State guarantee signals end of easy money for banks

Whether the Australian government's move to correct one of the unintended consequences of its guarantee of bank bonds, by offering a similar guarantee to the state governments, really solves any problems or will simply lead to more unintended consequences remains to be seen.

The problem that existed from the states' perspective was that they couldn't sell bonds at a credit margin they found acceptable, not that they couldn't sell bonds.

It seems they were most reluctant to set a precedent in terms of pricing relativities with bank bonds. Now we will have an exercise in smoke and mirrors, in which pricing relativities will be seen to be maintained but the states will pay a guarantee fee over and above the credit margin on their bonds to the Commonwealth government.

In the meantime, the guarantee is open ended in respect to term to maturity of any bonds that might be covered. This is probably appropriate given that state governments can issue bonds for 10 years or more. Given that this guarantee is intended to facilitate infrastructure project financing it is likely that some bonds guaranteed will have terms to maturity that are even longer.

However, this will place significant very long-term contingent liabilities on the Commonwealth government that will remain well after the guarantees on bank bonds, with a maximum term to maturity of five years, have expired.

In this context the fee of 30 to 35 basis points that the states are being asked to pay for the guarantee to be applied to new bond issues can be questioned.

At the wide end, that is 35 basis points for AA+ rated states, the fee is half what AA rated banks (only one rating notch lower) are being asked to pay.

The Federal opposition has already questioned this disparity and threatened to block the legislation that is needed for the guarantee to be provided.

Clearly, the government is prepared to provide a relative subsidy to the states but this is unlikely to be the only cost. The Commonwealth may well increase the cost of its own debt, as potential investors factor in the extent of the contingent liabilities the Commonwealth is carrying.

To some degree this must also flow through to the cost of the debt that it guarantees for the states and the banks.

In addition, the Commonwealth has likely further diluted demand for its own bonds with an increased supply of bonds offering a higher yield for the same credit risk.

The provision of a Commonwealth guarantee to the states is likely to bring a literally golden period for the banks to an end, at least in the domestic market - foreign currency bond issues by the states will not be covered. As it is, the timing of this initiative is not too bad for this fiscal year, as the banks have just about completed their borrowing programs.

The banks may well find that their funding costs have increased when they undertake future bond issues in the domestic market.

The rush of state bond issuance that will now ensue (with estimates of up to $135 billion of bonds to be issued over the next four years) will absorb much of the demand that the banks had been seeing for their own bonds from AAA only buyers, such as offshore banks and bank liquidity books.

Even the real money buyers, the fund managers, will weigh the greater liquidity of state government bonds against their own liquidity requirements.

The likely outcome, once things have had a little time to settle down, is that the cost of bank funding should not show any significant increase but it is likely that the multi-billion dollar issues from the banks that have been seen in the domestic market recently, are over.

It is not clear why the Commonwealth has offered to guarantee existing state government bond issues. The states have been given 28 days to decide if they wish to avail themselves of this offer.

Hopefully, they will have the good sense to decline and save their taxpayers an unnecessary expense. The existing bonds have been sold and the funds obtained.

The Commonwealth guarantee is there to ensure the states can raise funds in the future, not to ensure a liquid secondary market for all state government bonds.
 
The arguments that have been made for guaranteeing existing state government bond issues are fallacious. There is absolutely no reason why a split state government bond market, between guaranteed and non-guaranteed bonds, cannot exist.

There will simply be two classes of bonds, as there are now for guaranteed and non-guaranteed bank bonds and just as there was when the Commonwealth government removed its guarantee on Commonwealth Bank debt in 2000. One class of bonds will be more liquid and trade at finer margins than the other.

To suggest that investors need to be kept on side so they will be happy to buy future bond issues is equally fallacious. Investors will buy the bonds anyway. As we pointed out last week there is a lot of money out there looking for a home. Both arguments come from a market that is simply talking its own book.