Bonds: a key funding source
While the traditional source of funds for banks is deposits, in
Australia a significant amount of funds have been raised by banks issuing
bonds. From the 1990s these bonds have been supplemented by a new class of bonds
issued by some non‑bank lenders who essentially fund new loans by selling
off old ones. The loans are bundled up and bonds giving a claim on the cash
flows from them are sold. The process is known as 'securitisation' and the
resulting bonds are known as 'asset backed securities' (ABS). In Australia this
process has predominantly been applied to home loans with the resultant
securities being known as 'residential mortgage backed securities' (RMBS). This
technique allows a financial institution to expand its lending much faster than
would be possible were it relying on setting up a branch network to raise
retail deposits. In the 1990s new organisations which utilised wholesale
funding by securitisation such as Aussie Home Loans, RAMS and Wizard quickly became
household names. Some non-bank ADIs also tapped this new funding source to
expand their lending. This increased the competition in the housing loan market
Banks, and even more particularly non-bank mortgage originators, made increasing
use of securitisation prior to the GFC. At its peak in 2007, securitisation
accounted for over a fifth of new housing loans (Chart 13.1).
Chart 13.1: Share of
housing credit funded by securitisation (monthly)
Source: Reserve Bank of Australia, Submission 41, p 3.
The expansion in securitisation in Australia was part of a global
phenomenon. By 2006 the value of asset-backed securities issued in the US and
Europe had reached $4 trillion, comparable to that of all corporate bonds.
The GFC saw a collapse in the securitisation market, with issuance down to $1
trillion in 2009 and 'securitisation and the new intermediation model blamed
for financial instability'.
The subsequent collapse in the Australian market for residential
mortgage-backed securities (RMBS) is illustrated by Charts 13.1 and 13.2.
Australian RMBS issuance
Source: Reserve Bank of Australia, Statement on Monetary Policy,
February 2011, p 48. (Update of chart included in Heritage Building Society, Submission
113, p 3)
The Reserve Bank described the collapse and why they think it is
unlikely it will be (entirely) reversed:
The securitisation market was particularly adversely affected
by the financial crisis. The contraction in securitisation markets was not
unique to Australia, but was a world-wide trend driven by changes in global
markets. The business models of some of the Australian lenders reliant on it
were no longer viable and they either ceased lending or were bought by a larger
...a large part—probably half—of the flow of investment prior
to the crisis was by foreign investors, many of whom were SIVs
and conduits and so on. Those
people actually had a very risky business model, which we all know now. Those
people are not coming back, so we are not going to see that sort of investor
demand from offshore again virtually at any price, I would say.
The Reserve Bank believes that the securitisation market is now close to
its 'normal' size. This differs from some submitters who call for support
'until normality returns to the securitisation market'.
Some other participants concurred with the Reserve Bank:
...vehicles such as the structured investment vehicles, SIVs,
and some of the hedge funds are probably unlikely to come back. Certainly the
SIV is a not a business model that is sustainable post-crisis.
...the securitisation market is unlikely to return in either
volume or pricing to where it was pre-GFC.
A more critical note was sounded by a bank analyst:
...many organisations’ business models came under intense
pressure when the securitisation market froze in 2007. It could be argued that
many of these business models were flawed as they were too heavily reliant on a
single source of funding which was only available at economic levels during a
boom or a bull market.
Yellow Brick Road were a bit more optimistic, suggesting that some of
the overseas investors had 'gone into hibernation' with the implication they
will in time wake up.
There were also those somewhat agnostic about the prospects of a return
to pre-GFC securitisation levels:
...financial experts are not predicting an early end to the
effects of the GFC on global markets and economies, with some analysts
suggesting it will take another two years to see market conditions stabilise.
Furthermore, there is still uncertainty over whether or not funding costs will
then return to the lower levels seen in the years preceding the GFC.
It has been noted that the whole RMBS market has been tarred by the
excesses overseas and their reputation damaged:
...as an asset class globally, mortgage backed securities have
had a severe reputational hit. It is certainly true that the ones sold in this
country are of fabulous quality but, as an asset class as a whole,
unfortunately, there has been a reputational hit which will take time to be
Our assessment of the reason that there is not sufficient
liquidity today in the RMBS market is more about market perception of asset
qualities and liquidity.
The Australian Office of Financial Management (AOFM) was questioned
about the basis for securitisation:
Senator PRATT—I want to ask from the perspective of our financial
system as a whole rather than from the point of view of individual issuers what
the advantage is of having financial intermediators securitising mortgages
rather than issuing bonds to fund mortgage lending which remains on balance
Mr Bath—It tends to be more cost-effective. Because mortgages
are such a safe investment, by issuing debt that is backed by those mortgages
the overall cost of funds for a financial intermediary can be reduced
There are flaws, however, in the securitisation market, which have led
regulators in some countries to rethink whether it is desirable for there to be
no recourse to lenders once they have securitised loans :
The RMBS market is resource dependent, overly complex and
creates an ongoing operational burden for issuers due to the requirements
created by external stakeholders such as credit rating agencies. In addition,
changes in external stakeholder views or a shift in risk appetite, as well as
the punitive regulatory changes insisted on by APRA (often applied
retrospectively), reduce the efficiency of this channel from a capital and
operational perspective. ...there is an over-reliance on mortgage insurers
(another oligopoly within Australia) to support RMBS structures...
In theory, securitisation should result in risk being passed
to those agents best placed/most willing to manage it. However, the global
financial crisis has showed that, because of the complexity and opacity of
securitised products, investors did not understand the risk they were bearing
and, hence, credit was misallocated. As a result, global regulators are
proposing that banks retain 'skin in the game': that is, retain an exposure to
the underlying assets within the securitisation pool and hence to the quality
of their original credit assessment. These proposals are yet to be fully
developed but capital requirements will inevitably reflect the residual risk
that an ADI retains.
The basic issue with securitization is the role of asymmetric
information. In particular, banks rely on soft information to grant and manage
loans. Since this information cannot be credibly transmitted to the market when
loans are securitized, banks might lack incentives to screen borrowers at
origination or to keep monitoring them once the lending has been securitised...
The evidence on the whole supports the thesis that the rise of subprime
mortgages was accompanied by a decline in lending standards.
...mortgage originators in some countries failed to exercise
appropriate diligence in undertaking credit assessments. Asset retention
policies are one way in which other countries have sought to address this
issue. By requiring issuers to retain some ‘skin in the game’, these policies
are intended to incentivise mortgage originators to maintain appropriate
The UK experience was cited as a cautionary tale of how securitisation
can lead to problems:
...in the UK, with the Northern Rock example, such steady,
available and cheap funds through the securitisation market meant that they had
an unstable model and they fell over.
Between 1919 and 2000 the five (then four) UK major clearing
banks controlled ~85% of the deposit market. However, following the Cruickshank
Report into bank competition in 2000 and the substantial increase in funding
availability that coincided (via securitisation) the UK banking environment
changed substantially. Lending underwriting standards were loosened by
newcomers, first in mortgages then in commercial property, leverage increased
and asset prices rose sharply. Eventually the large banks followed to protect their
position. Then the Global Financial Crisis (GFC) hit. We believe the short-term
gains consumers enjoyed from competition appear more than offset by tax payer
bail-outs and the recession.
As discussed further below, the Government provided some temporary
support to the securitisation market during and just after the GFC. The ABA
called for more work to identify other means to rebuild the securitisation
Government should establish a working group with banking
industry experts to explore options, identify strategies and agree actions to
be taken to rebuild the securitisation market in Australia.
There is a concern that, as a result of the flaws in the securitisation
market having been exposed, it is unlikely ever to regain its former size.
Arguments that the government should support the market until this happens may
therefore effectively be calls for the government to prop up the market
indefinitely. The Governor of the Reserve Bank warned that:
...the taxpayer is being asked to shoulder more risk, one way
or another, in order to facilitate the provision of private finance.
Specifically addressing support for the RMBS market, the Governor
One idea that one sees around is the extension of guarantees
for mortgage‑backed securities by the government, which is done in some
other countries. Various people put forward arguments why that may be a good
idea, and it may be. But if one were inclined to go down that track one would
want to do it with great care because, when you think about extensive public
intervention in housing markets, we do not need to look any further than the
United States of America to see that that can go wrong if you are not very
careful about the way incentives are designed.
Treasury was among other witnesses who sympathised with the Governor's
...caution as to how far governments should get involved in
private market practices. Treasury is very much in agreement with the governor
I become concerned when taxpayer money is used to
artificially support markets and results in a risk transfer from the private
sector to the taxpayer.
While supportive of measures to invigorate the securitisation market,
even the Australian Bankers' Association was hesitant about permanent support:
A countervailing argument and one of importance is that we
also do not want to create a situation where certain markets or certain
participants require permanent government support, because that situation would
be a problem if it arose.
One alternative suggested that the cost of supporting the RMBS market be
borne by the banks:
We do not expect the government to fund this sort of
initiative. We do submit that if it cannot be funded through consolidated
revenue that a social licence fee on major banks, subject to conditions
including capacity and other things, be used as a levy to fund the initiative
in the early stages.
...by introducing a fee-based facility for offering Government
support for the payment of principal and interest on the securities, this
reform could provide an opportunity for improving liquidity in the secondary
market, but also encourage investment in primary issuance.
The Committee notes the important role the securitisation market played
in injecting competitive vigour into the home loan market (and lending markets
more broadly) before the GFC. It hopes that such vigour can be regained. It
accepts that the taxpayer should not be expected to underwrite the market
indefinitely as this is likely to delay restructuring of the market and
discourage innovation. But it calls for support for the rebuilding of the
A 'bullet' RMBS returns the principal to the investor in a single lump
sum upon maturity, with regular interest payments over the term of the
security. This contrasts with traditional RMBS where the principal is repaid
progressively over the term of the security.
One attraction of bullet bonds is that they may be eligible for
inclusion in bond market indices. As many institutional investors try to
replicate such indices, this increases demand for the bonds.
The AOFM has facilitated issue of a bullet bond by a smaller bank and the
Government is encouraging Treasury and AOFM to accelerate this work.
The Australian Securitisation Forum commented:
We are particularly supportive of and encouraged by the
interest of the government in promoting and facilitating the evolution of
bullet style residential mortgage backed securities.
They explained the attractions as follows:
...those that are less sophisticated in evaluating prepayment
speeds and the pass-through principle that is a characteristic of RMBS might be
attracted to buy a bullet security where they know they can invest in $10
million today and get $10 million back in three years time and treat it more
like a standard bond...bullet style of RMBS will help the market go back to the
international community because they will be able to source a currency swap at
a cheaper price than they would if they had to put in place a specialised or
tailored currency swap to account for the prepayments of principle that you can
expect comes through on the underlying portfolio of assets.
Others added about the attraction of bullet bonds:
There are coupon or interest payments over the life of the
transaction and then at what we call maturity you get back all of your
principle and the final coupon. Mortgage backed securities that we have been
investing in by and large until recently...have been amortising pass through
structures. These are less attractive to investors because not only do they get
their principle back in dribs and drabs over time but they also do not know
exactly when they will get it back. There are two types of risk—or features
that investors are not particularly attracted to—that the bullet structure
removes. One is the long-term dribs and drabs return of their capital and one
is the unknown rate at which the capital will come back. So the bullet
structure is attractive to investors.
...a bullet bond structure is something we do support. It is
something that makes a currency swap cheaper and more efficient to be able to
raise those funds.
We therefore welcome the support for the development of
bullet RMBS securities as a step toward satisfying the requirements of the
broader fixed interest market...[it would] facilitate superannuation fund
investment through incorporation in the fixed income index.
The Australian Securitisation Forum suggested:
...a more efficient way of achieving a bullet RMBS is to allow
for substitution of assets and to permit an ADI to buy-back the performing
assets at maturity – this eliminates negative drag and reduces extension risk
for investors. However, the ASF notes that the current prudential and
regulatory framework does not allow APRA (or any other relevant regulator) to
assess and administer such structures in a way that is efficient from a capital
and liquidity perspective for an ADI. It requires a more specific direction
from Government, from a policy perspective, to allow such structures.
The Committee is keen to encourage the securitisation market as a means
of promoting competition. Facilitating the issuance of bullet bonds would make
a contribution to this.
The Committee recommends that the Government ask the Australian
Prudential Regulation Authority to review aspects of its prudential framework
to ensure that there are no inadvertent impediments to the issuance and trading
of bullet bonds.
Treatment of securitisation
As noted above, views differ about whether it is desirable for
securitisation to remove totally the risk exposure from the originating lender,
or whether they should retain some exposure; some 'skin in the game' as it is
The International Organization of Securities Commissions (of which ASIC
is a member) issued a report in 2009 which recommended the following regulatory
responses to the problems that had arisen due to securitisation:
1. Consider requiring originators and/or sponsors to retain a
long-term economic exposure to the securitisation in order to appropriately
align interests in the securitisation value chain;
2. Require enhanced transparency through disclosure by
issuers to investors of all verification and risk assurance practices that have
been performed or undertaken by the underwriter, sponsor, and/or originator;
3. Require independence of service providers engaged by, or
on behalf of, an issuer, where an opinion or service provided by a service
provider may influence an investor's decision to acquire a securitised product;
4. Require service providers to issuers to maintain the
currency of reports, where appropriate, over the life of the securitised
The Australian Securitisation Forum commented:
...the securitiser, whether that is the seller of the assets or
the originator of the assets, should retain an interest that reflects the level
of risk in the underlying assets...something modest for prime pristine pools of
mortgages or it could be something higher for non-conforming mortgages,
equipment leases or credit card receivables...
The Reserve Bank Governor stressed the need to maintain the quality of
...underwriting standards in Australia remain pretty good. You
have to keep that, obviously, for the quality of the securities to remain high.
In fact, one of the thrusts of the global regulatory work that people are
working on has been how to restart securitisation globally but on a basis which
keeps the standards up, which keeps the incentives of the underwriters
correctly aligned, and that is not easy to do. But that is the key thing: to
keep the underwriting standards high. Most people seem to feel that one
component of doing that is for the originator to keep a stake in the outcome
rather than being able to shift all the risk away to the end investor, because
if they are able to totally shift the risk then their incentive to keep the
standards up is obviously weakened...we probably will be, over time, heading to a
world in the global regulatory architecture where it will be expected that the
originating lender retains some so-called 'skin in the game' as a way of
keeping the incentives correct.
Some other witnesses shared this view:
...it is very important that we look at the recourse of a
mortgage origination and that we do not move to an originate-to-sell model,
which was one of the primary causes of the US subprime crisis. If we learn one
thing from the GFC, it is that the writer of the loan must retain the majority
of the risk; otherwise, bad lending practices will develop.
...there is a need for some degree of skin in the game...
While supportive of the approach, one of the world's leading authorities
on financial supervision, Professor Charles Goodhart, warned it may constrain
the revival of the securitisation market:
...[securitisation] largely depended on trust that credit qualities
were guaranteed by the ratings agencies, by due diligence undertaken by the
originators and by the liquidity enhancement and support of the parent bank.
Without that trust, the duplication of information can be horrendously
expensive. The attempt to restore trust...by requiring banks to hold a share of
all tranches in a securitized product can make the whole exercise less
attractive to potential originators. So, the market for securitization remains
Mr Mark Bouris, an active participant in the RMBS market through his
former organisation Wizard and now with Yellow Brick Road, also supported the
idea of originators maintaining a stake:
...we are requiring issuers to put equity into the particular
issues—which is somewhat similar to the Canadian model, which shows that they
are not just buying their assets or originating assets and then loading the
risk off to somebody else—that they maintain equity in there; that there are
minimum standards of quality in relation to not only the performance of the
pool but how the pool is created; there is credit scoring and transparency; and
that they have capped LVRs.
APRA's regulation APS120 requires an ADI, if they are to get capital
relief, to satisfy APRA that there has been absolute transfer of the credit risk to third-party investors. If
ADIs are required to retain some 'skin in the game', either by allowing some
recourse from buyers of the ABS or more simply by just holding some of the ABS
on their balance sheet, they will therefore have to hold additional capital
consistent with the additional risk to which they will be exposed. This will,
of course, make securitisation somewhat less attractive as holding additional
capital represents an increased cost. It may be more of an issue for small
lenders with small capital bases who rely on securitisation to enable them to
originate more mortgages than they could support on their balance sheet.
The Committee recommends that, in order to retain incentives for careful
credit assessment, an authorised deposit-taking institution which securitises a
loan portfolio be required to keep a proportion of the resultant asset-backed
securities on its balance sheet and hold appropriate levels of capital. The
proportion should be set by the Australian Prudential Regulation Authority in
consultation with the Australian Securities and Investments Commission to
balance incentives to maintain credit standards with the desirability of
encouraging the recovery of the securitisation market.
The Reserve Bank's repo operations
Another area where smaller ADIs are, perhaps inadvertently,
disadvantaged arises from the Reserve Bank's rules on what securities they
accept in their repurchase arrangements:
The RBA’s definition of eligibility for repurchase
unreservedly favour the major banks, in that the existing definition only
provides ‘repo’ eligibility for long term debt issued by ADIs that are rated
A change is suggested:
...the current RBA definition relies too heavily on credit
rating opinions and does not give weight to the strong regulatory environment
under which all ADIs operate. A relaxation of the RBA definition to incorporate
all investment grade issuance would enhance the market for senior debt issuance
for smaller ADIs by providing access to a more diversified investor base and
reduce the need for smaller ADIs to rely predominantly on securitisation.
RBA repo eligibility criteria should be adjusted to include
all ADIs regardless of their rating (including unrated entities) and RMBS.
Concerns about the reliability of credit ratings have been noted in Chapter
The Committee, having more confidence in the Australian Prudential
Regulation Authority's oversight than in the opinions of credit rating
agencies, recommends that the Reserve Bank accept as eligible paper for
repurchase agreements long term debt issued by any authorised deposit-taking
institution rather than just those rated above A.
The Australian Office of Financial Management programme
The Government has supported smaller lenders by instructing the AOFM to
purchase AAA-rated RMBS. The measure had bipartisan support—indeed it was
argued whether the idea had first been proposed by the Government or the
The programme had three phases; $8 billion just after the GFC in
September 2008, a further $8 billion in October 2009 and the Government foreshadowed
a further $4 billion in its December 2010 statement which it initiated in April
The Australian Securitisation Forum views the three phases as having
The first $8 billion was probably almost a lifeline to keep
the sector going and particularly to provide funding to the smaller
institutions...The second tranche I think the AOFM played a more expanding role
to encourage investment by buying into the longer-dated tranches in the
transactions. ...With the last phase of the $4 billion there is the preparedness
for it to be used in ways that could aid, for example, the evolution of the
bullet-style residential mortgage backed securities.
The Reserve Bank pointed to a number of advantages of the programme
relative to alternatives:
...it can be directly tailored to help specific types of
institutions; the support can be phased out easily; the likelihood that the
Government loses money on its investment is very small; and there is no ongoing
contingent liability to the Government from the support.
The Governor added at the hearing:
The taxpayer takes on some risk. Doing it this way it is
confined, the securities are being managed by people who have got expertise, so
I do not have a problem with that; I think it was a sensible trade-off.
Treasury believe the AOFM programme has been effective:
It has been significant and, realistically, it has kept some
of the smaller players in the game.
The Government asserts:
The Government's $16 billion RMBS investment continues to put
downward pressure on borrowing costs for households and small business.
As argued in Chapter 5, with borrowing costs effectively determined by
the Reserve Bank, any impact is likely to be marginal. It may have increased
the supply of credit to some borrowers. The AOFM estimates that about a tenth
of funds have been lent to small business.
The AOFM programme is also supported by a number of market players:
We also welcome the government’s announcement of a further
tranche of AOFM’s RMBS investments because the recovery of the securitisation
market and better pricing for smaller banking institutions will help regional
banks, us and non-bank lenders to deliver tighter pricing and put more
competitive pressure on the banks.
...the AOFM has played an important role in both fundamentally
sustaining the businesses of some of the smaller players through the worst
aspects of the crisis and providing important signals to the investment markets
that the government sees that securitisation is an important sector of the
financing of the Australian economy and that the government has an interest in
seeing that the sector recovers. 
The government support for securitisation through the AOFM
has been vital to rebuilding confidence in that market.
...of the 13 Western economies and banking systems considered
by the KPMG review...in 2008 only two, Australia and the UK, had no government
involvement in the mortgage market.
Associate Professor Zumbo, bringing the perspective of a competition
policy academic rather than a financier, also called for some government
There needs to be a role for government to promote that
confidence in that securitisation market.
But some thought it did not go far enough, either in the amount of
funding or in being restricted to higher-rated bonds or in its focus on
... the injection of $16 billion of funds through the AOFM and
the promise of another $4 billion in the banking reform package. While that is
welcomed, it will not be sufficient to revive the securitisation market....
It will not hit the sides...that [additional $4 billion] is two
days of funding...Chickenfeed... If the government want to make a difference and
promote competition, they would have to invest at least $30 billion to $40
billion a year, and that is only a small amount.
...support has been restricted due to the AOFM’s current
investment mandate that only allows it to invest in A rated notes. While
investors have been returning to the higher rated notes, lower rated notes in
securitisation issues remain difficult to sell at reasonable margins and it
would greatly assist if the investment mandate was expanded to provide the AOFM
with the ability to invest in these notes.
The AOFM mandate should be expanded to permit the purchase of
these lower [class B] subordinated tranches....
There is support amongst some (but not all) industry
participants for the investment programme of the AOFM to be broadened to
include the lower tranches of RMBS as these classes are proving the hardest to
sell to investors...
...housing loans in Australia are $1 trillion. So even a below
average growth rate of, say, seven per cent will require $70 billion in
funding. So doubling the RMBS investment by another $16 billion would be
meaningful to competition.
Others cautioned about taking it further:
Substantial amounts of taxpayer money are now being used to
artificially stimulate these markets. At present, the risks taken are low,
given taxpayer money is only invested in the AAA tranches of RMBS. However, I
would be very cautious over any moves to use taxpayer money to go further down
the capital structure of RMBS to the subordinated tranches such as BBB or
equity or any proposals to have a government guarantee on those issues. This
would lead to a material risk transfer from the originator of the mortgages to
the taxpayer, especially at a time when household leverage in Australia is the
highest in the world and everyone acknowledges that housing is unaffordable.
The purpose of the programme is to support smaller lenders who would
otherwise have difficulty attracting funding. For this reason the AOFM has not
bought bonds issued by the major banks. It has also not bought bonds issued by
entities in which the major banks have large stakes, as these would presumably
be more able to attract funds from the major banks themselves.
This proved controversial in the case of Aussie, which is 33 per cent
owned by the Commonwealth Bank, but regards itself as acting independently.
The Committee welcomes the programme of AOFM purchases of RMBS, which it
would like to see continue. While the initial motivation was preventing the
Australian financial system seizing up during the global financial crisis, the
focus now should be on helping smaller lenders attract the funding they need to
compete in the market with the four major banks. With this new focus on
competition, the AOFM should now be allowed to invest in a wider range of
The Committee recommends that the Australian Office of Financial
Management programme be expanded to include asset-backed securities based on
assets other than home mortgages and to include securities rated AA or A (rather
than just AAA) or issued by a financial intermediary supervised by the Australian
Prudential Regulation Authority.
The Committee recommends that the Australian Office of Financial
Management be given the discretion to purchase residential mortgage-backed
securities issued by entities with a substantial bank shareholding where it
judges this would promote a more competitive market.
Other proposals for government support of securitisation
Mr Bouris believes areas where government support may be needed
initially is in establishing a secondary market for trading RMBS so that they
have the liquidity needed to give investors (in particular Australian
superannuation funds) confidence in holding them. This suggestion did not
appeal to the banks:
The ABA does not believe that the establishment of an
exchange would be of benefit to the securitisation market, and by itself would
not create or enhance liquidity. We consider that the additional transaction
costs associated with pre and post-trade infrastructure would likely have an
adverse impact on the desirability of securitised products.
Mr Bouris also suggested conducting a survey of potential demand for
types of RMBS. The Australian Securitisation Forum described this proposal as:
...a useful thing for us to consider. 
Mr Bouris would also like RMBS to be based on specific classes of
mortgages. For example:
backed mortgages which have this credit score and have been rated by their
agency, and lend money to everyone in Sydney who is earning over $70,000,’ or something like that.
He recommended various forms of standardisation:
...to support securitisation the Government should sponsor the
establishment of an industry standard for disclosure of information concerning
marketable pools of Australian mortgages...[and] for credit scoring of
applications for Australian mortgages, and require disclosure of the
distribution of such credit scores within each Standardised Australian Mortgage
The banks were not attracted to this idea:
The ABA believes that independent benchmarks might stifle
Mr Bouris' concept is somewhat similar to the new category of preferred
securities being proposed in the US. The Committee acknowledges that such well
defined securities that have characteristics meeting certain parameters will
make investment in such products more attractive, but would correspondingly,
render all other securities less attractive, as well as lower the average
quality of those securities not meeting the defined parameters. As such, in a
market such as Australia's, which does have some activity, it could limit the
market as much as improve it.
Abacus called for a government repurchase programme to improve
Currently some investors are unwilling to invest in
Australian RMBS because of doubts about the ability to resell that investment
before the expiry of the investment term. The presence of the Government as a
repurchaser (in circumstances to be controlled and prescribed) would provide
greater certainty to investors thus stimulating demand in the market.
The ABA thought liquidity support could be restricted to certain types
Furthermore, this reform could restructure the securitisation
market and achieve broader regulatory objectives by identifying those
securities that qualify for liquidity support. For example, certain market
attributes and credit quality standards could include setting minimum
loan-to-value ratios, imposing loan servicing criteria, improving transparency
of data about issuances/tranches, imposing a retention (or capital)
requirement, requiring credit quality enhancements or insurance, and
establishing origination standards by requiring APRA licensing.
One market player felt the regulation of the securitisation market needs
to be improved:
There is a pressing need for improved alignment and dialogue
between policy makers (Treasury), regulators (APRA/RBA) and industry to ensure
that the policy objectives of improved competition (via securitisation) is not
frustrated by unnecessary or unintended regulatory conduct. Measures to improve
the quality, efficacy, and coordination of engagement between relevant parties
would be of material assistance in improving policy outcomes.
The Canadian model
A number of submissions referred to the Canada Mortgage Bond programme
which was introduced there in 2001. The AOFM provided the Committee with a
description of the Canadian model:
...the Canadian model has two components to it. One is a
government intervention in what I would call the lenders mortgage insurance
market, so it guarantees credit performance...on the underlying mortgages...In
Australia in the 1960s or 1970s, the Australian government had a mortgage
insurer. However, as the market was opened up to the private sector and
competition, the government of the day stood back and now there are private
sector providers of lenders mortgage insurance...The other aspect of it is that
you have a facility that essentially guarantees the creation of a bullet
structure...There are coupon or interest payments over the life of the
transaction and then at what we call maturity you get back all of your
principle and the final coupon.
The Canadian programme is widely used there:
...the large Canadian lenders all access the CMB program. In
fact, 83 per cent of all issuances come from them. There is a good reason for
that: pre‑GFC the funding cost advantage of a Canadian mortgage bond
versus the next cheapest alternative source of funding was 23 basis points. In
early 2008, when the impact of the GFC had hit, the cost advantage was 105
If you look at the Canadian model, 30 per cent of all their
mortgages are securitised through the national scheme.
Some witnesses regarded the Canadian Mortgage Bonds Program as a model
which could be adopted here:
...what was needed was not a temporary or a bandaid fix but a
permanent system whereby lenders could be assured of access to funds, irrespective
of the economic environment. We pointed to the Canadian model of a good example
of what can be achieved by a government.
...the government should look at a system similar to the
Canadian system, where the government—with a similar population— over five
years have stood behind $300 billion in mortgage backed securities.
...that [Canadian mortgage] model has proven to be very
resilient during the global financial crisis. You would think if anyone was
going to be impacted by issues around securitisation
it would have been Canada because they are right next door to where the major
securitisation issues were. Yet it got through that period very well and
continues to do well.
One option, similar to that in the Canadian system, would be
to enable banks to access government guarantee for RMBS issuance for a fee,
effectively creating a new class of security which would be seen by investors
as an Aussie government guaranteed mortgage bond.
It could be argued, however, that the Canadian model is popular there because
it addresses problems that had arisen in North America but these problems have
not arisen in Australia:
Do you set up a permanent institution to guarantee credit
performance? Arguably, credit has not ever been an issue on mortgage backed
securities that have been issued in Australia. There has never been a credit
loss on a rated mortgage backed security in Australia, so why do you need the
government to guarantee something that does not need a guarantee?... The other
aspect of it is: do you want to set up a permanent institution that will enable
the ratio of bullet securities to the total amount of mortgages being financed
to be increased further? That is a separate question to whether a government
should be guaranteeing mortgage backed securities.
Some supporters of the AOFM programme do not want a permanent government
The Agency model is the securitisation of mortgage backed
securities by Government agencies...ME Bank does not support the agency model as
it does not result in a market led approach, instead relying upon a Government
intermediary interposing with the market, restricting investor choice. This
also disconnects each issuer from a direct relationship with investors creating
When Treasury was asked for their opinion, they referred the Committee
to their submission to an earlier inquiry. The submission concluded:
A Canadian-style program of support to the RMBS market, under
which the Government guaranteed RMBS issued by lenders or purchased such RMBS
outright using proceeds from the issuance of government-backed debt securities,
could potentially enhance smaller lenders’ access to funds. However, it is not
clear that such an intervention would necessarily result in substantially
greater choice and lower interest
rates for mortgage borrowers, or that the benefits of the proposal would
outweigh the associated risks and costs.
The Committee believes that enhancing the securitisation market would
facilitate smaller organisations providing competitive pressure to the major
banks. It therefore believes that proposals suggested by market players should
at the least be investigated further. It does not at this time favour the
introduction of a programme of government support such as that in Canada. It
would, however, like to see some more research done into how the Canadian model
could be applied in Australia so that a scheme is in the 'bottom drawer' of the
authorities ready to be implemented quickly if circumstances warrant it.
The Committee recommends that the Government commission a survey of
potential demand for types of asset backed securities.
The Committee recommends that the broader inquiry into the financial
system investigate ideas that may further the participation of smaller lenders
in the securitisation market, such as greater standardisation and disclosure,
liquidity support for securities issued by mutual ADIs meeting certain quality
standards and better co-ordination between regulators.
The Committee recommends that Treasury develop a plan to introduce a
support programme for RMBS similar to that operating in Canada in case a future
deterioration in the securitisation market requires its introduction.
The Government announced in its December 2010 package that it will amend
the Banking Act 1959 to allow Australian ADIs to issue covered
These are bonds giving the holder a preferred claim on a specific group of
assets on a bank's balance sheet. They differ from RMBS in that the assets stay
on the banks’ balance sheet but are 'ring-fenced' to give investors priority
over depositors and other creditors in the event of the issuer going bankrupt.
Covered bonds offer 'dual recourse' as:
If the cover assets are not sufficient to meet the bond
payments in full, covered bondholders also have an unsecured claim on the
issuer to recover any shortfall. In that case they would stand on an equal
footing with the issuer’s other unsecured creditors.
This initiative is designed to strengthen and diversify the
financial system's access to cheaper, more stable and longer duration funding
in domestic and offshore wholesale capital markets.
The attraction of covered bonds for the issuer is that they should be
able to be issued with a lower interest rate:
It will be cheaper because our wholesale funding is AA rated
and covered bonds are typically AAA rated.
ING Direct, for example, has a long term rating of A+ from
Standard and Poor's but could issue a covered bond with a AAA rating.
One caveat on this is that, as described in Chapter 12, government‑guaranteed
bonds were also expected to be issued at lower yields but, for reasons still
not clear, the market priced them instead at the issuer's rating.
Proposals to allow the issuance of covered bonds are welcomed by a
number of submitters:
...it is another important step in diversifying funding and we
would like to take advantage of it.
...covered bonds have a role in expanding and widening the
investor base and in diversifying the funding base of ADIs.
I believe that covered bonds are a good move. That will
improve the funding position of all the players.
...covered bonds are priced considerably cheaper than the bank
can borrow funds in its own name, and that will have a benefit for us in terms
of reducing the overall cost of funding to the industry.
Covered bonds are commonly used in a number of countries:
...they have been around in Germany, for instance, for about
150 years. The structure is fairly well established as to how they work...
They are used in many other markets. We [NAB] have issued
them ourselves out of our New Zealand bank.
The covered bond market is large, with a total global amount
outstanding of about €2.2 trillion in 2010. Around 300 institutions in over 30
countries have issued covered bonds. The bulk of covered bonds, around 90 per
cent, have been issued by countries in the euro area...
In more than twenty nations, covered bonds perform a critical
role on the liability and asset sides of bank balance sheets.
Australia's depositor protection arranged had prevented their issue here:
Under the Banking Act 1959...depositors must stand first
in the queue in the event that a bank or deposit-taking institution is put into
liquidation. That section in the Banking Act has always precluded the
introduction of covered bonds in Australia.
This has changed with the introduction of new arrangements for depositor
The Government’s position is that the introduction of the
Financial Claims Scheme has opened the door for Australian institutions to have
It seems to be generally accepted that, at least initially, covered
bonds will help the major banks but may be of limited use for smaller
competitors such as the mutuals:
Abacus strongly rejects however the notion that covered bonds
are pro‑competitive. There is little doubt that the major banks will be
able to source additional lower cost funding through covered bonds, however it
is unlikely that many smaller regional banks, credit unions or building
societies would be able to access funding through such an instrument.
...covered bonds. I think that is an obvious help to the major
...covered bond market...will not be an option for any bank under
an AA rating in the short term (ie. it will only provide a benefit to the major
The main reason is that it is generally regarded that the minimum viable
size for an issue of covered bonds is a few hundred million dollars.
The major banks suggested the smaller lenders could issue covered bonds
by pooling their operations:
...if there are willing issuers and there are buyers out there
the market will find a way to package or structure that so that the smaller
banks can benefit from that market. I have no doubt that will happen.
A warning was sounded by one submitter:
The impression their backers give is that they minimise risk.
In reality they simply redistribute risk, so that the bond holders are exposed
to less risk and the depositors, including the “mums and dads”, are exposed to
more risk then they would otherwise be.
One way of limiting this problem is the common international practice of
capping the amount of covered bonds that can be issued to around 5 per cent of
As the Reserve Bank describe:
Countries that have only recently begun to permit covered
bonds have tended to manage the subordination of depositors and other creditors
by setting limits on the issuance of covered bonds. Regulations in Canada and
rules proposed in the US Covered Bond Act limit covered bond issuance to 4 per
cent of a deposit-taker’s assets (in Canada) or liabilities (in the United
This has also been suggested as a response to concerns here:
...there is a limit on the proportion of the ADI’s assets that
can be encumbered for covered bond holders instead of deposit holders, so that
the latter still sufficient recourse to an issuer’s assets in the event of
Especially given the strong capitalisation of Australian banks and the
very low chance of one defaulting, this would ensure that the issue of covered
bonds does not pose any risk to depositors, or the taxpayers guaranteeing them.
The covered bond market proved more resilient than did that for RMBS
during the GFC, although the Reserve Bank caution that:
...despite providing more safety to investors, covered bond
issuers’ access to debt markets became seriously disrupted during the crisis,
suggesting that the robustness of covered bonds should not be overstated.
Fixed interest markets more generally
The weakness in the RMBS market is viewed by some as part of a generally
underdeveloped market for fixed interest securities:
...we do need a big increase in domestic appetite for fixed
interest. Our fixed interest market relative to our equity market is quite
small on international standards. That is the case even though we have got a
terrific savings pool in superannuation. Unless we can get a domestic fixed
interest market of substance up and running, we are going to remain hostage to
offshore investors, we are going to be reasonably inefficient as an economy
because there will be more going into equity and we will not be leveraging to
the appropriate amount we should, and there will be some restriction on funding
for lower rated institutions...
The Government aims to boost the vibrancy of bond markets by further
streamlining disclosure requirements and prospectus liability regulations, and
facilitating the trading of government bonds on securities exchanges to provide
a more visible benchmark yield.
As noted above, the Government links the issue of covered bonds to
accessing funds in superannuation:
A deep and liquid covered bond market will help to channel
Australia's national superannuation through the financial system into
productive investment in all sectors of our economy.
Some submitters want superannuation funds to be encouraged or required
to provide more funding to ADIs.
...the Government needs to clearly investigate if the funds
invested in Superannuation can be diversified in such a way that it could
assist with funding of the banking system... There is a need to bridge the gap
between superannuation funds sending much of their funds offshore and the needs
of the Australian community, which is made up of the members they serve.
Legislation could easily be drafted to support this public interest...Leaving the
superannuation funds (and other institutional investors) to direct investment
according to the market system contributed to the global financial crisis.
No fund manager will look at a BBB ADI but (they) are happy
to invest 20 per cent of their portfolios in offshore or emerging markets
equities. This is not sensible for banking competition...If the Government wants
to promote RMBS, the market needs to develop a link to a more significant
investor base, i.e. the Australian superannuation funding pool.
...investment and superannuation funds (both wholesale and
retail) have an asset allocation that is over-weight equities and under-weight
fixed income securities.
...there are also some other opportunities to support
competition...via further superannuation reform to encourage a greater proportion
of fixed interest investments by superannuation funds...
13.100 The ABA
The Federal Government should establish a working group with
banking industry experts to explore options, identify strategies and agree
actions to be taken to promote investment in deposits and fixed income assets
within superannuation and retirement income products.
...the Federal Government, in partnership with the banking
industry, should conduct...a research exercise as part of responding to the
‘Cooper Review’ should look at conducting thorough analysis of the drivers and
barriers for saving, thereby identifying how best to target savings messages.
Understanding the factors that influence individuals’ decisions about money,
savings, investment, superannuation, debt and lifestyle choices will be
important for determining how best to encourage greater personal superannuation
contributions and private savings.
13.101 The ABA,
clarified, however, that they are not looking for regulations:
Prescribing investment options or mandating asset allocations
is likely to have unintended and adverse consequences for superannuation fund
trustees acting in the best interests of all members in their fund.
13.102 One argument is
that this would just be restoring the ability of banks to fund their lending
from deposits to the situation prevailing before superannuation funds gained
more favourable tax treatment:
It wasn’t until the early 1990s when the Hawke/Keating
Government introduced compulsory superannuation laws and tax incentives for
voluntary superannuation contributions, that a gap emerged between the level of
deposits and the funding needed for loan growth. Compulsory superannuation drew
deposits away from banks and into superannuation trusts.
superannuation funds themselves, however, reject the approach of requiring them
to direct funds to the banks:
Changing the allocation of superannuation investments through
government intervention would move funds away from the optimal allocation
determined by trustees. The net result of such action would be to reduce
superannuation fund returns and ultimately deliver lower retirement incomes.
...we strongly oppose any suggestion that the superannuation
sector should in fact be treated as a cash cow for the ADI sector.
superannuation funds cite the recent Superannuation Review's recommendation
...government should not mandate that superannuation fund
trustees participate in any particular investment class or vehicle.
Valentine also opposes the suggestion:
...superannuation funds through the last 10 years have made a
deplorable return, and to compel them to hold low-yielding assets so people can
have low-yielding mortgages would mean that they would make an even lower
return. That is not a particularly desirable result.
13.106 The Committee
believes that superannuation trustees should continue to have the sole purpose
of maximising the (risk-adjusted) returns to their members. It does not favour
measures to direct them to invest in bank securities or any other asset class.
The Committee does support, however, removing any artificial barriers or
discouragements to superannuation funds investing in securities such as ABS or
covered bonds issued by banks.
13.107 The Committee
recommends that the Government establish a working group with an independent
chair, representatives from Treasury, the Australian Prudential Regulation
Authority, the Reserve Bank, and the banking and superannuation industries, and
also including academic experts, to explore and assess options that could
promote investment in deposits and fixed income assets by superannuation funds
and other funds managers.
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