Perfectly balanced

Unique features have insulated the Danish market against the credit problems recently suffered by world economies. Despite the relaxation of legislation governing the sector, Denmark's lenders say they are keen to stick to the old secrets of their success. Han-Nee Tay reports

Danish mortgage lenders are quick to point to history to illustrate that their way of doing things has withstood the test of time. Since the first covered bond was issued in 1797 in Denmark, the industry has provided an investment asset that is on a par in terms of safety with a government bond, has been popular with a robust local investor base and has been a source of low-cost funding for the sector. More recently, Danish mortgages have escaped virtually unscathed from the world credit markets turmoil.

Lenders believe the strength of the market is the result of their strict adherence to the balance principle: a rule that requires mortgage institutions to finance loans with covered bonds bearing exactly the same terms as the mortgages, with cash flows from the loan being directly passed through to investors in the bonds.

Safety first

To lenders elsewhere, this might seem stifling, but the Danes embrace the concept. Despite a new Covered Bond Act, which came into effect in July last year, stating that the balance principle is no longer mandatory, lenders say they will continue to apply the rule to their businesses as it has served the market well. "We have continued in the way we manage our risk by match funding the loans with bonds and that is what we are going to do going forward," says Henrik Hjortshoj-Nielsen, head of group treasury and executive vice-president of Nykredit in Copenhagen.

The principle requires that banks eliminate interest rate, currency or liquidity risks related to mortgage lending by tapping the covered bond market for funding once they have approved a mortgage. The bond must bear terms that mirror those offered in the mortgage. As such, any market risk is immediately offloaded to investors who also have first claim on the assets in the event of default. Since subprime lending is not allowed in Denmark, the credit quality of the underlying mortgages is reliably high. This original approach has been held up as a model for developing mortgage markets such as Mexico and is lauded by Danish market participants as having laid the foundation for a robust and resilient sector.

"The way we have financed our loans by applying this very strict balance principle is the main reason we have not been hurt the same way in the global credit crisis," says Ane Arnth Jensen, director general of the Association of Danish Mortgage Banks.

All the same, the changes to the legislative framework have been welcomed as a liberalisation of the market. But the main driver for the changes has been to bring Danish covered bonds, the second largest such market in the world after Germany's Pfandbrief, in line with EU capital requirement standards so they receive a preferential risk weighting (of 10%) under Basel II. The key change in Danish legislation is that commercial banks will now be allowed to issue covered bonds, an option previously available only to specialised mortgage banks. However, market participants expect little material impact on the competitive landscape of Denmark's mortgage market in the short term.

"You may see movements of the loans out of the mortgage banks into the commercial banks," says Hjortshoj-Nielsen. "But that doesn't change the competition, it's just a matter of where the loans are booked."

High barriers

At present, two commercial banks (Danske Bank and Sweden's Nordea) actively offer mortgages. To get around the rule that had previously forbidden them from issuing covered bonds, they had set up mortgage entities in the past through which bonds were issued to fund their mortgage business. Although the new law paves the way for more commercial banks to start offering mortgages, analysts say that high barriers to entry are likely to keep potential competitors at bay. Five main lenders dominate the market in Denmark. According to the association of Danish mortgage banks, Nykredit is the biggest issuer of mortgage bonds with a 41% market share, followed by Danske Bank-owned Realkredit Danmark with 32%, Nordea with 12%, BRFkredit with 10% and DLR Kredit with 5%. The remaining 1% of covered bonds is issued by smaller lenders.

Casper Rahbek Andersen, European covered bond ratings analyst at Standard and Poor's (S&P), says: "The lenders and investors are really set in their ways in this market, so it's unlikely that we will see major changes to the sellers and buyers." He expects the biggest commercial banks to start issuing, while some of the existing issuers will attempt to widen their investor base. But he stresses that in Denmark the mortgage market is a traditional business and has not changed dramatically for a long time.

Unlike in other mature markets, where riskier mortgages have become a large part of the market, fixed-rate callable mortgages in 20-year and 30-year formats are still the mainstay of Danish lending. Mortgage banks are reluctant to offer more innovative products because investors' trust in bonds matching the established format translates into low-cost funding.

Also, under the new rules, lenders must monitor loan-to-value (LTV) ratios daily to ensure they remain under 70%. Should house prices fall, issuers are required to provide additional collateral against the bonds. This could take the form of government bonds or issuers have the option under the new rules to sell subordinated (so-called junior) covered bonds to supplement capital. That said, Danish mortgage banks have been conservative in keeping LTVs low, preferring to lend at below 70% even when the property market was booming between 1995 and 2006. Given that growth in the property market has slowed during the past year, analysts believe banks are now less likely to lend aggressively. "Given the slowdown in house prices in Denmark, now is probably not the time to start lending at a higher LTV," says Alexandre Birry, associate director of financial institutions at Fitch Ratings in London.

So far, the investment community for Denmark's mortgage bonds has been made up of largely domestic professional investors. Up to 85% of Danish mortgage bonds are said to be in the hands of domestic investors as the bonds are typically issued in Danish kroner because of adherence to the balance principle and the need to eliminate currency risk. Investors tend to be local financial institutions, insurance firms and pension funds.

However, foreign ownership of Danish covered bonds could be set to increase now that commercial banks are allowed to issue. There has been talk that the commercial banks could try to tap international markets by issuing euro-denominated covered bonds to back their lending. Danske is said to have been preparing a euro-denominated covered bond for more than two years in anticipation of the changes in legislation. It is likely now to launch such a deal in the first quarter of 2008, should market conditions be favourable. Market sources suggest that Nordea could also be looking at this option.

Analysts say such issuance could become more regular when appetite for credit recovers across the world. If and when that occurs, the number of foreign investors in Danish covered bonds is likely to increase.

Changes in the Covered Bond Act could also see the introduction of a wider range of products. Lenders can now offer interest-only loans for a limitless tenor as long as the LTV stays at or below 70%. Previously, lenders were only permitted to offer borrowers the option to pay interest-only for up to 10 years, regardless of the actual tenor of the loan. On the back of this change, in October 2007 Nordea offered a 30-year fixed-rate callable interest-only loan. Two months later, Nykredit also began offering a similar mortgage. As the loans were relatively new to the market, the level of enthusiasm for these mortgages was still unclear at the time of writing, but Nordea officials say they are seeing fairly robust demand. The new rule opens up the possibility for banks to offer interest-only terms for longer periods, although lenders say this is unlikely in the near term.

"Historically, 30-year financing is the maximum time for the Danes," says Frank Klahsen, chief of international sales for Nordea Markets in Copenhagen. "We already have 30-year interest-only financing. The borrower wouldn't get a cheaper monthly payment if he took out a 50-year or 60-year. There's no capital gain or cheaper financing for the borrower, and also there needs to be demand on the investor side."

Opportunity

With more flexible financing options, analysts say there could also be more opportunity for product innovation in the future. Danske Bank's Realkredit Danmark recently started offering RenteDyk, a mortgage with interest rates that automatically adjust downwards, akin to the US version of the ratchet mortgage. "The mortgage banks have competitive advantages offering traditional 30-year fixed-rate callable mortgages, whereas the universal banks have competitive advantages offering open plan mortgages and other mortgages offered in combination with bank products," says Stig Tornes-Hansen, chief analyst of fixed-income research at Danske Markets. "Furthermore, the universal banks have strong branch networks, which none of the mortgage banks have on their own."

Legislative changes aside, the Danish market is also unique in some of the refinancing options it offers borrowers. For callable mortgages, which form the largest part of the market, borrowers can refinance by buying the bonds matched to their mortgage loan in the secondary market and delivering them to the lender, at which point the mortgage is cancelled. When interest rates fall, it is in the interest of borrowers to buy back bonds and refinance at lower levels. In the case of rising interest rates, borrowers can either continue to pay the existing mortgage or buy the bonds in the market (since those are now cheaper) and remortgage, thus offsetting more expensive future loan repayments.

The buyback option is so commonplace that borrowers can carry it out online. Buybacks are encouraged in Denmark because it is seen as healthy for borrowers to refinance whichever way interest rates go, depending on their personal circumstances. Since the borrower is unwinding a position when calling the mortgage, there is no prepayment risk for investors or lenders. Also, when a borrower buys back bonds in the market, the increased demand actually lends strength to bond prices. In fact, buybacks were once mandatory but are no longer compulsory under the new Covered Bond Act, although lenders say that the practice is still continuing.

Says Nordea's Klahsen: "The one big difference in the Danish mortgage market relative to all others is that the borrower holds the option to get out of his debt by buying back the bonds in the market. That means that you can refinance both when rates are going up and down. Paying attention to your debt is a public sport among Danes."

Henrik Theil, senior director at Nordea Markets, says investors are not left in the dark during this process as they can see on a daily and weekly basis how many loans are paid back in the series they own. "It's an open book," says Theil.

For borrowers with non-callable mortgages, there is a refinancing exercise at the end of each year in the form of an auction for new covered bonds. Typically, floating rate or adjustable rate mortgage (Arm) borrowers can refinance at this auction held in December - the largest of its kind in the world. Arms are financed by short-term non-callable bullet bonds, which are redeemed upon maturity. Lenders then issue new bonds to fund the remaining principal lent to the borrowers. During the auction, which takes place over a number of weeks, investors will bid for those new bonds and the lenders will take an average price and allocate accordingly. Borrowers can decide if they want to take the interest rate fixed on a particular day or they can choose to take the average over a number of days. All covered bonds until 2005 typically matured on January 1, explaining why the auction takes place in December. However, some institutions are now offering the auction at other times of the year, although on a much smaller scale.

These unique features of the Danish mortgage market convey just how sophisticated it is. The refinancing options in Denmark also show how savvy Danish homeowners are. Analysts say default rates are negligible, even though up to two-thirds of the population own homes. "It's seen as a success factor to be the owner of your own house and it's definitely one of the goals of the individual," says S&P's Andersen. "The mortgage is also likely to be one of the first things that Danes will pay off. If they have to default on something, they might do so on a consumer loan, but not on their mortgage."

Despite the relative stability of the mortgage market, the global economic outlook has cast a pall over the Danish property market. After more than 10 years of solid growth, property prices have been lacklustre over the past year. Part of this is due to several rounds of interest rate rises that have made mortgages more expensive.

Property prices drop

Another reason is the instability of the global economy following the subprime crisis. The average price for flats in Denmark fell for the first time in more than a decade this year. For the first three quarters of 2007, the average price per square metre for flats was down 2.7% from 2006, while that for houses rose just 6.7%. In comparison, the average price per square metre for flats had jumped 291% from 1995 to 2006, and 188% for houses (see figure 2). Although the Danish economy is strong, buyers could also be unnerved by possible external risks.

Jensen, at the association of Danish mortgage banks, says the biggest risk to the Danish market is a global recession. But she adds that the Danish economy is strong at the moment, with low unemployment, increasing net income after taxes and strong consumption. "But if we are facing a severe recession in the American economy, with effects felt in Europe, then of course there would be a risk that the Danish economy would be hurt as well."