentage as is prescribed by the regulations', which allows this figure to change in the future.
Appointment of a cover pool monitor
As is the experience with covered bonds in some overseas jurisdictions, a 'cover pool monitor' must be appointed. In Australia, the cover pool monitor will need to hold an Australian Financial Services Licence and must not be an 'associated entity' of the ADI. The role of the cover pool monitor will be to perform certain functions, including the maintenance of a register of the assets held in the cover pool and the monitoring of compliance with certain requirements, including the level of assets in the cover pool and certain liabilities of the SPV.
Maintenance of cover pool
As expected, the Draft Bill imposes an asset coverage test. The requirement in this case is that an ADI must ensure that the value of the assets in the cover pool is at all times sufficient to meet the liabilities to covered bondholders, together with any other liability in relation to the cover pool, such as the liabilities the SPV has to its service providers. This will be a key test for the transaction structure and will effectively require ADIs to top up performing assets into their cover pool from time to time, in order to ensure sufficient overcollateralisation.
Eligible assets for cover pool
The Draft Bill also sets out a list of the asset types that will be eligible for the SPV to hold. These include:
- residential loans secured by first ranking mortgages, provided that the loan-to-value (LTV) ratio of the loan when it was issued was no greater than 80%;
- commercial property loans secured by first ranking mortgages, provided that the LTV ratio of the loan when it was issued was no greater than 60%;
- government debt (limited to 20% of the value of the cover pool); and
- hedging agreements.
The Draft Bill also provides, in certain circumstances, for covered bonds that utilise one of two aggregation techniques.
Firstly, a transaction structure may be implemented which involves a new form of covered bond credit institution which is licensed by APRA, but is limited to undertaking activities associated with covered bonds. Under this structure, a number of ADIs may aggregate their cover pools into one cover pool for the purposes of a covered bond issued by the covered bond credit institution.
Secondly, in certain circumstances, covered bonds issued by ADIs may themselves be aggregated by packaging the covered bonds into a single issuing vehicle which then issues debt instruments secured by those underlying covered bonds.
Both of these aggregation structures will be of assistance for smaller ADIs that may not necessarily have the ability to issue highly rated covered bonds themselves.
The Draft Bill expressly states that APRA will implement further prudential standards to facilitate the introduction of covered bonds and to regulate certain matters relating to covered bonds. This will include matters relating to the issuance of covered bonds, the assets held in the cover pool and the maintenance of the cover pool.
In addition, the Draft Bill contemplates that regulations will also be drafted to supplement the Draft Bill and these should provide further detail as to how various aspects of the new covered bond regime will work.
The Government has invited comments in relation to the Draft Bill, with submissions to be made by 22 April 2011.