Recently, there has been some concern over the future stability of the Danish mortgage bond system. Indeed, in a country where private household debt is the highest in the developed world, it may seem incredible that the system can remain stable. Nevertheless, during the 200-plus years the system has existed in Denmark, there has never been a record of mortgage bond default.This is due, among other reasons, to the system’s unique legal setup. Strict regulation has been maintained and any negative assessments of the system have been refuted by the high liquidity ratings issued by the European Commission. Even though it has been forced to adapt to the demands of EU legislation, the system continues to be a basis for attractive investment.
It started with a fire
The particular nature of the Danish mortgage bond system arose from a desperate need for funding at a time when no one wanted to provide credit. In 1795, a huge fire had burned down a quarter of the houses in Copenhagen. In order to get funding to rebuild the city, lenders formed mortgage associations to provide loans secured by mortgages on real property. Due to the joint and several liability imposed, credit quality was enhanced remarkably and the first Danish mortgage bonds were issued to fund loans. Today the Danish mortgage market is one of the biggest in the world compared to GDP and the second largest in Europe.
Since the risk of default on the individual mortgage is spread across the security over large pools of real estate, mortgage banks are able to offer investors almost risk-free returns on their bonds while at the same time offering loans on highly attractive terms to borrowers, in comparison with normal bank loans.As well as making the Danish real estate sector attractive for investment, the system has proven capable of withstanding every economic challenge so far—from the bankruptcy of the Kingdom of Denmark in 1813 to the financial crisis of 2008.
Strict legal framework
The main reason why the system has proved so stable is its strong legislative framework.
Danish mortgage banking is regulated by the general Financial Business Act, the specific Mortgage Credit Loans and Mortgage Credit Bonds Act, along with a number of Ministerial Orders.
Some of the key points of the regulation are:
- mortgage loans can only be provided up to certain loan- to-value (LTV) limits
- restrictive criteria regarding valuation of the property offered as collateral
- mortgage banks can only get funding by issuing bonds
- specialist mortgage banks must operate under the balance principle, which restrictively regulates the market risk exposure of the banks by having a one-to-one correspondence between loans and the bonds funding them
- mandatory overcollateralization of the cover pool which ensures the mortgage bond investors’ capital in a bankruptcy scenario
- close supervision by the Danish FSA
The balance and investor protection principles are central to the regulation. Together with maintaining high liquidity, regulation ensures the mortgage-covered bond system remains stable.
In contrast to the high degree of regulation, there has been little direct government intervention in Denmark compared to other countries and only a few of the Danish mortgage banks had to buy state capital in 2008.
Challenging EU regulation
In 2007 the EU demands for capital coverage were implemented in Danish law. An EU Regulation introduced a loan-to-value demand which had to be met at all times and not just at the time of issuing the loan, which used to be the case in Denmark.
The purpose of the Regulation was to diminish the risk of default when loans exceeded the value of the collateral.
However, the risk of not having coverage for the loan was already covered by the national regulation of the Danish system and, instead of guaranteeing a more stable financial system, the EU Regulation has now introduced a new risk into the Danish mortgage bond system in addition to making loans considerably more expensive.
In countries that do not have a balance system with one-to-one correspondence between loans and bonds, the LTV clauses present less of a challenge since it is possible to fund the underwater mortgage loan in ways that Danish regulation prohibits.
There will be more EU regulation in this area with the Capital Requirement Directive IV gradually being implemented, entailing new demands for mortgage bond issuers.
Addressing the risks
In order to adapt to these new conditions both the government and the mortgage banks have made changes.The incentive to demand repayments has grown considerably after the introduction of the LTV clauses and further national regulation to limit the proportion of interest-only loans is on the way as well.This may spell trouble for first-time home buyers as well as for those who wish to refinance their underwater houses. So far the market has remained resilient and, considering the challenges the Danish mortgage bond market has faced in the past, it seems likely that the market will remain robust and competitive in the future.
Financial attraction value
Even Moody’s, one of the bond credit rating agencies that has been most critical of the Danish system, has admitted that the Danish covered bond market is remarkably stable. In Germany, home to the biggest covered bond market in Europe, insufficient asset- liability management, weak credits and lack of transparency in accounts led to the fall of one of the major pfandbrief issuers, Depfa. In Denmark, however, the system survived the crisis without having to stop issuing bonds at any point. Strict regulation, conservative underwriting motivated by the covered bond system and the use of recourse mortgages have also helped to prevent large-scale problems with defaults and foreclosures despite the recent decline in house prices.
In addition to this stability, Danish mortgage banks are still able to offer very competitive mortgage rates even though the EU sets high demands for liquidity and coverage. Another important factor is that Danish mortgage banks do not operate with loan to value requirements that force the borrowers on an individual level to refinance their loans in the event of falling valuations.
Moreover, Danish mortgage loan agreements consist of only a couple of pages in comparison to the often very lengthy agreements found in other countries.This fact reduces the costs associated with legal advice before entering into the contract.
Finally, an investment in Danish real estate results in high returns without an equally high risk because it can be funded with cheap loans backed by mortgage-covered bonds, while the demand for housing, especially in the major cities, continues to grow.