Denmark is bracing itself for an historic showdown with the European Union as lawmakers in the Nordic country settle on a definition of stable funding for mortgage banks that Brussels has yet to accept.
For the first time in the history of Denmark’s two-century-old mortgage bond market, lawmakers proposed last week adding a trigger to extend maturities on one-year notes at risk of failing to meet stable funding requirements. Never before have investors in the $530 billion market for Danish mortgage bonds faced government intervention in securities funding existing loans, according to the Danish Mortgage Bankers’ Federation.
The government in Copenhagen now needs to convince European regulators the new maturity profile satisfies stable funding rules intended to protect against market freezes. The Danish Financial Supervisory Authority, which deems funding shorter than 12 months as unstable for commercial banks, says the EU should accept the new mortgage bonds. Denmark is waiting for a response from Brussels as lawmakers, led by Economy Minister Margrethe Vestager, say they’re willing to do whatever it takes to save the world’s biggest mortgage market per capita.
“The Danish FSA’s position in the future EU development of the Net Stable Funding Ratio is that the new one-year mortgage bonds should be considered as stable funding,” Kristian Vie Madsen, the FSA’s deputy director general, said in an e-mailed response to questions on Nov. 8.
Standard & Poor’s, which warned in July that a failure to reduce issuance of one-year bonds could lead to downgrades, said it is looking at the proposal. Moody’s Investors Service, which has also criticized Denmark’s short-term mortgage bonds for introducing refinancing risks, is analyzing the proposal, it said last week. Investors still need time to decide what the changes mean, according to Pacific Investment Management Co.
“We are evaluating this development,” said Kristion Mierau, senior vice president for portfolio management at the Munich office of Pimco, the world’s largest bond fund.
Without European approval, banks in Denmark will have to slash sales of mortgages with rates that are reset annually. The one-year bonds make up about 40 percent of the market, comprising the single biggest category of mortgages.
At Danske Bank A/S, chief bond analyst Jens Peter Soerensen said Denmark’s proposal “might be stretching the interpretation of the net stable funding ratio a bit far, but this is dependent on the interpretation of the local FSA, and so far they seem positive. I don’t think the EU would comment on a specific Danish mortgage bond and say that’s not stable funding.”
The FSA may still limit use of the extended maturity one-year bonds when it introduces new guidelines for mortgage bond issuance, recommended earlier this year by a government-appointed committee examining the roots of Denmark’s financial crisis. Madsen at the FSA said the Copenhagen-based agency will unveil its recommendations in the first half of next year.
“We fear there will be a run on one-year bonds, and that’s why we’re emphasizing that it’s still important to have a focus” on the volume, Karsten Beltoft, head of the Mortgage Bankers’ Federation, said in an interview. The greater the volume of one-year bonds, the more likely it is that the maturity option would have to be exercised, he said.
Though banks had tried to wean borrowers off one-year funding, households resisted those efforts after rates in AAA-rated Denmark sank to record lows. That helped cushion the blow to homeowners of a 20 percent slump in property prices since their 2007 peak.
Yields on one-year mortgage bonds may be as low as 0.55 percent in auctions this month to refinance loans with a Jan. 1 interest reset date, according to Christian Heinig, chief economist at Realkredit Danmark A/S.
“The FSA will fight for the new one-year constructions as being compliant,” said Soeren Holm, chief financial officer for Copenhagen-based Nykredit Realkredit A/S, Europe’s largest issuer of covered bonds backed by home loans.
“This really eliminates the refinancing risk and reduces the interest rate risk for the customer,” Holm said. “We expected it to be at a reasonable price, 5 to 10 basis points.”
European banks are required to ensure by January 2016 they have diverse, stable funding for long-term obligations, according to rules approved by the European parliament earlier this year. A binding minimum standard will be set in 2018.
Business Minister Henrik Sass Larsen said last week the government was forced to push through its proposal, which still needs to be approved by parliament, after industry measures to comply with stable funding rules proved inadequate.
“The problem was that these various proposals didn’t remove the risk altogether, and that’s what the government now seeks to do,” Larsen said by phone.
Under the proposed legislation, an auction failure or interest rate increase of more than 5 percentage points would trigger conversion of one-year, three-year and five-year mortgage bonds, including index-linked notes, into callable, fixed-rate bonds with a maturity matching the underlying loans. That can be as long as 30 years, minus the maturity of the original loan. Yields would be set at the coupon plus 5 percentage points.
“It will always be our job to make sure mortgage finance remains as we know it,” Vestager told reporters last week.
The battle for the bonds won’t be the first for Denmark, whose mortgage market is more than three times the size of its government debt market. Vestager said in February the government will “do whatever it takes to guard it” after regulators suggested the securities didn’t qualify as highly liquid assets. The government ended up winning that fight and now expects the bonds’ top liquidity status to be confirmed by the end of the year.
“Both the Danish government and the members of parliament and the authorities have been very successful and very keen on fighting the battle for the mortgage system,” Ane Arnth Jensen, head of the Association of Danish Mortgage Banks, said in an interview. “I hope that we will win this battle as well.”