Denmark’s attempt to ease refinancing risks in its $530 billion mortgage-bond market may unleash harmful side effects, according to a venture backed by billionaire investor George Soros, which has so far championed the model globally.
“The government should be careful messing with the existing system, as it works so well,” saidAlan Boyce, a former bond trader at Soros Fund Management LLC, before becoming chief executive officer at Absalon Project, a joint venture with Copenhagen-based VP Securities A/S to promote Denmark’s mortgage system.
Business Minister Henrik Sass Larsen unveiled a proposal on Nov. 6 that would require all one-year mortgage bonds sold after April 1 to include an option to be extended for as long as 30 years. When investors balked at that plan, the government went back to the drawing board and said the maturity extension would be limited to 12 months at a time. The proposal is now in a public hearing period and is due to be put before parliament at the end of the month.
“Politicians understand the Danish mortgage system less well than everyone else,” Boyce said in an e-mailed reply to questions. “They should be very careful about changing the rules.” Even the watered-down proposal heaps “technicalities” on the market, adding a layer of complexity, he said.
Denmark’s one-year mortgage bonds, which have proven popular with investors including Pacific Investment Management Co., fund about 40 percent of the nation’s home loans. The notes have come under scrutiny from ratings companies and the central bank, who argue they’re too short to fund mortgages as long as 30 years.
The maturity mismatch has created refinancing risks that may ultimately destabilize the financial system in Denmark’s $340 billion economy, according to Standard & Poor’s.
The rating company said today in a statement the proposal to extend maturities has “no immediate impact” on its assessment of the banks it monitors or on the enhancement levels they’re assigned. S&P also said the plan won’t affect ratings of the lenders’ covered bonds.
“We will wait for clarity on the proposed law and relevant regulation before finalizing our opinion on the proposed changes,” Per Tornqvist, the report’s primary credit analyst, said in the statement.
Banks operating in Denmark’s two-century-old mortgage-bond market, the world’s biggest per capita, argue warnings about refinancing risks are exaggerated. They say the market’s ability to weather the global financial crisis is proof of its robustness to external shocks.
Yet S&P counters that the introduction of new securities, including adjustable-rate bonds in 1996 and interest-only loans in 2003, has driven homeowners away from the fixed-rate, 30-year bonds that once underpinned the Danish mortgage market’s stability.
The government’s decision earlier this month to respond to such warnings marks an unprecedented move to change the terms for existing bonds, according to the Danish Mortgage Bankers’ Federation. It also goes back on an August pledge by Larsen to let the market decide the future of the securities.
Yet mortgage banks have struggled to wean borrowers off the one-year bonds after borrowing costs in AAA-rated Denmark sank to record lows. Realkredit Danmark A/S, the mortgage arm of Danske Bank A/S (DANSKE), yesterday sold one-year bonds at a record-low rate of 0.2 percent, adjusting for margins. Mortgage banks will sell about $58 billion in bonds in quarterly auctions that began yesterday, Nordea estimates.
Boyce says he has criticized Denmark’s shift away from 30-year, fixed-rated mortgage bonds almost two decades ago.
“I have been arguing against interest-only loans and flex loans for a very long time,” Boyce said. “Nobody listened.”
S&P in July gave Danish mortgage banks two years to reduce issuance of short-term bonds or face downgrades. The rating company said then it would probably take a change in legislation to force the industry to cut issuance enough to stem refinancing risks.
Under Larsen’s latest plan, maturities on short-term mortgage bonds, including one-year and inflation-linked securities, would be extended by one year at a time if refinancing auctions fail or if interest rates jump more than 5 percentage points between refinancings.
According to Jesper Rangvid, professor of finance at the Copenhagen Business School and the head of a government-backed committee that probed the financial crisis in Denmark, the latest proposal to extend maturities “is clearly better, much better, than the original idea.”
Still, the proposal adds a new layer of complexity to a system that has been popular with investors because of its transparency, Rangvid said.
“You’re turning a very simple bond -- one that is super for the investor -- into a very complicated bond,” he said.
While solving the refinancing issue from the point of view of the mortgage institutions, “the risks don’t just disappear,” Rangvid said.
The crisis scenario that would trigger maturity conversion would also entail a liquidity squeeze similar to the one seen after Lehman Brothers Holdings Inc. failed in 2008, Rangvid said. While investors in one-year Danish mortgage bonds still got their money back during that crisis, the proposed maturity conversion means they no longer will, he said.
“You’re back in 2008 again, with the exception that in 2008, they got their money,” Rangvid said. “I will not rule out the scenario. We have to think crisis.”
Denmark has yet to learn whether its proposal to extend maturities will mean the short-term mortgage bonds meet stable funding and liquidity requirements. The Financial Supervisory Authority says the model should comply with European Union standards, though regulators in Copenhagen haven’t confirmed that with their counterparts in Brussels.
The “very rare” probability that the extension option gets exercised probably won’t “affect either the very low credit risk of the bonds or their high liquidity,” Kristian Vie Madsen, deputy director general at the Copenhagen-based FSA, said in an e-mailed response to questions. “As a consequence, we expect the proposal to have no effect on whether or not the bonds will be counted as highly liquid.”
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