Bloomberg News

Danish Mortgage Haven Debt Exposes Flaws in Basel Attack

May 31, 2012

Nykredit’s Mortgage Bond Index touched 398.3 points yesterday, the highest since the gauge was created in 1993. Photographer: Ulrik Jantzen/Bloomberg

Nykredit’s Mortgage Bond Index touched 398.3 points yesterday, the highest since the gauge was created in 1993. Photographer: Ulrik Jantzen/Bloomberg

Denmark’s mortgage bonds have won haven status as investors dump assets tainted by Europe’s crisis and flock to the safest markets. The development suggests the bonds are more resilient to turmoil than global regulators say.

The Nykredit Mortgage Bond Index, which tracks the largest and most traded series in Denmark’s $450 billion bond-backed home-loan market, surged to a record yesterday. The bonds have outperformed U.S. Treasury debt with maturities longer than one year since the end of September 2008, when the collapse of Lehman Brothers Holdings Inc. sent global capital markets into a tailspin.

The fate of the covered bonds, which back most of Denmark’s home loans, remains unclear. European regulators are still working to adapt proposals by the Basel Committee on Banking Supervision, which judges the securities to be less liquid than sovereign debt. Investors have shrugged off the warnings and foreign holdings of the bonds have climbed 39 percent since 2008, the Association of Danish Mortgage Banks estimates.

“It supports our case and it also underlines how grotesque it is that we’re trying to persuade international regulators that these papers are as safe and as liquid as sovereign debt,” said Jesper Berg, head of ratings and regulatory affairs at Nykredit A/S, Denmark’s largest mortgage lender and Europe’s biggest issuer of covered bonds backed by home loans.

Faced Criticism

Basel’s original proposal in December 2010 sought to cap banks’ use of mortgage assets for their liquid reserves to 40 percent of the total, with a 15 percent so-called hair-cut. In July, the European Commission said the bonds could be granted the same liquidity status as sovereign assets if they pass tests. The industry is still waiting to learn how those tests will be structured.

Inside Denmark, the mortgage industry has also faced criticism. The central bank has warned that interest-only loans destabilize the economy by triggering swings in house prices. Lenders, too, are growing overly reliant on short-term funding to back long-term home loans after the securities grew to make up about half the market, it said.

“There is a refinancing risk,” central bank Governor Nils Bernstein said in an interview. “It is highly unlikely, but if the risk materializes, it can have significant consequences.”

Still, the central bank isn’t ready to step in and push politicians to ban the loans, Bernstein said. Mortgage lenders are taking steps on their own to address the risks, and more time is needed to see whether they work, he said.

‘Fast Enough?’

“Are they doing it fast enough? Let’s wait and see,” Bernstein said. “I am not ready to urge the government to step in.”

The concerns have been echoed by Moody’s Investors Service, which was fired by Nykredit in April. The rater has downgraded much of Denmark’s mortgage industry amid refinancing risks and late yesterday cut Nykredit another three steps to Baa2.

Mortgage banks are at risk because of their exposure to declines in the housing market, Moody’s said. Home prices, which have dropped more than 20 percent since peaking in 2007, will decline a further 5.5 percent this year, the government estimates.

Yet mortgage bonds have grown in popularity as Denmark’s government debt and currency, which is pegged to the euro, become investor havens from the debt crisis. That’s pushed sovereign borrowing costs down to record lows, and even sent the yield on Denmark’s two-year note below zero.

Yield Slump

The yield on Nykredit’s 2 percent note due April 2013 sank to a low of 0.5788 percent yesterday. The note is rated AAA at Standard and Poor’s and Aa1 at Moody’s.

Nykredit’s Mortgage Bond Index touched 394.66 points yesterday, the highest since the gauge was created in 1993. The index has returned 32 percent since the end of September 2008, compared with 24 percent for U.S. Treasuries with maturities longer than one year, including re-invested interest.

The mortgage securities are at least as liquid as Danish sovereign bonds, said Jesper Lund, a finance professor at Copenhagen Business School who is doing a comparative study of the country’s fixed-income markets.

“There’s not much difference,” Lund said in an interview, citing his study findings. Mortgage bonds are “highly valuable for liquidity management for companies that don’t want to put their money in a bank that might fail next year,” he said.

‘Quite Amazing’

“It’s quite amazing how far rates have been pushed down, and it really shows how safe the securities are deemed to be,” Berg said. “However, clearly rate movements are influenced by what’s going on in some of Europe’s most stressed sovereign markets.”

The government of Prime Minister Helle Thorning-Schmidt last week cut its budget deficit targets for 2012 and 2013. The public shortfall will shrink to 1.7 percent of gross domestic product next year from 3.8 percent in 2012, the Finance Ministry said on May 25. That compares with European Union averages of 3.6 percent this year and 3.3 percent in 2013, the European Commission said on May 11.

Denmark is one of only 12 nations left still ranked AAA by the three major ratings companies, and pays about 17 basis points less than Germany to borrow for 10 years. The yield on its benchmark 2021 note dropped to a record low of 1.10 percent this week.

Popular Bonds

Fixed-income markets in the Nordic nation have grown in popularity even as Denmark struggles to emerge from a burst real estate bubble and regional banking crisis. Five banks have collapsed since house prices plunged from their 2007 peak, putting sending the economy into a recession in the second half of last year.

“The situation in Greece has once again sent shock waves through the financial sector,” Lise Bergmann, a Copenhagen- based economist at Nordea Kredit, said yesterday in a note.

Danish mortgage bonds differ from other countries in several respects: lenders convert loans into a security of the same amount that is then sold to investors. Prices are available in newspapers. Interest and principle payments accrue directly to investors. Mortgage issuers charge borrowers a fee to cover costs, and provide additional collateral if property values fall below loan values. Borrowers bear the interest-rate risk, issuers bear a credit risk in the event of a borrower default.

Higher Costs

“There are parts of the suggestions” from regulators “that would mean higher costs to the lenders from the Danish mortgage system without providing extra safety in the system, as it is already safe as can be,” Anne Jensen, one of Denmark’s European Parliament representatives, said in an interview.

Mortgage banks have had to put up 110 billion kroner in additional collateral since the country’s real estate bubble burst in 2007, according to data provided by the Association of Danish Mortgage Banks and the Danish Mortgage Banks’ Federation.

Property values will continue to fall through 2013, the government-backed Economic Council said May 29, putting further pressure on lenders to go to the capital markets for supplementary collateral.

“The biggest challenge right now is the regulatory one,” Lund said. “It’s unavoidable that there will be more regulations in the coming years. The question is whether it will be good or bad regulations.”

To contact the reporter on this story: Frances Schwartzkopff in Copenhagen at fschwartzko1@bloomberg.net.

To contact the editor responsible for this story: Tasneem Brogger at tbrogger@bloomberg.net; To contact the editor responsible for this story: Christian Wienberg at cwienberg@bloomberg.net.


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