19 Sep 2011

Final version of Government's covered bonds bill has some changes

The Australian Government's promise to allow covered bonds in Australia is one step closer to fulfilment with the introduction into Parliament of the Banking Amendment (Covered Bonds) Bill 2011. The Bill has been substantially revised from the exposure draft which was released in March 2011 by the Australian Treasury.

Whereas the exposure draft adopted many of the features from European regulated covered bond regimes (ie. UCITS), the Bill has been significantly pared down resulting in a less prescriptive regime. This will be seen as a positive development by those Australian Deposit-taking Institutions (ADIs) who had expressed concerns with some of the rigid requirements in the exposure draft. It will be interesting to see how investors and the rating agencies will respond to this development.

SPV structure

The definition of “covered bond special purpose vehicle” in the Bill does not provide much guidance on the legislative requirements for the covered bond SPV. However, the Bill does state that the "purposes" of the SPV must relate "only to the covered bonds". As the SPV role will necessarily cover a range of matters, “purposes” will need to be read broadly in this regard.

Helpfully, the explanatory memorandum to the Bill does shed some light on the nature of the covered bond SPV by stating that it can be either a company or a trust. Given that a trust has no separate existence at law, presumably this means that the SPV can be a corporate acting in either its own right or as trustee. On the basis of Australian securitisation industry precedent, the benefits of a trustee structure (including flexibility and accounting and tax benefits) will presumably mean that covered bond SPVs will be trustees.

Cap on covered bond issuance

Consistent with the exposure draft, the Bill imposes a cap on the value of assets an ADI can contribute to the cover pool of assets. This restricts the combined value of assets in covered pools securing covered bonds issued by an ADI to 8% of an ADI's assets in Australia, or such other percentage as prescribed by APRA.

Maintenance of cover pool

The ADI is required to maintain the assets in the cover pool such that the value of these assets is sufficient to meet 103% of the face value of the outstanding covered bonds. A 3% over-collateralisation is broadly similar to the requirements set out in a number of European countries. However, the Bill does not specify a maximum level of over-collateralisation and leaves this to each issuer to determine based on market factors. It is likely that significantly more than 3% overcollateralisation will be required by the rating agencies to achieve a AAA rating for the covered bonds. However, it should be noted that any over-collateralisation (including the legislative minimum of 3%) will count towards the 8% cap.

Eligible assets

The types of assets which can be included in the cover pool under the Bill are broadly similar to those set out in the exposure draft. However, the Bill specifies that the ADI must ensure that the value of bank accepted bills and certificates of deposit in the cover pool is no greater than 15% of the value of the assets in the cover pool. This is to ensure that the cover pool is comprised mainly of loans made by ADIs. There is no longer a reference to a 20% restriction on government debt instruments, which applied in the exposure draft.

Other differences between the Bill and the exposure draft include the types of residential mortgage loans which can be included in the cover pool. Under the exposure draft, these were limited to first mortgage loans with a maximum initial LVR of 80%. Similarly, the exposure draft required commercial mortgage loans to be first mortgage loans with a maximum initial LVR of 60%. The Bill has relaxed these eligibility requirements somewhat by allowing a residential mortgage loan (including second ranking mortgage loans) to be included with an LVR greater than 80% provided such loans are only ascribed a cover pool value of 80% of the value of the residential property. A similar test applies to loans secured by commercial property except that the limit is set at 60% of the value of the commercial property.

APRA's powers

APRA has a number of powers under the Bill which are broadly consistent with those in the exposure draft. For example, APRA can restrict the issuance of covered bonds by an ADI in certain circumstances (eg. where it has failed to comply with the covered bond legislation). One of the concerns raised with the exposure draft was that it allowed APRA to give directions to an ADI to stop top-ups of the cover pool in certain circumstances (including to protect depositors of an ADI, if there could be a material deterioration in the ADI's financial condition, or if the ADI is conducting its affairs in a way that may cause or promote instability in the Australian financial sector). The concern stemmed from the fact that other foreign covered bond regimes allow issuers to top-up the cover pool up until the point of insolvency. However, the Bill has retained APRA's ability to stop top-ups in the circumstances described earlier (albeit in a much less obvious manner).

There is also a new provision that expressly prevents APRA from directing the SPV as to its dealings with its assets and its payments in respect of covered bonds. This general prohibition is subject to one exception under which APRA is permitted to direct covered bond SPVs to return to the issuing ADI any asset that “does not secure covered bond liabilities” of the ADI. As the 8% cap test uses the same wording, presumably these assets are not part of the 8% cap and are generally to be considered assets of the ADI. This would equate most closely with so-called “voluntary” assets, which are assets that an ADI transfers to the SPV for administrative reasons to facilitate future “take down” issuance of covered bonds but which do not immediately secure any covered bonds as the assets are not required in order to meet rating agency over-collateralisation requirements (as referred to in paragraph 1.71 of the explanatory memorandum).

Prudential standards

APRA is empowered to set prudential standards with respect to the issuance of covered bonds by ADIs. The Bill also provides guidance to APRA in setting these prudential standards. Assets in the cover pool will be treated as assets of the ADI provided assets do not exceed the 8% cap. Should the assets in the cover pool exceed the 8% cap, APRA may impose different (and more stringent) prudential requirements on the excess assets.

The prudential requirements imposed by APRA in relation to ADI covered bond issuance may take into account the role of the covered bond SPV. The Bill is rather poorly drafted in this regard, as on one reading it could arguably give APRA an ability to impose prudential requirements on covered bond SPVs themselves (which cannot be the intended effect; as most covered bond SPVs will not be ADIs, it is not clear how prudential standards will be relevant to them).

Aggregation structure

The Bill has provided more details on the aggregation models which are a central plank of the Government's policy to enable smaller banks and credit institutions to issue highly rated covered bonds. Consistent with the exposure draft, the aggregation models will involve a group of smaller approved ADIs establishing a new entity which will issue debt instruments secured by covered bonds issued by each participating ADI. Also, consistent with the exposure draft, the Bill contemplates that the aggregation structures will be prescribed by regulation.

Investor comments to date have suggested some scepticism in relation to the attractiveness of covered bonds issued under an aggregation model, so it will be interesting to see whether the details that arise in the regulations can assuage investor concerns.

Other changes

The Bill provides a less prescriptive regime than the original regime set out in the exposure draft. Whereas under the exposure draft the assets of the SPV were required to be distributed in a particular order of priority on the insolvency of the ADI issuer, this requirement no longer appears in the Bill and will be left to the relevant documentation.

In addition, the Bill permits the cover pool monitor role to be performed by registered auditors and has limited the role to providing biannual reports on the cover pool based on sampling. This modified the position in the exposure draft which envisaged a far more proactive role for the cover pool monitor. However, the Bill retains APRA's entitlement in the exposure draft to request pool reports, of an unspecified nature (presumably within APRA's sole discretion), from the cover pool monitor. Regulations may also prescribe monitor functions from time to time.

When will this become law?

Parliament has a few sittings before the end of the year, and the Act would commence as soon as Royal Assent is given, so it is conceivable that it could be law in the next few months.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.