Soros Venture Urges Denmark to Ignore EBA Covered Bond Plan

Denmark should ignore the European Banking Authority and continue allowing its banks to use covered bonds as highly liquid assets, according to a venture backed by billionaire investor George Soros.

Denmark’s $530 billion mortgage-backed covered bond industry has been in crisis talks since it emerged last week that the London-based EBA will probably urge the European Commission not to give the securities the top liquidity stamp, an outcome Denmark has been lobbying to prevent since late 2010. Business Minister Henrik Sass Larsen said Dec. 2 Denmark will prevail in its efforts to persuade Europe not to interfere in its two-century-old mortgage system.

“Danish mortgage bonds were more liquid than most sovereign debt in 2008,” Alan Boyce, a former portfolio manager at Soros Fund Management LLC, before becoming chief executive officer at Absalon Project, a joint venture backed by Soros with Copenhagen-based VP Securities A/S, said in an e-mailed response to questions. “The Danes should tell the EBA to mind its own business.”

Denmark says the EBA’s recommendation not to treat covered bonds as highly liquid assets ignores its own findings, which show the securities are at least as safe as government debt. The Danish Bankers’ Association said last week it would mark a serious setback in relations between Denmark and Europe if the commission settles on a definition of liquidity that penalizes mortgage bonds.

Specific Qualities

The debate centers on whether Europe should adhere to global banking rules or base its assessment on an asset’s specific qualities, with Denmark favoring the latter approach, Business Minister Margrethe Vestager said today to reporters.

“We are putting in all our strength and engaging all the people concerned with this -- the Danish parliament, government, European lawmakers, the entire financial industry,” Vestager said. “That’s a pretty strong force.”

Danish banks and mortgage lenders held about 34 percent of the country’s mortgage debt last month, according to central bank data. During the financial crisis, lenders held more than 50 percent of the bonds.

Not Alone

The Danes aren’t alone in battling the EBA, which recommends that only sovereign debt be given the highest liquidity status. Germany and Norway have also questioned the logic of the proposal. The European Covered Bond Council said yesterday it is urging the London-based EBA to reconsider its plan or risk triggering “unintended disruptions to the level playing field that exists among European countries,” according to an e-mailed note.

The EBA’s plan would perpetuate an “over-reliance on sovereign debt by the European banking sector” and hamper “the objective of delinking the sovereign from the banking sector,” Luca Bertalot, head of the ECBC, said in a statement.

The EBA isn’t due to publish its final 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 earlier this week.

The EBA’s turnaround is bewildering the market.

Market Confusion

“One week they publish a study regarding liquidity that finds covered bonds are almost as liquid as most government debt,” said Bernd Volk, head of European covered bond and agency research at Deutsche Bank AG in Frankfurt. “Then the following week they turn around to probably the most liquid covered bond market and indicate that their own report is not sufficient to recognize covered bonds as Level 1 asset.”

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 bonds, whose outstanding volume is 1 1/2 times the $340 billion economy, Denmark’s mortgage lenders warn.

Boyce says investors will remain loyal to the bonds no matter what Europe decides. The Nykredit index of Denmark’s most-traded mortgage bonds has returned 28 percent since the end of 2008, compared with an 11 percent return on U.S. Treasuries with maturities longer than a year, according to data compiled by Bloomberg.

Pimco’s Preference

Short-term Danish mortgage bonds sold at refinancing auctions that went from Nov. 18 through Dec. 4 had average yield spreads relative to interbank rates that hit the lowest on record.

The bonds, which offer deeper volume and higher yields than AAA-rated Denmark’s government debt, have attracted some of the world’s biggest investors, including Pacific Investment Management Co.

“The short paper works for Pimco and other money market managers,” Boyce said. Even if banks were to cut their holdings in order to comply with new liquidity requirements, there would be buyers ready to step in “if it gets cheaper,” he said.

The EBA has sought to accommodate nations like Denmark by proposing alternatives for liquidity management. In a consultation paper published on Oct. 22, the EBA said Danish and Norwegian banks could either hold foreign assets or use a central bank credit line to meet requirements.

Faulty Fallback

According to the Financial Supervisory Authority in Copenhagen, those options only ensure banks can meet their liquidity needs, and don’t address the impact on the mortgage industry.

“It is true that we have a fallback option in a sense, but that is related to Danish banks’ fulfillment of their requirements,” FSA Director General Ulrik Noedgaard said in an interview. “What we’re after here is that covered bonds as such are treated at the highest level, because we think the analysis validates that they should be.”

Thomas Hovard, head of credit research at Danske Markets, said “banks can manage. The problem is for the mortgage markets.”

Europe’s discussion of which assets to treat as liquid is based on a 2010 set of standards from the Basel Committee on Banking Supervision. As the EU has worked on implementing Basel’s requirements, it has shown willingness to deviate from the global regulator’s ideas in its application of risk weights and leverage ratios, according to Jens Tolckmitt, chief executive officer of the Association of German Pfandbrief Banks.

“It wouldn’t necessarily be obvious why you shouldn’t do it in this instance,” he said in a phone interview. “I am not giving up hope.”

Before it's here, it's on the Bloomberg Terminal.