Denmark Cuts Mortgage Bond Risk in Intervention: Nordic Credit

Denmark’s government said it will seek to intervene in the nation’s mortgage bond auctions to address refinancing risks after industry steps proved inadequate.

“Rating agencies and others had questioned the safety of our model, and we felt we had to act, and that we had to act now,” Business Minister Henrik Sass Larsen said yesterday in a phone interview. Industry efforts “didn’t remove the risk altogether, and that’s what the government now seeks to do.”

The proposal, which has yet to be approved by parliament, seeks to address a funding mismatch criticized by rating companies and the central bank. Borrowers and banks in Denmark’s $530 billion mortgage bond market had grown too reliant on one-year bonds to finance loans as long as 30 years, according to Standard & Poor’s and Moody’s Investors Service.

The government wants to extend maturities on adjustable-rate bonds in the event the securities can’t be sold or if rates rise sharply. Though the Association of Danish Mortgage Banks and the central bank welcomed the step, investors warn they’ll demand a higher premium to hold a bond with an uncertain maturity profile.

Investor Concerns

“Some investors may not be able to buy into these bonds any more as they risk having a short bond converted to a 30-year bond,” Poul Kobberup, head of fixed-income investments at PFA, Denmark’s biggest private pension fund, said in an interview. “Then other investors, like ourselves, won’t accept this for free, and the conversion option will come with a price tag, but I don’t know how much yet.” Kobberup manages about $47 billion in fixed-income assets.

Danish mortgage banks have struggled to wean borrowers off loans funded by one-year bonds as deadlines near to demonstrate they can withstand a 12-month funding market freeze. S&P in July told lenders they risked downgrades if they don’t cut use of the securities over the next two years. The central bank has also criticized the bonds and the risks borrowers face if interest rates rise.

One-year bonds fund about 40 percent of home loans in Denmark. Borrowers have been attracted to record-low rates thanks to AAA-rated Denmark’s status as a haven from Europe’s debt crisis. Still, households have grown more exposed to interest-rate shocks as debt burdens soar to a world-record of 310 percent of disposable incomes, according to data compiled by the Organization for Economic Cooperation and Development.

S&P Watching

Under the government’s proposal, short-term bonds would convert to callable, longer-term securities if refinancing auctions fail or interest rates climb in auctions by more than 5 percentage points. The new yield would equal the existing coupon plus 5 percentage points. Existing bonds would be excluded from the measure, which would go into effect Jan. 1 if approved by lawmakers.

“This was a game changer,” Jens Peter Soerensen, chief analyst at Danske Markets, said by phone. “The key thing is what the rating agencies say. We have saved the one-year loan, if the rating agencies are positive.”

Per Tornqvist, a Stockholm-based analyst with S&P, said the rating company is looking closely at the proposal.

“Standard & Poor’s has begun assessing the potential impact on bank ratings from the proposed changes to Danish bond legislation,” he said by e-mail. “We may comment on the draft proposal to revise bond legislation as soon as possible.”

Slim Chance

The measure probably will make it more difficult for commercial banks to take market share from mortgage banks, which have raised prices to compensate for the refinancing risks. Jyske Bank A/S said earlier this month the higher fees had created an opportunity for the Silkeborg-based lender.

While the business remains “attractive,” Steen Nygaard, Jyske’s head of treasury, said today by phone, “borrowers may be less receptive to our product.” Central bank support will ensure investor demand for mortgage banks’ products, capping price rises, he said.

The likelihood of a sudden 5 percentage point rate rise is slim, according to the ministry. Only once in the past 150 years have rates fluctuated more than that over a 12-month period, it said. That improbability will limit the risk premium investors will charge, said Soeren Holm, chief financial officer at Copenhagen-based Nykredit Realkredit A/S, Europe’s largest issuer of mortgage-backed covered bonds.

Nykredit estimates “the extra price that will result from this extra feature will be under 5 basis points,” Holm said by phone. “We get a good solution that’s cheap.”