Covered Bonds free essay sample

With liquidly rationing, (credit crunch) does offering covered bonds hold the answer or does it just offer banks the opportunity to increase their margin?. Discuss critically. Introduction In the modern day world, with technology and global markets expanding, the need for credit is a constant issue for economies to monitor. Liquidity rationing has been most relevant since the GFC, when the credit market essentially froze, sending financial markets in turmoil. Therefore finding ways to increase liquidity at a time when markets are volatile requires instruments of low risk. Covered bonds have recently gained momentum as a popular tool for banks to increase their liquidity whilst taking on very limited risk. Theory A Credit Crunch also known commonly as liquidity rationing, is the reduction in general availability of loans or credit, or a sudden limitation of conditions required to obtain from a financial institution. A credit crunch is therefore independent of interest rate movements. This does however result in the relationship between credit and interest rates to change so that, credit becomes less available at a given interest rate, or there ceases to be a clear relationship between credit availability and interest rates. These events of a liquidity rationing are often the result of reckless lending management, which leads to bad debt for institutions. Consequently, when these loans take a turn for the worse and the investors cannot reimburse their loan payments, banks are forced to take sudden action and tighten the availability of loans or credit. The Financial Crisis is a prime example of a credit crunch that resulted in a near collapse of the global financial markets; in which case was saved by a sovereign bailout to ensure liquidity was restored. Covered bonds are debt securities backed by cash flows from mortgages or public sector loans. They are similar in many ways to asset-backed securities created in securitization, but covered bond assets remain on the issuer’s consolidated balance sheet. A covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or covers the bond if the originator (usually a financial institution) becomes insolvent. (Rosen, 2008) For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuers financials, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer. In addition, because asset’s remaining on the balance sheet covers the bond, means that it was essentially risk free when investing in a covered bond. This risk free sentiment surrounding covered bonds issued by institutions, have made covered bonds one of most successful and popular investment instruments since their creation in Denmark back in 1795. (Bujalance, 2010) The issue with covered bonds is if institutions can accurately evaluate the assets within their asset pools. Past events like the GFC have shown assets being falsely rated, which contributed to the decline in global financial markets. The difference between a covered bond and an unsecured bond is that an unsecured bond is dependent on the rating by the issuer, which means the structural enhancements and overcollateralization enables covered bonds to achieve higher ratings above the issuers of unsecured bonds. Furthermore, because a pool of assets does not back unsecured bonds, this results in greater volatility for unsecured bonds especially during downturns in the credit cycle. Asset back securities are therefore different to covered bonds as they are a security backed by a loan, lease or receivables. They operate under securitization. Often a separate institution, called a special purpose vehicle, is created to handle the securitization of asset-backed securities. The special purpose vehicle is responsible for bundling the underlying assets into a specified pool that will fit the risk preferences and other needs of investors. (Schwarcz, 2011) Discussion The covered bond market is the most important privately issued bond segment in Europe’s capital markets. Prior to the intensification of the financial crisis in October 2008, covered bonds were a key source of funding for euro area banks. The market had grown to over â‚ ¬2. 4 trillion by the end of 2008, compared with about â‚ ¬1. 5 trillion in 2003 (ECBC, 2009). The lack of credit risk transfer with covered bonds is an important distinction with this asset class compared with, for example, asset-backed securities (ABS) and other securities that were subject to securitization. This may well explain the resilience of the covered bond market at the initial stage of the crisis in August 2007. Biswas, 2010) Investors’ affinity for covered bonds can be explained by their relative safety compared with any non-securitized asset class. In relation to covered bonds, a pool of collateral backs the credit risk of the issuer, which is usually of high quality. Despite this, however, the covered bond market was not totally immune to the effects of the crisis. Up to the intensification of the crisis following the collapse of Lehman Brothers in mid-September 2008, it was clear that the covered bond market had outperformed other wholesale funding instruments. The widening of spreads was much less substantial for covered bonds than other ABS and unsecured debt. (Biswas, 2010) Graph 1 backs up this argument that the widening of spreads was less significant for covered bonds as the risk and leverage involved, is much lower. Graph 1 (BIS, 2012) A smoothly functioning covered bond market is highly important in the context of financial stability. This market provides a useful funding source for mortgage lending. For example, the issuance of covered bonds enables banks to match liability duration relative to its mortgage loan portfolio. As a result, this improves a bank’s ability to manage funding and interest rate risk. â€Å"In times of financial crisis, the risk appetite of investors shifted towards less risky assets. † (Bernanke, 2009) As the crisis progressed and became more intensive at the beginning of 2009, spreads in the euro area covered bond market continued to widen, and liquidity continued to worsen. The financial crisis exacerbated the lack of confidence between banks, leading to a halt in interbank market activity. In turn, this raised concerns about the liquidity risk of a large number of banks and, to a certain extent, their solvency, thereby threatening the whole banking system. This scenario sets the context for the introduction of the European Central Bank’s decision to provide support to the covered bond market in the euro area through outright purchases of covered bonds under the Covered Bond Purchase Programme (CBPP). This is evident in graph 2 shows the increase in covered bonds as opposed to unsecured and government-guaranteed bonds. Graph 2 (RBA, 2012) The rationale for selecting covered bonds to purchase outrightly over any other asset class can be summarised as follows (ECB, 2008): â€Å"Covered bonds possess a number of attractive features from the perspective of financial stability. Covered bonds as dual recourse instruments are less risky than most other bank securities and also increase banks’ access to long-term funding, thereby mitigating liquidity risks. In the context of the ongoing financial market turmoil, it is important to stress that, on the whole, covered bonds have proven themselves relatively resilient, in particular in comparison with securitisation†. Bernanke, 2012) The United States were at the forefront of the GFC and they also have significantly increased the number of covered bond purchases since the financial crisis. Graph 3 below is evidence of this. Graph 3 (Deutsche Bank 2011) It is evident that economies around the globe, in particular in the Eurozone have turned to covered bonds as a mean s to expand liquidity across financial markets. So much so that some many question if these covered bonds are just a means to increase their underlying margin, or are the benefits being filtered through to the consumers? An argument could be made that if an issuer increases there covered bond portfolio in ratio to its asset backed and unsecured products, the lower coupon they are able to place on the covered bond should be somewhat passed on to the consumer through the variable mortgage rate. If this isn’t the case, then a margin is produced as the issuer is receiving a higher rate on the loans than the coupon rate handed out. Therefore offering a cheaper source of funding and thus creating profit for the bank issuing the covered bonds. Firstly the covered bonds rates must be analysed in order to determine the potential margin that large financial institutions may acquire. The following graph represents the unsecured and covered bond rates. Graph 4 (Norges, 2007) The differences between the unsecured and covered bond rates are relatively marginal given the current policy decisions and market conditions since the GFC. It is evident from this graph that the margin gained from offering covered bonds is not significantly impacting the profits of Norges Bank. It is safe to assume instead that the benefit from covered bonds over unsecured bonds have to do with covered bonds low risk nature and liquidity benefits in times of crisis and recessions. Australia has also followed course and as of October 2011, the RBA issued $17 billion worth of covered across Australia’s top four banks. The reasoning behind this program was â€Å"The ability to achieve longer-term funding reflects the high credit quality of covered bonds, as well as an expanded investor base. † (RBA, 2011) The table below shows the Covered Bond program being distributed by Austalia’s largest banks. Table 5 (RBA, 2012) When looking at the table we have seen 17. 3 billion dollars’ worth of covered bonds being issued out of the total bond market of $90 billion in Australia. This poses the question to whether this cheaper source of funding through the lower coupon yield has been transferred across to the consumer through lowering the variable mortgage rate. However if the difference were rather minute, then passing on the margin through to the customers would not be required. It would therefore be plausible to assume that most globalised economies would be issuing interest rates are at all-time lows. In particular throughout the US and Europe interest rates are sitting about . 5-1%. It would be fair to assume that any earnings are not being transferred through to the consumer by lowering the variable interest rate. Table 6 highlights the Variable lending rate in Australia taken from the RBA. Table 6 (RBA, 2011) As can be viewed within the table, there is a definite drop in variable interest rates since the introduction of covered bond rates. Although this difference between the unsecured bond rate on average and the covered bond coupon rate can be up to 4%, the rate change we see here is a drop of . 4%. It is evident that the amount of funding that is and will be taken from covered bonds in comparison to the average banks source of funding on the whole is insignificant. This is would be seen to be an inadequate trade off. This provides clear evidence that the amount of funding that banks throughout Australia are accumulating from covered bonds in comparison to their average lendi ng rates are so minute that profits taken from covered bonds, would not make a significant impact on the banks overall profit margin. Therefore whether the banks are passing the funds on to consumers in not making a significant impact to the banks’ balance sheets. Conclusion There are significant advantages for utilising covered bonds due to the low risk nature, and liquidity requirements that has proven to reduce the effect of credit crunches on financial markets. This is evident in the growth of covered bond volumes that has been introduced by major economies post GFC. It is therefore safe to assume that major banks would be taking some sort of margin from the low coupon rates associated with covered bonds. With this being the case however, the difference in covered bond rates, unsecured and variables rates as seen above, demonstrates that on a overall scale, the margins generate would be relatively minute, thus not passing through to customers. In conclusion, covered bonds have been successful in cushioning the blow that the GFC has had on the credit market and liquidity rationing. However the increased volumes of covered bonds being issued by financial institutions have not resulted in significant profits to warrant any margins being filtered through to consumers.