Australia is progressing positively towards a viable covered bond framework, but needs to address several issues where uncertainties remain, according to observers. Doubts have also been raised about the viability of aggregation models detailed in a draft law.

The Australian Treasury released the exposure draft on 24 March and the consultation period closed on Friday.

The Treasury, Australia

Fitch considered the draft as being “a solid first step”, it said in a report last week, adding that this was particularly true with respect to segregation of assets. However, a lack of clarity in several areas of the proposed framework led UniCredit analysts to declare the draft “no more than a first step”.

Analysts noted that the draft legislation did not deal with minimum liquidity requirements or the maintenance of a minimum overcollateralisation level. Fitch said it believes that these issues will be addressed through consecutive drafts and result in a future rating of Australian covered bonds of up to triple-A.

S&P said that unlike under covered bond legislation in other jurisdictions, special purpose vehicles (SPVs) envisaged in Australian structures do not provide a guarantee of the ADI’s obligations to covered bond holders.

“The exposure draft refers to the ADI’s debt obligation as being ‘secured against’ the pool of assets and the explanatory memorandum refers to the bondholders’ right to enforce a charge,” said the rating agency, “but neither document stipulates how any ‘security’ will work or be enforced.

“If the intention is for the SPV to grant a third party security, the mechanisms for enforcing and applying proceeds from the security interest held on behalf of bondholders will need to be explicitly dealt with, for example, in the programme-specific documentation.”

S&P also said that the exposure draft does not appropriately tackle funding and refinancing alternatives following insolvency.

“We believe that it does not explicitly preclude the SPV from addressing maturity mismatches following an ADI’s insolvency – for example, by incurring new debt or creating security over the cover pool assets in favour of other lenders,” it said. “We anticipate that the relevant programme documentation and structure of a covered bond issuance would specify any mechanisms or frameworks by which the SPV may incur new debt or source funding to meet any liquidity needs.

“In addition, the proposed framework does not discuss matters concerning the eligibility of the cover pool for repurchase arrangements with the Reserve Bank of Australia.”

Less than the sum of its parts?

Fitch noted the legislation was unique for offering joint funding for several institutions through either a pooling of assets into one specialised credit institution or a pooling of covered bonds into a special purpose company.

Credit analysts at Tyndall Investments suggested in research this month that aggregation models could help second tier Australian banks benefit from covered bonds.

“Due to their lower credit ratings, their associated covered bonds may not be able to achieve triple-A ratings,” they said. “In addition, the smaller size of the non-major banks means that they may not be able to reach the critical mass for a covered bond issue.

“With specific legislation, a pooling structure for non-major banks could potentially be a solution that enables these issuers to access the market.”

But Clayton Utz raised concerns about the viability of aggregation structures in a client briefing.

“Based on investor feedback during the consultation with Treasury”, said the law firm, “it is possible that the aggregation structures proposed by the Bill will not receive the same level of investor support that the European structures have benefited from.”

And S&P also appeared unsure about the extent to which smaller Australian banks might benefit.

“The Australian government’s announcement on December 12, 2010, that it is committed to allowing the issuance of covered bonds by banks, credit unions, and building societies, underscores the possibility of parties using aggregation models,” said the rating agency. “ADIs may be able to pool their issuances, potentially creating higher secondary market liquidity and lowering funding costs to the institutions, compared to individual, small-sized, and less liquid issuances.

“It remains to be seen, however, how any aggregation and pooling mechanisms may work for smaller ADIs to issue covered bonds in Australia. We anticipate that Australian covered bond issuers would initially comprise the highest rated and larger ADIs.”

Cover pool asset disclosure requirements were not discussed in the proposal, noted Fitch.

“Covered bond investors are looking for greater reporting transparency and consistency from covered bond issuers,” said Claire Heaton, director in Fitch’s covered bonds group, “especially those investors who are new to covered bonds. Standardised and transparent reporting disclosure requirements would facilitate the establishment of a covered bonds market in Australia.”

Tyndall’s analysts highlighted the contrast between reporting in the RMBS and covered bond markets.

“RMBS reporting has been well developed in most countries and investors are usually provided with regular and reasonable consistent collateral performance disclosure,” they said. “This has yet to be developed in the covered bond market partly because the collateral pool is more dynamic.”