03 September 2011

Danish Mortgage System: From Simple and Transparent to Increasingly Complex and Risky*

Danes have been proud of their unique mortgage system – and perhaps rightly so. For more than 200 years the system has displayed amazing resilience by going successfully through several occasions of economic and political turmoil (including the bankruptcy of the Kingdom of Denmark in the early-19th century, the depression of the 1930s, the two oil crises of the 1970s, the 1986 austerity package and the 1978 tax reform, and the 2001 dot-com bubble) plus standing out as one of the most robust and stable systems during the 2008-2009 crisis. Only now there are rising concerns about market for home loans growing less stable, and several Danish mortgage lenders have had their credit rating cuts by Moody’s recently (Realkredit Danmark, the Danske Bank’s mortgage unit and the second-largest mortgage bank in the country, decided to drop Moody’s, and may be approaching Fitch instead). I think that the Danish case provides a good example of a simple and transparent system growing increasingly complex. Here is an overview of the issue; see how it looks to you.

Traditional Danish Mortgage System

It’s June 1795. Copenhagen is in flames again (after the Copenhagen Fire of 1728). Nearly 1,000 houses are destroyed this time by making around 6,000 residents homeless. (Source: Wikipedia) That’s where the Traditional Danish Mortgage System has its roots. Funding was needed to rebuild the city, but provision of credit was scarce. In 1797 lenders formed the Denmark’s first mortgage institution, Kreditkassen for Husejerne i Kjøbenhavn (Copenhagen’s Credit Organization for House Owners) to provide loans secured by mortgages on real property on the basis of joint and several liability to enhance credit quality. To fund the loans, the first Danish mortgage bonds were issued, and thus a more than 200-year tradition of mortgage bond issuance in Denmark commenced.

The main characteristics of this traditional Danish mortgage model were and at least part of them (although changed) still are:
* Match funding principle, also referred to as the “balance principle”, which means that each new loan is funded by the issuance of new mortgage bonds of equal size and identical cash flow and maturity characteristics;
* Pass-through system where the mortgage bank did not take interest rate, volatility, FX or liquidity risks, but the proceeds from the sale of the bonds are passed to the borrower and similarly, interest and principal payments are passed directly to investors holding mortgage bonds;
* Specialist bank principle which implies that mortgage banks operate as monoline businesses; they only grant loans which meet the eligibility criteria and they are confined to issuing mortgage bonds, i.e. collecting deposits is not an applicable source of funding;
* Standardised supply of loan products
* Transparent loan costs for borrowers – total costs consist of interest and principal payments relating to the bonds funding the loan as well as a margin charged by mortgage banks to cover their daily operating costs including any losses; traditionally, the interest rate was fixed for the entire loan term and directly linked to the yield on the bonds funding the loan;
* Unique prepayment options – borrowers may always prepay their loans by buying the underlying bonds in the market or at the par price of 100 (whichever makes more sense to the borrower at the moment);
* Maintaining credit risk by mortgage banks as they suffer a loss if a borrower fails to make interest and principal payments;
* Privileged position of mortgage bond investors in the case of bankruptcy of a mortgage bank;
* Strong legislative framework which limits risk-taking by mortgage banks, ensures effective registration of property units and rights in land as well as well-functioning foreclosure process, protects mortgage bond investors etc

Homeowners do not borrow from either a mortgage originator or a GSE. They borrow from the bond market, through a mortgage credit intermediary.  Every mortgage is balanced by an equivalent amount of an identical, and freely traded, bond. Simple, transparent and resilient, although the system has not prevented housing bubbles from developing, it has never broken down.

Yet there have been significant departures from this traditional model. No matter how these departures are explained or justified, the basic drivers of changes have been the intentions to increase mortgage funding and the business of mortgage financiers – and then, from time to time, regulators step in because of various more or less political reasons and/or because of the needs of changing business practices (just as it is the case with the other types of financing).

Timeline

The short (and not comprehensive but just illustrative) timeline of the developments in Danish mortgage system is provided below.

The following developments leaved the main characteristics of the traditional model unchanged:
* The adoption of the Constitution of the Kingdom of Denmark Act in 1849 gave the deciding push to the establishment of mortgage associations by groups of borrowers that were jointly liable for the capital raised through the issuance of bonds.
* During its first 100 years, the Danish mortgage credit sector consisted of many mortgage credit associations, where mutuality was in focus. As the joint liability of the associations resulted in very restrictive credit policies, at the end of the 1950s the Danish government took the initiative to establish independent mortgage banks. Commitment to mutuality gradually disappeared and institutions with independent means were established. This resulted in a more liberal lending policy.
* In 1970 the Danish parliament adopted the Danish Mortgage Credit Act of 1970. The Act limited the very free access to organised mortgage lending and introduced lower LTV limits, shorter loan terms and limitations to the purposes for which mortgage loans are available. The number of mortgage banks was subsequently reduced from 24 to seven (economies of scale).

This is where the European Community (directly via regulatory frameworks and indirectly via example) began to change the Danish mortgage system:
* In 1989, a new reform (deregulation) of the Danish mortgage legislation was introduced in accordance with an EC directive. New institutions could no longer be denied approval based on an assessment of demand. In addition, new mortgage banks had to be public limited companies. Existing mortgage banks were also allowed to convert into public limited companies. A number of Denmark’s large banks established own mortgage banks as a consequence of the reform. This led to fierce competition and further consolidation in the sector.
* During the last 15 years the range of mortgage products has broadened considerably. Adjustable-rate mortgages (ARMs or the mortgage loans the interest rate of which is reset typically every year through the issuance of new bond) were introduced in 1996; to fund these loans, noncallable bullet bonds were introduced. Interest-only loans are being sold from 2003. So-called capped floaters, which offer a floating interest rate with a ceiling on how high borrow costs can rise, came in 2004.

A major break away from the traditional mortgage model took in place on 1 July 2007 when the Danish covered bond legislation came into force. The purpose of the covered bond legislation was to implement a new set of rules from the EU – the Capital Requirements Directive – into Danish law. The Danish parliament took the opportunity to make further adjustments of the Danish mortgage market than those directly required by the EU rules. In result:
* Universal banks access to covered bond funding alongside the established specialist mortgage banks.
* There are now three types of bonds to choose from instead of one: the traditional mortgage bond (RO), the covered mortgage bond (SDRO) and the covered bond (SDO).
* Both mortgage banks and commercial banks may grant loans without any restrictions on the loan term and repayment profile, if they are funded by covered bonds (or covered mortgage bonds as regards mortgage banks).
* Mortgage banks and commercial banks issuing covered bonds or covered mortgage bonds may issue a new type of bond, junior covered bonds, to obtain capital for supplementary security to ensure compliance with LTV limits.
* The new balance principle – general balance principle – was introduced. The general balance principle allows non-compliance with the direct match funding practice. Instead, it governs the balance required between the lender’s total lending and the bonds funding it. Effectively, commercial banks and mortgage banks can now segregate loans and underlying bonds completely.
* To secure the advantages relating to prepayment under the traditional Danish mortgage model, the Danish parliament adopted the so-called par rule in connection with the covered bond legislation. The rule prescribes that a loan may be prepaid at a price of 100 (par) if it is not directly linked to listed bonds.

Where is the Danish mortgage market today?

On one hand, the Danish mortgage market has clearly benefitted from its flawless history. Indeed, the fact that no Danish mortgage bank has ever defaulted on a covered bond is impressing. The benefits include high liquidity and top credit ratings for mortgage bonds, low risk weightings of mortgage exposures in capital adequacy framework, low risk margins in credit prices etc. On the other hand, the market has also ballooned as a result result of the liberalisations and departure from the traditional model while at the same time maintaining investors’ confidence by stressing exceptionally good historical performance (which largely reflects the traditional principles that are being departed, as well as the illusion of low risk deriving from the fact that if a customer has to pay interest only, her/his probability of default during the interest-only period is lower by definition).

To illustrate it with numbers: even though Denmark is a small country, it has one of the largest mortgage markets in Europe, and the mortgage system makes up a substantial part of the financial sector in Denmark. Issued covered bonds total nearly DKK 2,400bn (end-2010). The amount exceeds Denmark’s annual GDP of about DKK 1,700bn by nearly 50% and is roughly four times higher than the sovereign debt of around DKK 700bn. The fact that at end-Q4/2010, ARMs (introduced only in 2003) accounted for 49% of total private residential lending clearly points to the triumph of riskier mortgage financing practices.

These very same popular ARMs are currently causing serious headaches to the Danish mortgage banks:
* Since the match funding principle is not followed, adjustable-rate mortgages have to be refinanced more frequently.
* This leads (or should lead because why should the financiers of one country benefit from the historical conditions that are no longer there) rating agencies to re-consider the triple-A ratings for the covered bonds.
* A downgrade of the rating of a covered bond from AAA to AA will imply that the capital requirement for credit risk nearly doubles.
* Mortgage banks are far from meeting the new liquidity rules of Basel III / CRD IV. As stated by the Association of Danish Mortgage Banks in its 2010 Annual Report, if the rule is not changed, it will mean the end of ARMs as we know them today. This makes bond investors reluctant...
* ... and so we are not far from a true downward spiral in Danish mortgage market the triggers of which would ironically be the new regulations and attempts to reflect refinancing risks in bond ratings. (I say “would” because mortgage banks are lobbying, European policy makers will probably reconsider the regulatory frameworks to prevent the worst happening and investors are generally expecting it.)

Perspectives

That’s how questionable business practices are crowding out good ones. If these developments continue, we should soon say farewell to the traditional Danish Mortgage System. There is a totally different perspective too: in its traditional form, the Danish Mortgage System could serve as a model for Western mortgage financing (as suggested by G. Soros for example). The later, however, is unlikely before the American mortgage financing system and/or European banks break down completely, and the need for viable alternatives can no longer be ignored by decision-makers.

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Note. The main sources of this overview are:
* The Association of Danish Mortgage Banks
* “Danish Covered Bond Handbook” by Danske Markets in September 2010

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