Covered Bond Dispute Seen by Denmark Ending in EBA’s Defeat

Denmark’s central bank Governor Lars Rohde characterized as nonsensical a European Banking Authority plan not to give covered bonds the highest liquidity status and predicted policy makers in Brussels will ignore the advice.

“It’s a paradox if highly rated, very liquid bonds get a lower status than lower-rated, illiquid government bonds,” Rohde said in an interview yesterday in Copenhagen. Business Minister Henrik Sass Larsen said Denmark “expects to win this battle as we have very good arguments” against the EBA.

Denmark’s Economy Ministry said last week it had received information indicating the London-based EBA was planning to recommend covered bonds not be treated as highly liquid assets, dealing a blow to the nation’s $530 billion mortgage bond market. In doing so, the EBA was ignoring the findings of its own report, which suggested covered bonds have all the key characteristics of the most liquid assets, the ministry said.

If approved by the European Commission, the EBA’s recommendation would limit banks’ ability to use covered bonds to fulfill their liquidity requirements. That would trigger a sell-off of the securities and send mortgage rates higher, the industry warns.

“It won’t miscredit the review as such,” Rohde said. “The EBA was asked to make an empirical survey of liquidity in different asset classes; we are confident that the European Commission will rest on objective, identifiable conditions.”

‘Extremely Important’

The EBA isn’t due to publish its recommendations until later this month, with draft technical standards set to be finalized by March. The European Commission is scheduled to decide in June.

Franca Congiu, EBA spokeswoman, declined to comment on the liquidity rule. The EBA’s recommendation marks a major setback in relations between Denmark and the European Union, according to the Danish Bankers’ Association.

The Association of German Pfandbrief Banks, VDP, last week called the EBA’s plan “astonishing.” Germany shares Denmark’s view, VDP Chief Executive Officer Jens Tolckmitt said by phone on Nov. 28. Norway today joined Denmark in questioning the EBA’s reasoning and said it was seeking a broader review of the liquidity characteristics of covered bonds.

“The market for Norwegian krone denominated covered bonds is now larger -- in terms of outstanding volumes -- than the Norwegian government bond market, and is by market participants regarded to be as liquid as the government bond market,” Erik Johansen, head of economics and capital markets at Oslo-based Finance Norway, said in an e-mailed reply to questions.

Fitch Watching

Fitch Ratings Director Jens Hallen said he is closely monitoring the outcome of the EBA’s proposal. While banks may have alternatives to building their liquidity buffers, the biggest fallout would be felt by the Danish mortgage market, Hallen said in an e-mailed reply to questions.

“We are looking at the potential demand for these debt instruments, that is, could other domestic investors buy a larger share if banks reduced their holdings,” he said.

Were the EU Commission to follow the EBA’s advice, Denmark would have no choice but to implement the changes even if they “place more demands on Danish mortgage lenders,” Larsen said.

Nordea Bank AB, Scandinavia’s biggest lender, said the EBA’s proposal risks weakening financial stability rather than contributing to it.

“It is extremely important that we don’t introduce risks into the overall system that are not inherently there,” Anders Jensen, chief executive officer of Nordea’s Danish unit, said in an interview yesterday. “That was not the intention of the Liquidity Coverage Ratio.”

Undermining Credibility

Ignoring the findings in its own report may undermine the EBA’s credibility as an independent authority, according to Jesper Berg, head of regulatory affairs and senior vice president at Nykredit Realkredit A/S, Europe’s biggest issuer of covered bonds backed by residential mortgages.

“I can understand that they need to give the highest liquidity status to sovereign debt because otherwise Europe would be in a mess, but that’s a political decision,” Berg said in a Nov. 29 interview. “It’s a bit of a joke to say Danish banks would be better off holding Greek government bonds than Danish mortgage bonds.”

While Danish mortgage bonds withstood the worst of the global financial crisis, proving as liquid as government bonds in a central bank study, the industry is now being buffeted on several sides.

‘Great Pity’

The government of Prime Minister Helle Thorning-Schmidt last week submitted a proposal to parliament that allows for an extension of maturities on short-term bonds used to back 30-year mortgages after rating companies warned they created refinancing risks. The market has come under increasing scrutiny after relying less on the fixed-rate, 30-year bonds that once underpinned its stability.

“We’re standing by the Danish mortgage system,” Thorning-Schmidt said today at a Copenhagen press conference. “We perceive these bonds as first class and that’s the view we’re trying to purvey to the Commission.”

Investors have so far remained loyal to Denmark’s mortgage bonds, embracing the extra yield relative to the nation’s government debt market. The Nykredit index of Denmark’s most-traded mortgage bonds has returned 28 percent since the end of 2008, compared with a 12 percent return on U.S. Treasuries with maturities longer than a year, according to data compiled by Bloomberg.

“It would be a great pity if a system that has performed well through the crisis is suddenly forced to change,” Berg at Nykredit said. “The lesson is that if you’re different, you’re at risk.”

(Updates with Danish Prime Minister comment in 19th paragraph.)
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