Credit FAQ:

Why Denmark's Proposed Covered Bond Law Doesn't Fully Eradicate Refinancing Risks
Primary Credit Analyst: Alexander Ekbom, Stockholm (46) 8-440-5911; alexander.ekbom@standardandpoors.com Secondary Contacts: Sean Cotten, Stockholm (46) 8-440-5928; sean.cotten@standardandpoors.com Markus W Schmaus, Frankfurt (49) 69-33-999-155; markus.schmaus@standardandpoors.com

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Frequently Asked Questions Related Criteria And Research

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Credit FAQ:

Why Denmark's Proposed Covered Bond Law Doesn't Fully Eradicate Refinancing Risks
The Danish authorities' planned changes to mortgage covered bond law alleviate Standard & Poor's Ratings Services' immediate concerns about mortgage banks' refinancing risk. But they fall short of neutralizing the risk from the banks' heavy reliance on short-term funding, in our view. Every year, about one-third of outstanding mortgage covered bonds come up for refinancing, to the tune of several billion krone. Mortgage banks' heavy reliance on covered bonds as a short-term funding source therefore represents substantial, albeit latent, default risk if, for example, there were a market disruption. Acknowledging this, the authorities proposed an amendment to the covered bond legislation on Nov. 28, 2013, that extends the maturity date of bonds related to adjustable-rate mortgages in certain circumstances. Depending on these situations, a failed refinancing auction would lead to an automatic 12-month extension of the mortgage covered bonds affected. The new law is set to take effect from April this year for new or refinanced bonds with terms of less than 14 months, and from January 2015 for other bonds. In our view, the proposal is a step in the right direction. However, we don't believe it fully addresses the fundamental issue of mortgage lenders' significant annual refinancing needs or decreases the probability of situations that would trigger automatic extensions. Although we consider that there is a very low likelihood of a bond refinancing failure, the proposed legislation--as currently drafted--clarifies how such an event will be handled, providing investors with a clear framework. That said, we believe the government may still step in even before a bond auction is at risk of failing. This is because of the importance of covered bonds as a funding tool for domestic banks. In this FAQ, we answer some of the frequently asked questions from investors regarding the credit implications of the proposed covered bond law in Denmark. We also consider various issues arising from the draft legislation.

Frequently Asked Questions

Why do Danish mortgage lenders need to refinance such large amounts of covered bonds every year?
A key feature of Denmark's mortgage loan market is the "balance principle," which means lenders pass the funding conditions on to the borrowers. According to strict rules, banks' funding instruments have to match the currency, interest rate, and maturities of the mortgage loans on their books. This means that mortgage banks cannot collect deposits or extend the bonds' maturity dates. The introduction of adjustable-rate mortgage loans in 1996 changed the Danish mortgage market. By far the most popular loan of this type is the one-year "F1" mortgage loan, mainly because of its attractive interest rates for borrowers, and it now accounts for 30%-35% of the market. With such a loan, a homebuyer will refinance a mortgage loan 30 times during a 30-year commitment period. Adhering to the balance principle, the bank, in turn, funds F1 loans with one-year mortgage covered bonds that it has to refinance until the borrower pays off the loan.

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Credit FAQ: Why Denmark's Proposed Covered Bond Law Doesn't Fully Eradicate Refinancing Risks

The end effect is that about one-third of Denmark's large mortgage covered bond market has to be refinanced every year. And the success of this refinancing relies on the market being open and functioning, especially during the various refinancing auctions. We note, however, that there were no market disruptions during the global financial crisis in 2008-2009 or after the liquidity freeze in 2011, indicating strong demand from domestic investors. Yet various market participants are increasingly aware that mortgage banks' dependence on short-dated bonds and the related refinancing risks, albeit dormant at present, could threaten the banking system because of the sheer size of the amounts involved: about Danish krone 800 billion (about 107 billion) in 2012. The ensuing debate within the Danish banking industry, and across the regulatory and political sphere, on how to tackle this issue has led to the authorities' recent proposal.

How has the bond refinancing issue affected Standard & Poor's bank ratings in Denmark?
We see a comparatively large mismatch between several Danish banks' assets and liabilities and their dependence on wholesale funding. This led us to revise several rating outlooks downward last year (see "Various Outlook Actions On Five Danish Banks Due To Funding Reassessment; All Ratings Affirmed," published July 19, 2013, on RatingsDirect). Our ratios indicate that the shortfall stems mainly from the share of wholesale funding with terms of less than 12 months, given F1 mortgage loans' popularity. On average, mortgage banks' ratio of broad liquid assets to short-term wholesale funding was about 0.3x and the stable funding ratio at 70% as of year-end 2012. These ratios are among the weakest in a global peer comparison. Although the rating actions highlighted our concerns regarding refinancing risk, we also stated that we saw strong institutional support for the market. In our view, domestic investors (80%-85% of the investor base) continue to support covered bonds denominated in Danish krone, and the Danish market is one of the few that stayed open and functioning in 2008 and early 2009 during the financial crisis. In addition, we believe the government remains willing and able to provide ongoing support to banks, ensuring liquidity at all times. We affirmed the ratings on the five Danish banks we rate because of their relatively resilient business models and efforts to reduce their reliance on short-term funding. In the case of Nykredit Realkredit and BRFkredit, the only banks to which we assigned negative rating outlooks, a one-notch downgrade would not affect the 'AAA' ratings on these institutions' covered bonds, all other factors remaining unchanged. The reason is that, under our criteria for assessing asset-liability mismatch in covered bonds, the ratings on the covered bonds can be up to seven notches higher than the long-term issuer credit rating.

How does Standard & Poor's view the proposed law?

If the law is enacted as drafted, we consider that it won't fully address the fundamental issue of the annual refinancing of a large portion of the covered bond market. The law, as we understand it, will not discourage the use of short-term F1 mortgage loans. Therefore mortgage lenders' dependence on short-term liabilities will remain high, perpetuating the status quo. What's more, the proposed extension of mortgage covered bonds' maturity dates, in effect, passes the role of lender of last resort from the central bank to investors. In our view, mortgage banks might eventually reduce their vulnerability to acute market stress by developing alternative products that prolong the fixed-interest period of mortgage loans, thereby lessening the need for yearly refinancing. We believe this would also decrease the likelihood of bond extensions under the new law and the risk that

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Credit FAQ: Why Denmark's Proposed Covered Bond Law Doesn't Fully Eradicate Refinancing Risks

investors will have to wait longer to be repaid. In addition, we think such a development might reduce homeowners' high sensitivity to fluctuations in mortgage loan interest rates. Positively, the proposal addresses our immediate concerns on refinancing risks because it extends mortgage lenders' short-term liabilities if there is a market stress. Specifically, we understand it virtually eliminates Danish mortgage banks' default risk from a failed mortgage covered bond auction. In addition, the draft legislation provides investors with a clear framework for how the authorities will deal with failed bond refinancing, and this will be included in new bond documentation. We believe that, together, the law and the covered bond market's structure can counteract adverse developments, such as a general loss of investor confidence or problems at a particular mortgage-lending institution. In our view, refinancing will be assured in either case. The franchise of individual mortgage bond issuers in difficulty will likely deteriorate significantly, but we don't expect a default to stem from bond refinancing issues. That said, although we see a very low likelihood of a failed bond auction, we don't exclude the possibility of government intervention if some market instability emerged. This is because we believe such a situation could harm the whole banking industry, covered bonds being an important refinancing tool for domestic banks.

What are the main features of the draft legislation?

With the new law, the Danish government plans to introduce a mandatory soft-bullet structure for all bonds with matching adjustable-rate mortgages that have longer commitment periods. This, in effect, allows for an automatic 12-month extension of such bonds' maturity dates in two situations: If the bond market stops functioning, which the draft proposal defines as mortgage banks' failure to sell enough new covered bonds to refinance the underlying loans; or For bonds with terms of up to three years, if the coupon rate rises by more than 500 basis points (bps) compared with the coupon the previous year. The draft legislation therefore addresses refinancing risks for banks that issue adjustable-rate mortgage covered bonds. But if bond refinancing rates were to spike, it would also reduce credit risk for the underlying borrowers who would otherwise face a steep rise in loan interest payments. That said, if the bond refinancing problems persisted beyond the initial 12-month period, the same law would extend the maturity dates for additional 12-month periods until the bonds are sold. We understand that the coupon on an extended bond, regardless of which situation led to the extension, will be the one paid on it in the last refinancing auction (or on an equivalent instrument for longer-dated bonds) plus 500 bps. However, the 500 bps increase will only take effect on the first extension. The coupon then stays at that level, even if there were several more extensions. The draft legislation also introduces special treatment for the mortgage covered bonds of an institution that is under resolution. If bond refinancing failed or the coupon increased by more than 500 bps, the bond will not be extended for one year but converted to a bond with terms and instalments corresponding to the underlying loan. At the same time, the loan will become a convertible loan with a fixed interest rate.

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Credit FAQ: Why Denmark's Proposed Covered Bond Law Doesn't Fully Eradicate Refinancing Risks

How might the new law affect default risk on the underlying mortgage loans?
Should a bond refinancing auction result in an extension of maturity dates, this will raise the interest costs on the underlying mortgage loans by 500 bps for the next 12 months. In any market, this would constitute a heavy additional burden on borrowers, but even more so in Denmark, where household debt is very high and the use of variable-rate mortgage loans is common. Nevertheless, we understand that the proposed law includes an interest rate cap. This means that without the new law, borrowers could face even higher interest rates in the unlikely event that bond refinancing failed. But we believe a market failure may occur even before an interest rate increase reaches 500 bps, in which case, the proposed law would extend the maturity dates of outstanding covered bonds, with the same outcome for investors. Regardless of the implementation of the new law, we believe any scenario that led to a failure of the covered bond market in Denmark, although unlikely, would also result in falling domestic consumption and a possible recession. In turn, rising unemployment and sinking house prices could result in higher credit losses for the banking system.

Does Standard & Poor's believe the situations that can trigger bond extensions could occur?
We consider a trigger event to be unlikely. A 500 bps change in interest rates would be very rare in the Danish covered bond market, in our view. In addition, no mortgage bond auction has failed since the market's inception in the late 18th century. However, short-term interest rates have occasionally risen by more than 500 bps for brief spells over a 12-month period. Over the past 25 years, there has been only one interest rate change that might have triggered an extension of bonds backed by such loans if the new law had been in place at that time. In 1992, during the European currency crisis, short-term interest rates rose by more than 500 bps for at least a year. However, the increase in 12-month rates has never exceeded the 500 bps mark for that length of time. For longer-dated bonds, interest rate volatility is even lower. A potential scenario that could produce a large change in interest rates is therefore another speculative run on the Danish krone, which is pegged to the euro.

When will the law take effect and which mortgage covered bonds will it cover?
The time line for implementing the new law is April 1, 2014, for bonds with an initial term of less than 14 months, and Jan. 1, 2015, for all other adjustable-rate mortgage covered bonds with terms of up to 10 years. We understand that the documentation for bonds already issued will not be adjusted after the law comes into force. All new bond documentation should carry the provisions established by the new law, however. This means the existing stock of short-term F1-mortgage covered bonds would carry the new provisions from the second quarter of 2015, after issues mature and are refinanced. In addition, we understand that, to complement the draft legislation, the Ministry of Business and Growth will publish more comprehensive details on the features in the proposal (see "Safeguarding the Danish Mortgage-credit model" on the ministry's website: http://www.evm.dk/english).

How might the proposed law change market participants' behavior?

Because the new bill will initially only affect the very short end of the market, the impact will likely be strongest at banks and international investors with large amounts of outstanding F1-mortgage covered bonds. We also expect

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Credit FAQ: Why Denmark's Proposed Covered Bond Law Doesn't Fully Eradicate Refinancing Risks

Danish pension funds and insurance companies to have some exposure, primarily to adjustable-rate mortgage covered bonds with longer maturities, which will fall under the new law as of Jan. 1, 2015. Furthermore, we expect pension funds and insurance companies to stay in the market because alternative instruments denominated in Danish krone remain scarce. An important consideration is whether market participants would be aware of the full implications of the triggers in the new law. The central bank estimates that the new mandatory extension would add up to 10 bps to the risk premium on bond prices, given the low probability of a trigger event. In our view, domestic banks and pension funds are quite familiar with renewal options because bonds with such options have been on the Danish market for several years. Consequently, we believe the new law would not result in a major shift in the composition of investors' portfolios. However, the conversion of mortgage covered bonds to soft-bullet maturity may cause certain international investors to leave the market. Among other reasons, this could be because of policy restrictions on investing in extendible bonds. Today, the share of international investors is about 18% of the nominal volume of outstanding bonds, which represents an all-time high. We don't believe international investors would likely leave the Danish covered bond market entirely, however. In the end, the attractiveness of Danish mortgage covered bonds will depend not only on the risks, but also the yield relative to that of alternative investments. Even though some investors might opt out of the market, we believe others would likely take their place.

Will Danish covered bonds comply with new regulatory liquidity standards?
One of the key tools in Basel III is the short-term liquidity coverage ratio (LCR), which will gradually take effect as of 2015. The ratio's objective is to promote stronger liquidity risk profiles for banks. A much-discussed topic regarding this ratio is which securities should be considered high-quality liquid assets (see "The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks," published on Jan. 17, 2013). We understand the European Commission will take a decision on this matter in June 2014. The future regulatory treatment of mortgage covered bonds could therefore significantly affect Danish banks' liquidity management, given the widespread use of these instruments and the fairly small government bond market. The European Banking Authority has proposed to the European Commission that covered bonds should be considered "level 2" securities, and therefore less liquid than government bonds ("level 1"). We understand the Basel Committee on Banking Supervision has stipulated that, for the LCR calculation, no more than 40% (after haircuts) of a bank's high quality liquid assets should carry level 2 status. The committee also recommends a haircut of 15% of such securities' market value. In our view, if future regulation labels mortgage covered bonds level 2 instruments, this could have a more profound effect on the Danish market than the proposed bond-extension bill. We envisage a shift of the investor structure because banks, which account for more than 30% of the market, will likely have to reduce their holdings of short-term covered bonds. This, in turn, will likely push up prices for short-dated mortgage lending, resulting in rising costs for many borrowers. In addition, we anticipate increased foreign currency exposure for banks and, possibly, a less liquid government bond market as banks invest more in Danish government debt, which is already scarce.

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Credit FAQ: Why Denmark's Proposed Covered Bond Law Doesn't Fully Eradicate Refinancing Risks

However, we understand that there is room for partial exemptions of these rules in countries with small government bond markets. We view Denmark as a likely candidate for such an exemption if, in the future, regulators considered covered bonds less liquid than government bonds.

Related Criteria And Research

Related criteria:
Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011 Revised Methodology And Assumptions For Assessing Asset-Liability Mismatch Risk In Covered Bonds, Dec. 16, 2009

Related research:
Danish Legislative Changes To Address Refinance Risk Are Credit Neutral For Covered Bonds, Nov. 7, 2013 Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market, Oct. 31, 2013 Banking Industry Country Risk Assessment: Denmark, Oct. 24, 2013 Various Outlook Actions On Five Danish Banks Due To Funding Reassessment; All Ratings Affirmed, July 19, 2013 The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks, Jan. 17, 2013

Standard & Poor's rating actions are determined by a Ratings Committee. This commentary has not been determined by a Ratings Committee. The opinions expressed in this article do not represent a change to or affirmation of Standard & Poor's Ratings Services' opinion of the creditworthiness of any entity/entities (named or inferred) or the likely direction of ratings.
Additional Contacts: Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com Covered Bonds Surveillance; CoveredBondSurveillance@standardandpoors.com

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