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Erhvervsudvalget 2009-10
KOM (2009) 0362 Bilag 3
Offentligt

MEMORANDUM

The Danish Financial

Supervisory Authority and

Danmarks Nationalbank

Danish Mortgage Credit and International Regulation

Proposals for quantitative liquidity standards are being considered

internationally as part of the follow-up on the financial crisis. The Danish

Financial Supervisory Authority and Danmarks Nationalbank support the

efforts to improve international regulation of the financial sector and find

that the proposal contains many positive elements and is a step in the right

direction. The proposal also gives cause for concern, however.

Danish mortgage credit is a key element of the Danish financial system.

There is a risk that current deliberations concerning new international

regulation may undermine parts of the system. These are primarily:

1. A new definition of liquid assets that fails to allow for the fact that

Danish mortgage-credit bonds are just as liquid as many

government bonds.

2. Liquidity requirements that make it impossible to maintain the

present adjustable-rate loan model.

3. A leverage restriction that does not take into account the collateral

pledged for mortgage-credit loans.

This memorandum describes the above three challenges in more detail. The

Danish Financial Supervisory Authority and Danmarks Nationalbank have

positions on other aspects of the proposal, but the focus here is on the above

three.

Danish mortgage credit

The Danish mortgage-credit system is of major significance to the entire

Danish financial sector and thus also to financial stability in Denmark. Its

significance can be illustrated by the fact that the market value of all

mortgage-credit bonds is approximately kr. 2,300 billion. In comparison,

Denmark's GDP is approximately kr. 1,700 billion. The market value of the

bonds is thus approximately 1.4 times Denmark's GDP.

The Danish mortgage-credit system is highly efficient and transparent.

Borrowers pay the market rate on the mortgage-credit bonds plus a fee of

approximately 0.5 percentage point to the mortgage-credit institute. The

yield spread between government bonds and mortgage-credit bonds is

normally limited as the real property pledged as collateral gives mortgage-

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credit bonds a very high degree of security. During periods without market

turmoil the yield spread may be as low as 0.1 percentage point in e.g. the 2-

year segment and 0.25 percentage point in the 5-year segment. This means

that during such periods the overall borrowing rate will only be up to 0.75

percentage point higher than the government-bond yield.

From the investor's point of view it is a very secure product that has never

led to credit losses. In practice, the mortgage-credit institutes achieve this

level of security by solely granting loans against real property as collateral,

financed by issuing mortgage-credit bonds. Furthermore, the "balance

principle" limits the institutes' ability to assume risks other than credit risks.

This ensures a close link between loans and bonds. Credit risk is limited by

restricting the extent to which the properties can be pledged as collateral and

laying down detailed rules on property valuation. In addition, bond investors

have priority in the event of failure, and borrowers are personally liable for

the loans. The lack of personal liability for the loans is a major explanatory

factor behind the substantial losses on mortgage-credit loans in the USA.

Finally, Denmark has a highly effective enforcement system.

The above characteristics make the bonds particularly secure investments

while supporting Denmark's financial stability, cf. Chart 1, which shows the

institutes' write-downs as a percentage of loans.

WRITE-DOWNS AS A PERCENTAGE OF LOANS, MORTGAGE-CREDIT

INSTITUTES

Per cent

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Chart 1

The robustness of Danish mortgage credit can be illustrated by the fact that

it was possible to sell bonds for refinancing of adjustable-rate loans in the

amount of approximately kr. 350 billion during the financial crisis, albeit

with a certain widening of the yield spread to government bonds. The

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mortgage-credit institutes were able to do this without incurring higher

costs, as the higher yield is passed on to the borrowers. For further details,

reference is made to an article in

BIS Quarterly Review,

March 2004 on the

Danish mortgage market.

International regulation

Both the Basel Committee and the EU are preparing proposals for new

regulation to address some of the weaknesses revealed by the financial

crisis.

As illustrated above, the mortgage-credit institutes are important to financial

stability in Denmark. Substantial changes in the rules applying to "covered

bonds" – the European term for mortgage-credit bonds – and their use as

liquidity instruments for the banks could have significant consequences, not

only for Danish mortgage-credit institutes, but also for Danish banks and

Denmark as such.

New definition of liquid assets

In the liquidity area, the introduction of new strict definitions of liquid assets

is being considered. The proposal distinguishes between three types of

assets: 1) Fully liquid securities, including government bonds. 2) Corporate

bonds and covered bonds, which may under certain circumstances be

included in the stock of liquid assets. 3) Other securities, which may not be

included. The assets under item 2 must not exceed 50 per cent of the overall

stock and can be included at no more than 60 or 80 per cent of their market

value (40 or 20 per cent haircut).

For corporate bonds and covered bonds to be included under item 2, they

must meet a number of requirements. A good many government bonds (e.g.

low-rated government bonds) will not be able to meet those requirements,

although they are immediately eligible for inclusion in the stock of liquid

assets as a result of item 1.

Since the breakdown between the first group of liquid assets and covered

bonds relates to the issuer, it does not take into account the liquidity of the

asset concerned. Most Danish covered bonds are fully liquid securities as

they have remained liquid even during the financial crisis. Nevertheless,

covered bonds can only be included as a limited share of the overall stock

and at maximum 80 per cent of their value. The same applies to other groups

of securities that are not eligible for inclusion in the stock of liquid assets

despite the fact that they are liquid.

Frankel, A, Gyntelberg, J, Kjeldsen, K and Persson, M (2004): The Danish mortgage

market,

BIS Quarterly Review,

March, pp. 95-109

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Danmarks Nationalbank includes mortgage-credit bonds in its collateral base

at a value reflecting the considerable liquidity of the securities. This was

also the case before the crisis. Restricting the share of covered bonds that

can be included in the stock of liquid assets and applying large haircuts may

give the institutes an incentive to pledge covered bonds as collateral to

Danmarks Nationalbank rather than keeping the securities on their own

books, so that they can hold assets that can be fully included instead. All

other things being equal, this will make the institutes more dependent on

Danmarks Nationalbank, which will be contrary to the object of the new

rules.

The proposed limits will also create problems for both banks and mortgage-

credit institutes, which currently use covered bonds to a considerable extent

in their liquidity management. It will be very difficult to replace Danish

krone-denominated covered bonds by krone-denominated government

bonds. At present, the volume of circulating Danish government securities

constitutes only around one fourth of the circulation of covered bonds. This

issue is particularly relevant if the liquidity requirement includes a currency

match requirement.

Other countries have also significantly reduced their government debt, cf.

Chart 2. In such a situation with a limited supply of government bonds, a

definition of liquid assets that is too narrow may therefore have an

undesirable impact on prices in the local markets.

GOVERNMENT DEBT AS PERCENTAGES OF GDP

Per cent

1998

Canada

1999

2000

Denmark

2001

2002

Finland

2003

2004

Norw ay

2005

2006

2007

2008

Sw eden

Sw it zerland

Chart 2

Note:

Selected OECD countries.

Source: OECD.

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An alternative to the Basel proposal would be to base the assessment of all

assets on their actual liquidity rather than whether they are government

bonds or covered bonds. More specifically, this may entail that covered

bonds become eligible for inclusion in the first group if they have been

admitted to trading on a regulated market, if the markets where they are

traded are of a considerable size, and if the markets have shown stable

pricing (but not necessarily price stability) throughout the crisis. To the

extent that it is necessary to make a distinction between securities with

differing price stability, this can be done via the haircuts applied.

Liquidity of Danish mortgage-credit bonds

Several countries have a long-standing tradition for issuing covered bonds,

and the outstanding volume of covered bonds is substantial compared to

government debt, cf. Chart 3. In Denmark the volume of covered bonds is

more than 4.5 times as large as the government debt. Germany, Spain and

Sweden also have considerable volumes of covered bonds, however.

GOVERNMENT DEBT AND COVERED BONDS AS PERCENTAGES OF GDP

Per cent

180

160

140

120

100

2003

2004

2005

2006

2007

2008

Chart 3

Denmark - Covered Bonds

Sw eden - Covered Bonds

Spain - Government debt

Germany - Covered Bonds

Denmark - Government debt

Sw eden - Government debt

Spain - Covered Bonds

Germany - Government debt

The data has been compiled on a comparable basis across countries, but it is not necessarily fully comparable with other Danish

statistics.

Source: Eurostat and European Covered Bond Fact Book 2009.

Note:

In addition to the considerable size of the market, Danish covered bonds

have a broad investor base. Table 1 shows the ownership distribution from

2005 to 2009. As can be seen, the distribution is very stable over time.

Although a tendency for foreign divestment of Danish covered bonds could

be seen in 2008, the volume was only reduced from 14 to 11 per cent and

was offset by an increased ownership share for MFIs (monetary financial

institutions), which hold around one third of the issued bonds. This very

large MFI ownership share is also reflected in the fact that covered bonds

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currently make up a considerable share of their liquid assets, cf. the section

below on the liquidity of banks.

MORTGAGE-CREDIT ISSUE BY OWNER

MFIs

(excl.

Non-financial

own

corporations holdings )

Other

financial

inter-

General Households,

mediaries, Insurance

etc.

and pension government

etc.

Unallocated

Table 1

Per cent

Abroad

2005

2006

2007

2008

2009

................................

Note: Calculated on the basis of market values at year-end.

Source: Danmarks Nationalbank.

The considerable volume and broad investor base support very stable pricing

of Danish covered bonds. Chart 4 shows the 30-day price change (in per

cent) for an investment in a portfolio of non-callable covered bonds with a

duration of two years compared with investments in two-year benchmark

government securities in three Aaa-rated countries: Denmark, the UK and

the USA. It appears from the chart that in terms of prices the portfolio of

covered bonds is just as stable an investment as Aaa-rated government

securities. Accordingly, the negative return on the covered bond portfolio

only exceeded that on government bonds in the autumn of 2008. Even then,

the loss measured over 30 days was smaller than the losses on government

bonds seen in mid-2008.

Chart 4 compares Danish covered bonds with government bonds from Aaa-

rated countries. Government bonds are not required to be Aaa-rated in order

to be included in the banks' stock of liquid assets, however. A comparison of

Danish covered bonds with lower-rated government bonds will show that

Danish covered bonds are periodically a

stable investment in terms of

prices than such government bonds.

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GOVERNMENT BONDS AND DANISH COVERED BONDS

Per cent

-1

-2

-3

-4

2003

2004

2005

2006

2007

2008

2009

Chart 4

2010

Denmark government bonds

USA government bonds

Note:

UK government bonds

Denmark covered bonds

Return over 30 trading days. 2-year benchmark government bond. Covered bonds is a portfolio of non-callable bonds with a

constant duration of two years.

Source: Nordea Analytics.

However, it is not only the pricing of short-term covered bonds that is very

stable. Chart 5 shows the return over 30 days for investments in benchmark

Danish covered bonds with a remaining maturity of 10 and 30 years,

respectively. According to the chart, the financial crisis has not resulted in

negative returns of much more than 4 per cent, viewed over a 30-day period.

This is much less than the benchmark price fluctuations of 10 per cent in the

proposal. Despite the fact that the spread between covered bonds and

government securities has widened slightly during the financial crisis, this

has not resulted in negative returns that are larger in a historical perspective

than previously observed based on general yield fluctuations. In the light of

the price development, it is therefore difficult to see why covered bonds

should not be included in liquidity on an equal footing with government

bonds.

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DANISH COVERED BONDS

Per cent

-2

-4

-6

-8

-10

1996

1997

1998

1999 2000

2001

2002

2003

2004

2005

2006 2007

2008

2009

Chart 5

2010

10-year benchmark securit y

Note:

Return over 30 trading days.

Source: Nordea Analytics.

30-year benchmark securit y

One argument against using covered bonds as liquidity on an equal footing

with government bonds might be that the return on the securities relative to

government bonds is correlated with the market's confidence in the financial

sector. If this is the case, the yield spread between covered bonds and

government bonds and the price development for financial corporations

must be expected to be negatively correlated, i.e. falling prices will lead to

higher yield spreads.

Chart 6 shows the weekly changes in the yield spread between a 10-year

Danish benchmark covered bond and a 10-year Danish government bond for

the period from mid-2001 to end-2009 and for 2008, respectively. The yield

spread changes are plotted against the weekly price changes for Danish

financial shares. The chart indicates a weak tendency for the yield spread to

widen in connection with a decline in the prices of financial shares. The

coefficient of determination is very low, however.

It is clear that the changes in the yield spread were greater in 2008 than

previously observed – particularly with regard to widening of the spread –

which must be attributed to the financial crisis. Even during the peak of the

financial turmoil, the correlation with the development in financial shares

remains weak, so there is no reason to restrict the use of covered bonds as

liquidity against this background. Again, the yield spreads of certain

government bonds – measured relative to Germany – show a somewhat

greater correlation with the development in financial shares quoted in the

country in question.

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CORRELATION BETWEEN THE YIELD SPREAD AND FINANCIAL SHARES

Change in yield spread, bps

Mid-2001 t o end 2009

2008 (R = 5,8 pct .)

Chart 6

= 5,2 pct .)

-10

-20

Change in share

prices, per cent

-30

Note:

-30

-20

-10

Changes in yield spreads are weekly option-adjusted changes. Changes in share prices are weekly changes in an index of

financial shares in Denmark.

Source: Nordea Analytics and Bloomberg.

As a general rule, Danish covered bonds are all admitted to trading at

NASDAQ OMX Copenhagen and registered in VP Securities. This means

they are eligible as collateral for loans from Danmarks Nationalbank and are

traded in large volumes in secondary markets (securities denominated in

euro and registered in VP Lux S.à r.l., VP Securities' subsidiary in

Luxembourg, are also eligible as collateral for loans from the European

Central Bank).

When covered bonds are pledged as collateral for loans from Danmarks

Nationalbank, the collateral value is calculated according to rules laid down

by the European Central Bank. Covered bonds with a circulating volume

exceeding 1 billion euro or the equivalent amount in Danish kroner that are

comprised by the Danish Securities Dealers Association's market maker

arrangement

and have at least three price quoters are placed in liquidity

category 2, while the other covered bonds are placed in liquidity category 3,

cf. Table 2. Compared with the haircuts used for covered bonds by the

European Central Bank and Danmarks Nationalbank, the proposal from the

Basel Committee for a haircut of 20 per cent at a rating of minimum AA

seems to be an extremely conservative approach.

The Danish Securities Dealers Association's market maker arrangement is a voluntary

arrangement between members of the Association for trading among themselves in a

number of mortgage-credit bonds.

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HAIRCUTS FOR "COVERED BONDS" WITH A FIXED COUPON RATE AT DANMARKS

NATIONALBANK

Remaining maturity

Category 1

Category 3

Table 2

0-1 year ..................................................................

1-3 years .................................................................

3-5 years .................................................................

5-7 years .................................................................

7-10 years ...............................................................

> 10 years ...............................................................

1.0 pct.

2.5 pct.

3.5 pct.

4.5 pct.

5.5 pct.

7.5 pct.

1.5 pct.

3.0 pct.

4.5 pct.

5.5 pct.

6.5 pct.

9.0 pct.

Note: For eligible securities with a zero coupon rate, a floating coupun rate or an inverse floating rate, the haircuts appear from "The

implementation of monetary policy in the euro area", ECB, November 2008.

When Danish covered bonds are pledged as collateral for loans in Danish

kroner, no rating requirement is applied to the bonds. In practice, the bonds

would be able to meet an exceedingly stringent rating requirement, however.

The most important bond issuances from the three largest issuers have thus

been given the highest possible rating by both Moody's and Standard &

Poor's, while issuances from the other rated institutes have been given the

second-highest rating by Moody's. A comparison of these ratings with the

government debt of various EU countries clearly shows that despite the fact

that they are generally beginning to show a more conservative approach to

covered bonds, rating agencies continue to rate Danish covered bonds as a

class of assets with a very low credit risk.

Consequences of the proposed change for the banks' liquidity

The liquidity requirements must also take into account the banks' ability to

acquire a sufficient volume of assets that are defined as liquid. It would

therefore seem obvious that the most liquid covered bonds should be eligible

for inclusion in the same group as government bonds. This would also allow

for the fact that in terms of credit risk and liquidity these bonds have more

features in common with government bonds than with corporate bonds.

At end-2008, the banks' liquidity calculated according to national rules

amounted to kr. 940 billion. The Basel proposal restricts the definition of

liquidity. In the strictest interpretation of the proposal, where no types of

securities other than government bonds are eligible for inclusion in the stock

of liquid assets, Danish banks will have "secure" liquidity of only kr. 174

billion.

The Basel proposal provides the option of including covered bonds and

corporate bonds in liquidity, albeit with a number of restrictions. They are

not allowed to make up more than 50 per cent of the overall stock of liquid

assets. Considerable haircuts will be applied, and the bonds will have to

meet a number of requirements as regards market structures, bid-ask

spreads, etc.

At end-2008, the banks' securities amounted to approximately kr. 900

billion, cf. Table 3.

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THE BANKS' HOLDINGS OF SECURITIES AT END-2008

Kr. billion

Table 3

Mortgage-credit bonds ............................................

Government bonds .................................................

Other bonds ............................................................

Bonds, total .............................................................

Shares, etc. .............................................................

443

370

882

Assuming that mortgage-credit bonds meet the criteria for inclusion as

covered bonds, and that they must not exceed 50 per cent of stock of liquid

assets, the overall stock will amount to kr. 348 billion, cf. Table 4.

THE BANKS' STOCK OF LIQUID ASSETS, INCLUDING MORTGAGE-CREDIT BONDS, END-

2008

Table 4

Kr. billion

"Secure" liquidity ..........................................................................

Mortgage-credit bonds, including haircuts of 20 per cent ..............

Total liquidity, max. 50 per cent mortgage-credit bonds ................

174

354

348

Hence, there seems to be a risk that the proposal will reduce the banks'

liquidity from kr. 940 billion according to the existing local rules to just

under kr. 350 billion.

The immediate conclusion is therefore that the banks will have to perform

extensive rebalancing, including portfolio restructuring from mortgage-

credit bonds, etc. to government bonds, in order to comply with the Basel

proposal.

Requirement for stable funding – net stable funding ratio

The Basel proposal also operates with a requirement concerning funding

stability. According to the definition of stable funding, Danish covered

bonds with a remaining maturity of less than one year are not regarded as

stable funding. At the same time, loans with a maturity of more than one

year are subject to a 100 per cent stable funding requirement. This will

create considerable problems in relation to Danish adjustable-rate loans that

are financed by short-term bonds.

The same problem will occur – even without the stable funding requirement

– in the last 30 days before the short-term bonds mature. The reason is that a

new short-term liquidity coverage ratio is also being considered, which

would require institutes to hold liquid assets that, as a minimum, match their

liquidity requirements over a 30-day horizon.

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With regard to Danish mortgage-credit institutes, it should be noted that any

increases in interest rates in connection with refinancing are borne by the

borrower rather than the mortgage-credit institute. The Basel Committee's

liquidity target does not allow for the fact that this reduces the refinancing

risk.

Leverage restriction

Finally, it should be noted that placing a restriction on leverage – total

activities as a ratio of equity – is currently being considered. This is to be

done by introducing a leverage ratio as an actual capital requirement. Unlike

the usual capital requirement, such a leverage ratio would disregard whether

the loans granted by the institute are good or bad. Particularly for the Danish

mortgage-credit institutes, which are characterised by a very low credit risk,

a universal capital requirement that does not take into account the specific

circumstances of the institute may result in much higher levels that do not

reflect the actual underlying, more limited risks of the mortgage-credit

institutes.

Assuming a capital requirement of 4 per cent of unweighted assets, the

immediate result would be much stricter capital requirements than today.

For several institutes this would raise the capital requirement by 100-200 per

cent.

Given the mortgage-credit institutes' existing capital base, such a

requirement would result in the capital base of a few institutes no longer

being sufficient. For other institutes it would lead to a substantial reduction

of the existing excess cover.

In view of the limited risk that mortgage-credit institutes are allowed to

assume as a result of considerable restrictions on market and credit risk, as

well as the borrower's personal liability, etc., such a substantial leverage

restriction therefore seems unreasonable for mortgage-credit institutes.

If the requirement is maintained, leaving it up to the supervisory authority to

determine such a target based on the specific history and risk profile of the

individual institute should be considered.

Alternatively, it may be considered to set a reduced target for mortgage-

credit institutes in the light of historical experience in the area – with no

bond investors ever having suffered credit losses – e.g. a low minimum

requirement such as 2 per cent of the balance sheet/loan stock.

As a negative consequence of a requirement of e.g. 4 per cent, the mortgage-

credit institutes may choose more risky corporate loans over more secure

retail mortgage loans. Having to hold so much equity capital might give the

institutes an incentive to take on more risky and profitable business of this

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nature in order to achieve a return on equity. This will not benefit the

security of covered bonds, and in view of the importance and volume of

covered bonds in Denmark it may also ultimately have a negative impact on

financial stability.

An alternative consequence might be that the institutes increase the

contribution rates (corresponding to the interest-rate margin) and thus the

borrowers' costs.

Leverage ratios should therefore not constitute specific independent capital

requirements. Instead, they should be included in the calculation of the

institutes' capital (solvency) need, which should, obviously, be supervised

by the Financial Supervisory Authority.