Denmark’s $470 billion mortgage bond market has proven resilient to the stresses of the country’s real-estate slump, banking failures and Europe’s sovereign debt crisis. Now the system’s success is helping lenders and borrowers to take on greater risks.
Issuers have grown increasingly reliant on short-term financing to back 30-year mortgages, a year after the central bank in Copenhagen said the world’s third-largest mortgage bond market was becoming less safe because of the mismatch. Even as securities with maturities under five years now back 68 percent of all outstanding home loans, investors are shrugging off concerns, with an index of Denmark’s most-traded mortgage bonds reaching a record last month.
“Though the Danish covered bond market has shown resilience historically, we do not deem it to be immune to the stresses that affect other types of market funding,” Alexander Zeidler, an analyst at Moody’s Investors Service, said in an interview. “There has been a shift from the traditional bonds, which did not have refinancing risks, to bonds today which have significant refinancing risk.”
Lenders including Nykredit A/S and Realkredit Danmark A/S are luring borrowers with cheaper loans as Denmark moves away from the 30-year fixed-rate bonds that once dominated offerings. Since the 1996 debut of adjustable-rate mortgages, which homeowners refinance by tapping bond markets as often as annually, repayment risks for investors have grown, according to Moody’s. Central bank Governor Nils Bernstein in March last year said adjustable-rate mortgage bonds pose a refinancing risk as part of their “product design.”
200-Year Default History
Notes with maturities of one to five years backed 70 percent of gross mortgage lending in the fourth quarter, versus 50 percent in the second, the Association of Danish Mortgage Banks estimates. The industry, which hasn’t registered a default on its bonds in its 200-year history, argues Moody’s and the central bank are overstating the issue.
“Adjustable-rate mortgages have helped to stabilize the economy,” said Jesper Berg, head of ratings and regulatory affairs at Nykredit, Europe’s biggest issuer of covered bonds backed by home loans. He argues mortgage lenders fed loans to the economy just as banks withdrew credit at the height of the financial crisis.
“There’s a very big awareness that in order to protect the country from a credit crunch, it’s important that the system works and that it works well,” Berg said.
Homeowners have snapped up the adjustable-rate mortgages, and even snubbed the option of locking into rates as low as 3.5 percent for 30 years as they bet it will still be cheap to borrow 12 months from now. Auctions to refinance bonds that matured Jan. 1 sent one-year rates below 2 percent.
Robyn Pihl, a marketing strategist who lives in central Copenhagen, remortgaged her apartment last month, swapping her 5 percent 30-year loan for an adjustable-rate mortgage. She’ll pay 1.2 percent interest for the next three years before the rate is reset in 2015.
“Interest rates are so low now it seems silly not to take advantage of it,” said Pihl, 50, whose interest payments will drop by two-thirds thanks to the switch. “I’m choosing to gamble that rates will not be over 5 percent in three years.”
Record-low rates have encouraged homeowners to take on more debt. Danes have the world’s highest ratio of debt at 310 percent of incomes in 2010, Exane BNP Paribas estimates. Household debt has swelled from 158 percent since 2000 as mortgage banks developed cheaper loans to attract borrowers.
Denmark AAA Rating
Denmark, one of only 12 nations with AAA ratings at Moody’s Standard & Poor’s and Fitch Ratings, will see its economy grow 1.1 percent this year, the European Commission said on Feb. 23. The 17-member euro region will shrink 0.3 percent as eight of its members suffer economic contractions, the commission estimates.
The Danish mortgage bond market differs from other countries’ in several key respects. When a homeowner in Denmark takes out a loan, the mortgage is immediately converted into a security of the same amount. A homeowner can then retire a mortgage either by paying off the loan or by purchasing an equivalent face value of the bonds at the market price. The mortgages also stay on the issuer’s balance sheet.
Danes call this the balance principle. Mortgage issuers take the credit risk, providing reserves in case a borrower defaults. Investors face a risk on interest-rate fluctuations. There are no government-sponsored companies involved in the market, in contrast with the U.S.
George Soros, the billionaire investor and philanthropist, started a joint venture with VP Securities A/S in 2005 to establish the model in Mexico and he’s argued a similar system should be adopted in the U.S.
The Nykredit Mortgage Bond Index (NYKRINDX), which includes the largest, most-traded of the securities, has returned 7.7 percent in the past year and has advanced about 21 percent since the end of 2008. That compares with a gain of 11.9 percent for U.S. Treasuries.
The index reached a record last month even after bad real estate and farming loans led to three bank failures last year, two of which pushed losses on to senior creditors and caused most of Denmark’s 120 banks to be shut out of funding markets. Home prices in the country are projected to fall 25 percent by 2013 since the global credit crisis.
Central Bank Warning
Still, the introduction of new securities such as the adjustable-rate mortgage bonds has prompted the central bank to warn of imbalances in the home-loan market. Interest-only loans, which the central bank says are exacerbating price volatility in the property market, were sold starting in 2003. So-called capped floaters, which offer a floating interest rate with a ceiling on how high borrower costs can rise, came in 2004.
Moody’s downgraded Nykredit in July and said the lender’s bonds stood to lose their top credit grade unless extra collateral was set aside to mitigate refinancing risks. The Copenhagen-based lender responded by ring-fencing its issuance of bonds backing adjustable-rate mortgages to protect the rest of its business. Its adjustable-rate bonds are rated Aa1, compared with the Aaa grade the fixed-rate bonds carry.
Nykredit also split its financing for adjustable-rate loans, with bonds financing the first 60 percent of the loan-to- value ratio backed by the strictest collateral requirements and the next 20 percent adhering to laxer rules. Nykredit says that creates more transparency for investors and reduces the potential risks.
“Introducing two-tier mortgaging means for us risk shifting,” said Moody’s Zeidler. “The overall risk would be the same but the risk might be shifted from one capital centre to another.”
Realkredit Danmark, which is owned by Denmark’s biggest lender Danske Bank A/S (DANSKE), in June fired Moody’s after being told it would need to boost the collateral backing its bonds by more than $6 billion to maintain a top rating. BRFKredit A/S, Denmark’s fourth-biggest mortgage bank, terminated its contract with Moody’s in October citing a disagreement over risk assessments.
The central bank in a December report urged mortgage lenders to do more to cut risk, arguing that any ripples in the industry would have consequences that could “potentially be big if many loans are affected simultaneously.”
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