Caroline Hay examines the Danish mortgage bond market

When US Washington Mutual Bank (WM) went bust, it sent shock waves far and wide, including some directly towards the European covered bond market. WM was one of the first US entities to issue covered bonds within Europe and the parent bank’s bankruptcy immediately raises serious concerns for the ‘safety’ of those bonds.

JP Morgan has said that it will acquire various WM assets, although it has yet to state specifically that this includes the covered bond liabilities. In the UK, the partial nationalisation of Bradford & Bingley Bank raises questions about the outlook for its extensive covered bond programme. Hypo Real Estate, Germany’s second biggest commercial property lender, is also in deep trouble.

So far, Denmark’s mortgage bond market is proud that not once in its 200-plus year history has there been a default by a Danish mortgage bank, neither during the bankruptcy of the Kingdom of Denmark in the early 1800s nor the great depression. There have been many changes over the years but it has always proved itself extremely resilient and adaptable and is today one of the world’s most sophisticated and respected housing finance markets.

 

Introduced in 1797 as part of a money-raising initiative to help pay for huge reconstruction costs after a terrible fire had ravaged Copenhagen in 1795, Denmark’s mortgage banks and their bonds have grown into a remarkably stable and well respected market. Indeed since the middle of the nineteenth century, the mortgage banks have been the central participants in property financing in Denmark. The market has grown substantially and today it is the largest mortgage market in the world relative to GDP, and second only to German Pfandbriefe in terms of outstanding issuance. It dwarfs its own government bond market.

Over the past five decades, there have been big changes, but at all times the regulation has remained both explicit and restrictive and Denmark’s financial supervisory authority Finanstilsynet retains tight regulatory and supervisory control.

The latest modifications to the legislation - to the Financial Business Act and others, which came into force in July 2007 - will create some important changes in the marketplace. Essentially Danish covered bonds will become fully compliant with the EU’s Capital Requirements Directive (CRD), ensuring the covered/mortgage bonds are eligible for low risk weighting of 10%. The legislation has also opened the door to universal banks, enabling them to join Denmark’s mortgage banks and to issue covered bonds.

So far, only Danske Bank has taken out a licence and joins its subsidiary, the mortgage bank Realkredit Danmark. Although it is doubtful that there will be others applying during these worldwide troubled times, it seems likely that other banks will in the future, in order to access the very cheap funding.

Overall, most participants think the changes will not alter the market too much. “The CRD compliance was more about LTV [loan-to-value] monitoring and other technical issues,” says Pernille Lohmann, investor relations manager at Nykredit. “The mortgage banks have not changed their business model, loan products nor their underwriting criteria. And the law still does not allow for lower standards - in fact some LTV limits were decreased, raising the standards even higher.”

Jens Kristian Kimper, head of development at Realkredit, agrees: “The new regulations do not change the fact that, with the balanced principle, our regime is very strict and certainly the strictest in Europe,” he says. “If you ask me whether a Danish mortgage bank could be in trouble, I would say that in today’s climate it is not impossible, but I strongly believe that our legislative structure will prevent this happening.”

Nykredit’s Lohmann goes on to point out: “We do not believe that the SDO legislation has made significant changes. ROs [realkreditobligationer] and SDOs [saerligt daekkede obligationer] adhere to the old Danish balance principle, implying full asset liability matching on the mortgage banks’ balance sheets. As a consequence, a mortgage bank still has virtually no risk and mortgage loans are still 100% matched on an individual level.”

Having survived more than 200 years with a faultless record, Danish mortgage banks will be very keen to maintain it. These are, however, extraordinary times and Lohmann believes that the Danish mortgage market will feel the pressures, but will remain intact. “Our market has not been protected from spread widening as investors have shifted to government bonds,” he says. “However, to some extent we have been hit by our own success as investors have been able to trade Danish covered bonds when other markets have closed.”

“Spreads are wide,” agrees Kimper. “In today’s climate, investors are pricing any sort of credit risk extremely expensively. The tap issuance is not having a problem and our market appears to be working virtually as normal.”

Lohmann agrees, adding “The Danish system of tap issuance on a daily basis means that there is always an underlying offer and often a bid from the issuers to support the market. There is a huge domestic investor base and this has, of course, provided good support for the market.”

“In light of the current crisis, the strengths of the Danish mortgage system have become very clear,” says Lohmann. “And the [Danish] market continued to function when other covered bond markets broke down.”

The instruments

From 1850 until 2007 Danish mortgage bonds, realkreditobligationer or ROs, were issued solely by the licensed mortgage banks. Since their inception, ROs and the mortgage banks have always had to comply with a very strict asset/liability management regime called the balance principle. Unlike other European covered bond legislations, the Danish system before 2008 ruled that any changes in the mortgage pool be almost immediately passed through to the bondholders. Most bonds are open for daily tap issuance.

Danish mortgages tend to have early prepayment options and should it occur, the callable bonds are redeemed proportionally. In this way the prepayment risk, and with it re-investment and duration risk, is always passed on to the bondholder. The mortgagee is also permitted to buy himself out in the open market. The mortgage banks are required to balance the maturity and repayment profiles of the underlying mortgages with those of the underlying mortgage bonds.

The credit risk of the mortgage banks is kept very low by tight regulation, and is perhaps one of the most important contributors to the remarkably strong performance, during even the most appalling of economic downturns. All loans are secured by mortgages on real property, and the LTV ratio must be maintained at 80% or higher.

The 2007 legislation is essentially creating a two tier covered bond system where grandfathered RO bonds (those issued before January 2008) will exist alongside the ‘new covered mortgage-credit bonds’ SDROs (saerligt daekkede realkreditobligationer) which fulfil both old and new legal requirements, and the ‘new covered bonds’ SDOs (saerligt daekkede obligationer) which can be issued by both the mortgage banks and the new entrants, the commercial banks.

ROs today make up the bulk of the outstanding issuance in the Danish mortgage bond market, but SDO and SDRO issuance will become far more significant. All Danish mortgage bonds are issued as pass-throughs and essentially fall into three categories: fixed rate callables, fixed rate bullets and floaters. At the end of 2007, Denmark’s market was around €345bn in size, with around 91% denominated in Danish kroner and only 7% in euros.

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