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‘Grotesque’ Basel Rules May Kill Danish Bonds: Credit Markets

According to the central bank, seen here, trading in Denmark’s covered bonds rose during the financial crisis, both in total value and in the median size of individual trades. Photographer: Chris Ratcliffe/Bloomberg
According to the central bank, seen here, trading in Denmark’s covered bonds rose during the financial crisis, both in total value and in the median size of individual trades. Photographer: Chris Ratcliffe/Bloomberg

Denmark says the Basel Committee on Banking Supervision’s rules will force the country’s lenders to dump top-rated mortgage debt to meet new requirements on holdings and may destroy the world’s third-biggest covered-bond market.

The Nordic country is planning to challenge the rules, published on Dec. 16. and Economy Minister Brian Mikkelsen has already taken Denmark’s grievances to the European Commission. The government and the country’s lenders are now waiting to see how much the European Union will change the rules as they’re put into effect next year. The final deadline for enforcement is 2015.

“It’s almost impossible to see how our financial system as we know it will continue to function” if Basel’s liquidity coverage ratio is enforced, Ane Arnth Jensen, director of the Copenhagen-based Association of Danish Mortgage Banks, said in a Dec. 21 interview.

Denmark’s lenders, which hold more than half the country’s $490 billion of mortgage bonds, would be forced to sell off holdings to comply with Basel’s 40 percent cap on using the securities as liquid assets, Arnth Jensen said. Basel, which says the rule will provide lenders with more liquid assets to guard against times of financial stress, doesn’t place any limit on sovereign-debt holdings.

The rule represents a “grotesque notion -- it shows the committee doesn’t really understand the Danish mortgage-bond market,” Arnth Jensen said.

Market Size

Denmark’s mortgage bond market is about 1 1/2 times the size of the country’s economy and more than seven times the size of the government bond market, according to the central bank. Denmark, which isn’t one of the Basel Committee’s 27 members, is one of the most vocal critics of the liquidity rules.

Elsewhere in credit markets, UBS AG lost an arbitration ruling over structured products backed by Lehman Brothers Holdings Inc. that will force it to pay more than $2.2 million to Thomas Motamed, chief executive officer of CNA Financial Corp.

A Financial Industry Regulatory Authority arbitration panel ruled Dec. 20 that UBS must buy back the notes at their original cost and pay interest to Motamed, who’s also chairman of the Chicago-based commercial insurer, and his wife, Christine. A UBS adviser in Charleston, South Carolina, recommended the investments, some of which were called principal protected, said G. Trenholm Walker, Motamed’s attorney at Pratt-Thomas Walker.

Corporate Bond Yields

The extra yield investors demand to own corporate bonds worldwide instead of similar-maturity government narrowed 1 basis point to 1.7 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Yields averaged 4.1 percent.

The cost of protecting bonds from default in the U.S. climbed from the lowest level in eight months and bond mutual funds had the biggest client withdrawals in more than two years as a flight from fixed-income investments accelerated.

U.S. bond funds experienced withdrawals of $8.62 billion in the week ended Dec. 15, up from $1.66 billion the week before, according to a news release from the Investment Company Institute, a Washington-based trade group. Last week’s withdrawals were the largest since the period ended Oct. 15, 2008, when investors yanked $17.6 billion from bond funds.

Most of the money was probably pulled by institutional investors looking to lock in higher yields by buying bonds directly, rather than through funds, said Geoff Bobroff, a consultant based in East Greenwich, Rhode Island.

‘Staying Put’

“I would guess most retail investors are staying put because you aren’t seeing the money go anywhere else,” he said in a telephone interview.

The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, increased 0.75 basis point to a mid-price of 85.5 basis points as of 12:20 p.m. in New York, according to index administrator Markit Group Ltd.

The rise came after a U.S. government report showed orders for durable goods fell 1.3 percent in November, a bigger drop than the 0.5 percent median forecast of economists surveyed by Bloomberg News.

The CDX index typically rises as investor confidence deteriorates and falls as it improves.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point, or 0.01 percentage point, equals $1,000 annually on a contract protecting $10 million of debt.

Trading Denmark’s Bonds

Trading in Denmark’s covered bonds -- securities backed by the cash flow from a pool of mortgage loans -- rose during the financial crisis, both in the total value of securities traded and in the median size of individual trades, according to Denmark’s central bank. It was easier to trade short-term mortgage bonds than government notes, the bank said.

Reducing mortgage-debt stakes to comply with the Basel rules is “simply out of the question, it can’t be done,” said Jesper Berg, senior vice president in charge of regulatory affairs at Nykredit A/S, the country’s biggest mortgage lender. “It would lead to a credit crunch the likes of which this country has never seen.”

Denmark’s government-bond market is too small by about 300 billion kroner ($53 billion) to bridge the liquidity gap the Basel rules would create, Arnth Jensen said.

Euro Debt

Danish mortgage bonds returned 4.5 percent this year, according to Danske Bank A/S’s index tracking the securities. The debt yielded 7.1 percent in 2009 and 6.6 percent in 2008. By comparison, euro-area government bonds on average returned 1.1 percent this year, 4.4 percent in 2009 and 9.3 percent in 2008. Denmark’s mortgage bonds haven’t suffered a default since they were introduced after the great Copenhagen fire of 1795.

The Basel Committee says it’s taken national circumstances into account in its design of the liquidity rules.

“We’ve gone a long way to diversifying what counts as liquid assets compared to December 2009,” said Stefan Walter, secretary general of the Basel Committee. Basel makes room for allowances in the liquidity rule for banks in countries with low government debt levels. The plans put “in place a process to address any unintended consequences,” Walter said.

Arnth Jensen says the concessions aren’t enough.

‘Very Critical’

“We’re in principle very critical of the notion that the liquidity status of Danish mortgage bonds should depend on the level of government debt,” she said. “The securities are liquid whether the state has a high or a low level of debt.”

The EU may alter the Basel rules if they threaten the economic recovery in the region, said Michel Barnier, financial services chief in charge of implementing the capital adequacy and liquidity rules in the 27-member bloc, at a Dec. 2 banking conference in Brussels.

Denmark’s mortgage bank association is also warning that the Basel rules may bring to an end the country’s annual adjustable-rate mortgage-bond auctions. Basel’s so-called net stable funding ratio requirement, which won’t be enforced until the beginning of 2018, deems bonds with maturities of less than one year to be unstable.

“This may well force Denmark to drop its annual adjustable-rate auction” in the short-term securities, Arnth Jensen said.

This year’s $97 billion auction attracted record foreign demand as non-Danish investors bought as much as 20 percent of the adjustable-rate bonds on offer, according to Danske Bank. The auctions, which ran from Nov. 25 through Dec. 13, drew investors seeking refuge from Europe’s debt crisis.

Berg at Nykredit says Basel needs to draw more lessons from the sovereign-debt crisis that left two euro-area governments reliant on international bailouts, with some investors betting more rescue packages are needed to support the region’s single currency.

“The last year has shown very clearly that government debt isn’t necessarily always more liquid than other forms of debt,” Berg said. “It’s just not the case. The assumption is absurd.”

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