## _cr07123

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---

### I. Introduction
- Danish mortgage system described as among the most sophisticated housing finance markets in the world.
- Paper objectives:
  - discuss the particularities of the regulatory framework of the Danish mortgage system;
  - compare and contrast mortgage financing in Denmark and in other European countries (product side: mortgage loans; funding side: mortgage bonds) and discuss recent European regulatory evolutions;
  - highlight challenges faced by the Danish mortgage system.

### II. The Danish mortgage system: regulatory framework — core features
- System implements a strict balance principle enabling pass-through mortgage financing and allowing borrowers to obtain close-to-capital market financing conditions.
- Mortgage bonds transfer market risk from issuing mortgage banks to bond investors.
- Strict property appraisal rules and credit risk management by mortgage banks historically shield mortgage bonds from default risk.

### A. Mortgage Credit Institutions (MCIs): structure and constraints
- MCIs are specialized lenders restricted to narrowly defined mortgage credit activities and are the only financial institutions allowed to grant loans against mortgage on real property by issuing mortgage bonds (Realkreditobligationer).
- Permitted activities:
  - Origination and servicing of mortgage loans, funding exclusively through issuance of mortgage bonds, and activities deemed accessory.
  - Not authorized to fund credit activity with deposits or issue guarantees, but can develop banking and insurance activities through subsidiaries.
- Historical and market structure notes:
  - System established as a cooperative or mutual system at the end of the 18th century; first Danish Mortgage Act passed in 1850.
  - Major reform in 1989 removed restrictions to establishment of new mortgage credit institutions and authorized commercial banks to own MCIs.
  - Today, eight mortgage credit institutions active in the Danish mortgage market (examples in source).
  - Market concentration: Market Share of the Five Biggest Lenders, in Percent (2003): Denmark 95; France 75; Germany 45; Italy 65; Netherlands 75; Spain 50; Sweden 95; UK 60; Czech. Republic 80; Hungary 70; Poland 80.
  - Footnote: Following the acquisition of Totalkredit by Nykredit in 2004, the five biggest lenders represent more than 99 percent of mortgage lending in Denmark.
- Distribution and competition:
  - MCIs often rely on branch networks of commercial banks and agreements with realtors for distribution.
  - Competition focuses on product innovation and distribution.

### B. The balance principle — matching, limits, and risk management
- Matching rule:
  - Each new loan is in principle funded by issuance of new mortgage bonds of equal size and identical cash flow and maturity characteristics; proceeds from bond sales passed to borrowers; interest and principal payments passed directly to bond investors.
- Fees and margins:
  - Mortgage institution service paid by borrowers via front-end fees, annual administrative fees, and pre-payment fees.
  - Annual contribution paid by borrowers depends on the level of the Loan To Value ratio at bond issuance and usually represents 0.5 percent of the remaining debt.
- Evolution:
  - Prior to 2000: perfect match required between assets and liabilities for interest rate and maturity.
  - 2000 amendments: “global” balance principle focusing on aggregate risks (interest rate, liquidity, exchange rate and counterparty risks).
- Specific relaxations and limits:
  - Up to 2 percent of a bond series can be collateralized by safe substitute assets.
  - Interest rate risk from mismatches cannot represent more than 1 percent of the capital base.
  - Liquidity gaps limited as a declining proportion of capital base by payment date:
    - payments expected in more than 10 years: can represent up to 100 percent of the capital base;
    - payments due between year 4 and year 10: cannot exceed 50 percent of the capital base;
    - payments due between year 1 and year 3: limited to 25 percent of the capital base.
  - Options to manage assets and liabilities normally limited to options with a maturity of four years or less.
  - Exchange rate risk not allowed in excess of 0.1 percent of the capital base.
- Capital base management:
  - Capital adequacy requirements apply at the institution level and at each capital center.
  - At least 60 percent of the capital base (and reserves) must be invested in listed bonds, and the associated interest rate risk, measured as a 100 bp adjustment, must not exceed 8 percent of the capital base.
  - Real estate assets and property companies cannot represent more than 20 percent of the capital base.
- Risk profile:
  - MCIs' principal residual risk is credit risk: borrower default risk and property value risk.
  - New loan types (e.g., deferred amortization loans) increase credit risk because repayments are postponed.

### C. Strict lending rules and foreclosure
- Maximum lending periods and LTV ratios:
  - Maximum lending period: up to 30 years for all categories of properties (and up to 35 years for cooperative homes).
  - Maximum LTV ratios by property type:
    - owner-occupied homes, rental properties, cooperative homes and housing projects: up to 80 percent of property value;
    - agricultural properties: 70 percent;
    - commercial real estate and secondary residences: 60 percent;
    - un-built sites: 40 percent.
  - Change in property purpose or category can change mortgage loan characteristics.
- Property valuation:
  - Conservative approach required; estimated value should fall within amount an experienced buyer with market knowledge would be willing to pay.
  - Factors resulting in particularly high prices shall be discarded; property must be valued on sight.
  - Mortgage lenders not required to periodically mark-to-market property values after initial assessment.
- Registration and foreclosure:
  - Three registers: the cadastre (Kort-og Matrikelstyrelsen); the Land Book (registers rights and provides safe titles; administered by district courts under the Ministry of Justice); the Municipal Register of Real Properties (valuation for land taxes).
  - Foreclosure: mortgage bank may put the property up for forced sale via enforcement courts; mortgagees covered in order of priority; uncovered mortgage loans deleted from Land Register but mortgagees retain personal claims.
  - Typical timeline: typically takes no more than six months from borrower default until a forced sale can be carried through.

### D. Supervision of mortgage banks
- Supervisory approach:
  - Danish Financial Supervisory Authority (DFSA) combines general risk-based supervision for banking with a specific focus on the Mortgage Credit Act framework.
  - DFSA distinguishes “general risk” inherent to institution type and “specific risk” associated with each institution.
  - MCIs considered “average general risk” (commercial banks considered “high general risk”) due to legal/regulatory limitations on risks.
- Supervisory tools and indicators:
  - Internal rating system estimates specific risk using ratios related to solvency, growth in loan portfolios, and evolution of market risks to set supervision intensity.
  - Indicators based on issuance of mortgage bonds and origination of loans assess implementation of the balance principle.
  - Analysis by property type and comparative reports on late payments and losses monitor credit risk.
  - On-site inspections focus on property valuation practices; complement off-site supervision.

### 16. Product side — mortgage loans (major features and market dynamics)
- Dominant product:
  - Fixed rate callable annuity loans remain the dominant mortgage loans.
- New loan types since mid-1990s:
  - Adjustable interest rate loans reintroduced in 1996, maturity up to 30 years; associated bonds shorter than loans; refinancing at periodic intervals with interest adjusted at refinancing.
  - Adjustable interest loans may be granted in installments over specified years.
  - Interest-only loans with installment free period up to 10 years introduced in 2003 (adjustable or fixed).
  - Mortgage loans with interest rate guarantees introduced in 2004 in two main forms:
    - floating-to-fixed loans: conversion when 6-month CIBOR reaches cap, then remain fixed;
    - capped-floater loans: interest rate reduced if rate later declines; combine fixed-interest loan with interest reset features; based on variable interest bonds adjusted over CIBOR every 6 months.
  - Underlying bond maturities for these products range from 5 to 30 years; entire loan refinanced when bond matures.
- Balance principle effect:
  - New loan types do not result in additional large funding or liquidity risk for mortgage banks due to balance principle.
  - Some loans (interest-only) may increase borrower risk and could contribute to higher non-performing loans when credit cycle deteriorates.
- Market trends:
  - Mortgage loans with interest rate fixation periods of less than a year (including capped loans) in Denmark grew from 4.2 percent to about 37 percent between 1999 and Q2 2006.
  - In the UK, their market share declined from 80.5 percent to 75 percent over the same period.
- Call and delivery options:
  - Standard loans embed call and delivery options enabling borrowers to pre-pay or buy-back loans at par or at prevailing market price.
  - Fixed-rate mortgage loans can be callable or non-callable; callable loans may be prepaid at par before maturity on a payment date or “at once”.
  - Adjustable interest rate loans and index-linked loans are always non-callable and can only be redeemed at par at adjustment; they can be prepaid any time by delivering underlying bonds.
- Bond loans vs cash loans (high-level distinctions preserved):
  - Bond loan: principal matches volume of issued bonds; amount paid to borrower corresponds to market value of issued bonds; interest equals coupon rate on underlying bonds.
  - Cash loan: principal corresponds to proceeds effectively paid to borrower; face value corresponds to market value of underlying bonds; interest equals yield to maturity and is higher than coupon since bonds usually issued below par.
  - Tax and hedging implications noted (Fixed Price Agreements and guarantees).
- Remortgaging dynamics and advisory services:
  - Increased product variety contributed to higher remortgaging during declining long-term interest rates.
  - Remortgaging often yields lower future net payments but may increase overall outstanding debt.
  - Adjustable loans expanded remortgaging strategies depending on yield curve movements.
  - Advisory services became more sophisticated and systematic in monitoring remortgaging opportunities.
  - Products such as capped loans may lead to a decline in remortgaging over the longer term.
- Market completeness and cost-efficiency:
  - Danish system combines a relatively high degree of completeness and cost-efficiency compared to other European systems.
  - 2003 Mercer Oliver Wyman and European Mortgage Federation study ranked Danish market third out of a sample of eight European markets on product variety, market access, distribution, and availability of information and advice.
  - Mercer Oliver Wyman computations (2003) found mortgage costs in Denmark were the third lowest among a sample of eight European countries; fees and credit risk management represented less than 10 bp each.

### B. Funding side — the Danish mortgage bond market
- Bond types and maturities:
  - Predominantly callable bonds with maturities between 10 and 30 years.
  - Non-callable bullet bonds used to finance interest reset loans with maturities between 1 and 11 years.
- Table 3 features (preserved structure):
  - Noncallable Bullet Bonds: Interest Payments Annual; Repayment Bullet; Coupon Fixed; Currency DKK and €; Maturities 1─11 years; Issuance Tap and auction, throughout maturity.
  - Callable Bonds: Interest Payments Quarterly; Repayment Annuity or IO; Coupon Fixed; Currency DKK and €; Maturities 10, 15, 20, 30 years; Issuance Tap, during the first 3 years.
  - Capped Floaters: Interest Payments Quarterly; Repayment Annuity or IO; Coupon Floating, capped; Currency DKK; Maturities 30 years; Issuance Tap, during the first 3 years.
  - Floating to Fixed Bonds: Interest Payments Quarterly; Repayment Annuity or IO; Coupon Floating, fixed; Currency DKK; Maturities 30 years; Issuance Tap, during the first 3 years.
- Market concentration and liquidity:
  - A small number of series (10─15) reach high outstanding amounts—the 10 largest mortgage bonds account for approximately 25 percent of total mortgage bond outstanding volumes—and are very liquid.
  - Mortgage banks enhance liquidity by reusing bonds when refinancing and by issuing bonds identical to those issued by others.
  - Majority of mortgage bonds traded primarily over-the-counter (OTC); also quoted on the Copenhagen Stock Exchange.
  - Market benefits from active repo market; mortgage bonds eligible as central bank collateral.
- Investor base and holdings (Q1 2005 and end-2004 figures in source):
  - Monetary institutions (commercial banks and mortgage banks) hold about 43 percent of mortgage bonds in circulation.
  - Pension funds and insurance companies together hold an estimated 25 percent.
  - Direct retail holding: 5 percent.
  - Share of foreign investors: close to 15 percent overall and increasing.
  - Foreign investors hold about 20 percent of the most liquid bonds and about 57 percent of total holdings of callable bonds by foreign investors.
  - Foreign holdings of short term non callable bullet mortgage bonds denominated in DKr: 6 percent; in euros: 22 percent at the end of 2004.

### C. Danish mortgage bonds and evolution of the European covered bond market
- Market composition and size (2004 data):
  - Mortgage bonds (and bonds issued by special institutions) accounted for 71 percent of the market value of bonds listed on the Copenhagen Stock Exchange.
  - Government bonds accounted for 27.4 percent; Asset-Backed Securities and corporate bonds represented 1.6 percent.
  - 1,673 mortgage bond issues listed, representing 75 percent of all listed bond issues.
- Relative European size:
  - Danish mortgage market is the second largest mortgage market in Europe: 14.2 percent of outstanding covered bonds, and 29.3 percent of covered bonds backed by mortgage loans.
  - Germany: 61.4 percent of total outstanding covered bonds; 32.4 percent mortgage bonds; 89.5 percent public sector bonds.
- Table 4 country shares (end 2004, preserved):
  - Germany: Total Covered Bonds 61.4; Mortgage Bonds 32.4; Public Sector Bonds 89.5
  - Denmark: Total Covered Bonds 14.2; Mortgage Bonds 29.3
  - France: Total Covered Bonds 6.1; Mortgage Bonds 8.2; Public Sector Bonds 4.2
  - Spain: Total Covered Bonds 6.1; Mortgage Bonds 11.9; Public Sector Bonds 0.7
  - Sweden: Total Covered Bonds 5; Mortgage Bonds 10.4
  - Ireland: Total Covered Bonds 1.9; Mortgage Bonds 0.3; Public Sector Bonds 3.4
  - Switzerland: Total Covered Bonds 1.8; Mortgage Bonds 3.6
  - Luxembourg: Total Covered Bonds 1.2; Public Sector Bonds 2.3
  - U.K: Total Covered Bonds 0.9; Mortgage Bonds 1.9
  - Netherlands: Total Covered Bonds 0.8; Mortgage Bonds 1.6
  - Others: Total Covered Bonds 0.7; Mortgage Bonds 1.4
  - Total: 100; Mortgage Bonds: 100; Public Sector Bonds: 100
  - Memo: in € million: 1,644,927 (Total Covered Bonds); 795,135 (Mortgage Bonds); 849,792 (Public Sector Bonds)
- Potential risks:
  - Increased diversity of mortgage loans may produce smaller and more heterogeneous bond issues, reducing liquidity.
  - Reduced liquidity could affect foreign investor appetite and limit ability to build a complete, homogeneous mortgage bond yield curve.

### 28–36. Covered bonds: legal features, CRD/UCITS changes, and implications
- Covered bonds defined: debt instruments secured on a specific pool of assets with senior claim; investors have recourse to both a pool of collateral and the issuing entity.
- Structural contrasts summarized (covered bonds vs Danish mortgage bonds vs ABS/MBS):
  - Production process: Bundled Process for covered bonds and Danish mortgage bonds; Unbundled Process for Asset/MBS.
  - Type of securitization: On-Balance sheet for covered and Danish mortgage bonds; Off-Balance sheet for Asset/MBS.
  - Source of cash flows: Issuer cash flows for covered and Danish mortgage bonds; Collateral cash flows for Asset/MBS.
  - Loan pool structure: Covered and Danish mortgage bonds have dynamic pools with substitutable and mainly heterogeneous assets; Asset/MBS generally static, not substitutable, mainly homogeneous assets.
  - Investor protection: Bankruptcy privilege and asset segregation for covered and Danish mortgage bonds; Bankruptcy Remoteness for Asset/MBS.
- Country legal-framework differences (selected preserved entries):
  - Denmark: Entry into force "1850/1989/2003"; Specialist Bank "Yes"; Authorized assets "Any loan mortgaged on real property"; Loan to value "40–80 percent"; Basis for Valuation "Market value"; Protection against mismatches "Currency, interest rate and liquidity, strict balance principle"; Over-Collateralization (pool level) "Coincidental, but protected by law"; Asset pool after bankruptcy "Continues, legal segregation"; Special pool administration (in bankruptcy) "No".
  - Germany: Entry into force "1900/2004"; Specialist Bank "No"; Authorized assets "PS, RM, CM"; Loan to value "60 percent"; Basis for Valuation "Long-term sustainable value"; Over-Collateralization (pool level) "2 percent on a net present value basis"; Asset pool after bankruptcy "Continues, legal segregation"; Special pool administration "Yes".
  - France: Entry into force "1999"; Specialist Bank "Yes"; Authorized assets "PS, EM and CM"; Loan to value "60, 100 percent"; Basis for Valuation "Market value"; Over-Collateralization (pool level) "Mandatory (10 percent of cover assets)"; Asset pool after bankruptcy "Continues, insolvency privilege"; Special pool administration "No".
  - Spain: Entry into force "1981/2003"; Specialist Bank "No"; Authorized assets "PS, RM, CM"; Loan to value "70, 80 percent"; Basis for Valuation "Market value"; Over-Collateralization (pool level) "Mandatory (11-43 percent of cover assets)"; Asset pool after bankruptcy "Continues, insolvency privilege"; Special pool administration "No".
- European Directives (UCITS and Capital Requirement Directive — CRD) changes:
  - Revised UCITS Directive and CRD provide clearer definition of covered bonds and list classes of eligible collateral.
  - Major changes: additional minimum requirements on type and credit quality of cover assets, and on valuation and monitoring of loan collaterals for privileged risk weighting.
  - Uniform 10 percent privilege risk weighting previously applied to covered bonds will be discontinued.
  - UCITS Art. 22 (4) definition preserved in source (four conditions).
- Preferential investment limits preserved:
  - Member states can authorize UCITS to invest up to "25 percent" of their assets in covered bonds issued by the same issuer (instead of the standard "5 percent").
  - Life insurance directive authorizes life insurers to invest up to "40 percent" (rather than "5 percent") of “bound assets” in covered bonds issued by a single issuer.
  - Banking Coordination Directive permits member states to ascribe a "10 percent" risk weighting to bonds that fall within the UCITS definition.
- CRD eligibility categories and limits (exact text preserved):
  - (i) Exposures to (or guaranteed by) central banks, central and regional governments, local authorities and other public sector entities in the European Union,
  - (ii) Exposures to (or guaranteed by) non-EU central banks, central governments, public sector entities, regional government and local authorities, multilateral development banks, international organizations, with ratings equivalent to "AA-" or better. Exposures to issuers with lower ratings ("A") should not exceed "20 percent" of the nominal amount of outstanding covered bonds of issuing institutions,
  - (iii) Loans secured by residential real estate ... for up to "80 percent" of the value of the pledged properties,
  - (iv) Loans secured by commercial real estate ... for up to "60 percent" of the value of the pledged properties,
  - (v) Total exposure to financial institutions (rated between "AA-" and "AAA"), permitted as liquid, substitution assets, cannot exceed "15 percent" of the nominal amount of outstanding covered bonds of the issuing institution.
- Risk-weighting implications under CRD (preserved ranges and values):
  - CRD allows options resulting in risk-weightings for covered bonds ranging "from 3 percent to 20 percent".
  - Standardized Approach table highlights "10" and "20" percent entries for various issuer ratings.
  - IRB Foundation (LGD "11.25 percent") example ranges: AAA "3.5-4.5"; AA+ to AA- "4.5-7.5"; A+ to A- "7.5-12.5"; BBB+ to BBB- "12.5-20".
  - IRB Advanced (example LGD "9 percent"): AAA "3-4"; AA+ to AA- "4-6.5"; A+ to A- "6.5-10.5"; BBB+ to BBB- "10.5-16".
- Market and incentive effects:
  - Variety of risk-weighting options will affect relative demand and lead to increased spread differentiation between issues.
  - Assessing CRD impact is difficult: credit institutions subject to CRD estimated to represent around "40 percent" of covered bond investors, but not the only investors; CRD applies only to investing banks located in E.U. countries.
  - Basel II/CRD framework provides little incentive to securitize residential mortgage loans; capital charges for low-rated securitization tranches are high under Basel II.
  - Likely stronger incentives to securitize asset classes with more punitive treatment under Basel II (examples: "CMBS, SMEs, low-rated corporates").

### Policy implications, trade-offs, and priorities for Denmark
- Transitional challenges:
  - To be recognized and given preferential treatment under Directives, the Danish mortgage framework would need amendments.
  - Specific mismatches:
    - Danish LTV requirements based on value at origination; Directive requires LTV calculations to be performed and respected "over the full life of the covered loan".
    - Danish regulatory framework currently recognizes only mortgage loans as eligible collateral; Directives recognize a wider range of collateral.
- Diverging stakeholder positions:
  - Commercial banks seek significant reshuffle to enter covered bond market and create level playing field.
  - Mortgage banks seek to preserve essential characteristics of the current mortgage system and advocate limited alterations.
- Trade-offs and risks:
  - Strict Danish balance principle makes mortgage bonds "true pass-through securities", transferring market risk from borrowers to bond investors and limiting mortgage banks' exposure largely to credit risk.
  - Amending the system to align with EU regulations may trade off some attractive features for potential benefits; careful attention needed to consumer protection, disclosure, transparency, and flexibility.
- Policy priorities emphasized:
  - Ensure continued effective disclosure and transparency.
  - Ensure a level playing field among market participants.

### Key numeric values and thresholds (preserved exactly from source)
- Annual borrower contribution: usually represents 0.5 percent of the remaining debt.
- Up to 2 percent of a bond series can be collateralized by safe substitute assets.
- Interest rate mismatch limit: 1 percent of the capital base.
- Exchange rate risk cap: 0.1 percent of the capital base.
- Liquidity gap limits by payment date:
  - >10 years: up to 100 percent of the capital base;
  - year 4–10: up to 50 percent of the capital base;
  - year 1–3: up to 25 percent of the capital base.
- Capital base investment requirement: at least 60 percent invested in listed bonds; interest rate risk measured as a 100 bp adjustment must not exceed 8 percent of the capital base.
- Real estate assets limit: cannot represent more than 20 percent of the capital base.
- Maximum lending period: up to 30 years (up to 35 years for cooperative homes).
- Maximum LTV ratios by property type:
  - owner-occupied, rental, cooperative homes, housing projects: up to 80 percent;
  - agricultural properties: 70 percent;
  - commercial real estate and secondary residences: 60 percent;
  - un-built sites: 40 percent.
- Market concentration (2003): Denmark 95 (Market Share of the Five Biggest Lenders, in Percent).
- Mortgage loans with interest rate fixation <1 year in Denmark: grew from 4.2 percent to about 37 percent between 1999 and Q2 2006.
- Comparable UK market share change: 80.5 percent to 75 percent over same period.
- Ten largest mortgage bonds account for approximately 25 percent of total mortgage bond outstanding volumes.
- Investor holdings (Q1 2005 / end-2004):
  - Monetary institutions hold about 43 percent of mortgage bonds.
  - Pension funds and insurance companies together hold an estimated 25 percent.
  - Direct retail holding: 5 percent.
  - Foreign investors: close to 15 percent overall.
  - Foreign holdings of short term non callable bullet mortgage bonds denominated in DKr: 6 percent; in euros: 22 percent at the end of 2004.
- Market shares (end 2004):
  - Mortgage bonds accounted for 71 percent of market value of bonds listed on Copenhagen Stock Exchange; government bonds 27.4 percent; Asset-Backed Securities and corporate bonds 1.6 percent.
  - Danish share of outstanding covered bonds: 14.2 percent; share of covered bonds backed by mortgage loans: 29.3 percent.
  - Memo values in € million: 1,644,927 (Total Covered Bonds); 795,135 (Mortgage Bonds); 849,792 (Public Sector Bonds).
- UCITS and CRD thresholds and examples:
  - UCITS investment limit in covered bonds by same issuer: "25 percent" (vs "5 percent" standard).
  - Life insurers: "40 percent" (vs "5 percent").
  - Previous uniform privileged risk weighting: "10 percent".
  - CRD Foundation IRB LGD example values: "11.25 or 12.5 percent".
  - Eligible collateral constraints: exposures to lower-rated issuers ("A") should not exceed "20 percent" of nominal outstanding covered bonds; substitution assets exposure cap "15 percent".
  - Possible risk-weighting range for covered bonds under CRD: "from 3 percent to 20 percent".
  - IRB Foundation example ranges: AAA "3.5-4.5"; AA+ to AA- "4.5-7.5"; A+ to A- "7.5-12.5"; BBB+ to BBB- "12.5-20".
  - IRB Advanced example ranges: AAA "3-4"; AA+ to AA- "4-6.5"; A+ to A- "6.5-10.5"; BBB+ to BBB- "10.5-16".
  - Market investor share estimate: credit institutions subject to CRD estimated to represent around "40 percent" of covered bond investors.
- Country-specific LTV examples:
  - Denmark "40–80 percent"; Germany "60 percent"; France "60, 100 percent"; Spain "70, 80 percent"; Sweden "60–75 percent".
- Over-collateralization examples:
  - France "Mandatory (10 percent of cover assets)"; Spain "Mandatory (11-43 percent of cover assets)"; Germany "2 percent on a net present value basis".

*Source: _cr07123 - References..............................................................................................................*

### References..............................................................................................................

### _cr07123 - References..............................................................................................................

### I. INTRODUCTION
- The Danish mortgage system is described as among the most sophisticated housing finance markets in the world.
- The paper will:
  - discuss the particularities of the regulatory framework of the Danish mortgage system;
  - compare and contrast mortgage financing in Denmark and in other European countries (product side: mortgage loans; funding side: mortgage bonds) and discuss recent European regulatory evolutions;
  - highlight challenges faced by the Danish mortgage system.

### II. THE DANISH MORTGAGE SYSTEM: REGULATORY FRAMEWORK
- The system implements a strict balance principle enabling pass-through mortgage financing and allowing borrowers to obtain close-to-capital market financing conditions.
- Mortgage bonds transfer market risk from issuing mortgage banks to bond investors.
- Strict property appraisal rules and credit risk management by mortgage banks have historically shielded mortgage bonds from default risk.

### A. Mortgage Credit Institutions are Specialized Lenders
- Mortgage Credit Institutions (MCIs):
  - are specialized lenders restricted to narrowly defined mortgage credit activities;
  - are the only financial institutions allowed to grant loans against mortgage on real property by issuing mortgage bonds (Realkreditobligationer);
  - are limited to origination and servicing of mortgage loans, funding exclusively through issuance of mortgage bonds, and activities deemed accessory;
  - are not authorized to fund credit activity with deposits or issue guarantees, but can develop banking and insurance activities through subsidiaries.
- Structure and concentration:
  - The Danish mortgage system includes mutual associations and public limited companies and was first established as a cooperative or mutual system at the end of the 18th century.
  - The first Danish Mortgage Act was passed in 1850.
  - Major reform in 1989 removed restrictions to establishment of new mortgage credit institutions and authorized commercial banks to own MCIs.
  - Today, there are eight mortgage credit institutions active in the Danish mortgage market; examples provided: DLR, LR, Nordea Kredit, RealKredit Danmark, FIH, BRFKredit, NykreditRealkredit.
  - The Danish mortgage market is highly concentrated; Table 1 reports: Market Share of the Five Biggest Lenders, in Percent (2003):
    - Denmark 95
    - France 75
    - Germany 45
    - Italy 65
    - Netherlands 75
    - Spain 50
    - Sweden 95
    - UK 60
    - Czech. Republic 80
    - Hungary 70
    - Poland 80
  - Footnote: Following the acquisition of Totalkredit by Nykredit in 2004, the five biggest lenders represent more than 99 percent of mortgage lending in Denmark.
- Distribution channels:
  - MCIs often lack own distribution networks and offer products through branch networks of commercial banks and agreements with realtors.
  - Competition focuses on product innovation and distribution.

### B. The Balance Principle
- Core features:
  - The balance principle imposes strict matching rules between assets (mortgage loans) and liabilities (mortgage bonds).
  - Each new loan is in principle funded by issuance of new mortgage bonds of equal size and identical cash flow and maturity characteristics.
  - Proceeds from bond sales are passed to borrowers; interest and principal payments are passed directly to bond investors.
- Fees and margins:
  - Service by mortgage institution is paid by borrowers via front-end fees, annual administrative fees, and pre-payment fees.
  - The annual contribution paid by borrowers depends on the level of the Loan To Value ratio at bond issuance and usually represents 0.5 percent of the remaining debt.
- Evolution of balance rules:
  - Prior to 2000: perfect match required between assets and liabilities for interest rate and maturity.
  - 2000 amendments introduced a “global” balance principle focusing on aggregate risks (interest rate, liquidity, exchange rate and counterparty risks), allowing enhanced product innovation while retaining tight asset and liability management constraints.
- Specific relaxations and limits:
  - Up to 2 percent of a bond series can be collateralized by safe substitute assets (e.g., government bonds) to facilitate redemption risk management.
  - Interest rate risk arising from mismatches between assets and liabilities cannot represent more than 1 percent of the capital base of the institution.
  - Liquidity gaps, measured as the net present value of cash flows related to loans and funding, are limited to a declining proportion of the capital base as payment date nears:
    - payments expected in more than 10 years: can represent up to 100 percent of the capital base;
    - payments due between year 4 and year 10: cannot exceed 50 percent of the capital base;
    - payments due between year 1 and year 3: limited to 25 percent of the capital base.
  - Options to manage assets and liabilities are normally limited to options with a maturity of four years or less.
  - Mortgage credit institutions are not allowed to carry exchange rate risk in excess of 0.1 percent of their capital base.
- Capital base management:
  - Capital adequacy requirements apply at the level of the institution and at the level of each capital center.
  - At least 60 percent of the capital base (and reserves) must be invested in listed bonds, and the associated interest rate risk, measured as a 100 bp adjustment, must not exceed 8 percent of the capital base.
  - Real estate assets and property companies cannot represent more than 20 percent of the capital base.
- Risk profile:
  - The risk assumed by MCIs is largely limited to credit risk, comprising borrower default risk and property value risk.
  - New loan types (e.g., deferred amortization loans) increase credit risk because repayments are postponed.

### C. Strict Lending Rules
- Maximum lending periods and LTV ratios:
  - Maximum lending period: up to 30 years for all categories of properties (and up to 35 years for cooperative homes).
  - Maximum LTV ratios by property type:
    - owner-occupied homes, rental properties, cooperative homes and housing projects: up to 80 percent of property value;
    - agricultural properties: 70 percent;
    - commercial real estate and secondary residences: 60 percent;
    - un-built sites: 40 percent.
  - A change in the purpose of a mortgaged property or transfer to another property category can change mortgage loan characteristics.
- Property valuation:
  - MCIs are expected to adopt a conservative approach when assessing mortgageable value.
  - Valuation principle: estimated value should fall within the amount an experienced buyer with market knowledge would be willing to pay.
  - Risks of changes in market conditions and structural conditions must be taken into account; factors resulting in particularly high prices shall be discarded.
  - The property serving as collateral must be valued on sight.
  - After initial assessment, mortgage lenders are not required to periodically mark-to-market property values backing loans.

### D. Registration and Foreclosure
- Registers:
  - Denmark maintains three registers of real properties:
    - The cadastre (Kort-og Matrikelstyrelsen) gives a specific identification number to each land parcel.
    - The Land Book registers all rights attached to each property and provides safe titles; only when a mortgage is correctly registered in the Land Book can the mortgage bank grant a loan without other security. The Land Book is administered by district courts under the Ministry of Justice.
    - The Municipal Register of Real Properties gathers data on valuation of land parcels and buildings and is mainly used for land taxes.
- Foreclosure procedures:
  - In case of mortgage non-payment, the mortgage bank may put the property up for forced sale via enforcement courts.
  - Mortgagees are covered in order of priority; uncovered mortgage loans will be deleted from the Land Register but mortgagees retain personal claims against the borrower.
  - Typical timeline: it typically takes no more than six months from borrower default until a forced sale can be carried through.

### E. The Supervision of Mortgage Banks
- Supervisory approach:
  - The Danish FSA supervision combines the general risk-based approach used for banking institutions with a specific focus on the Mortgage Credit Act framework.
  - The DFSA distinguishes between “general risk” inherent to the institution type and “specific risk” associated with each institution.
  - MCIs are considered “average general risk” (in contrast to commercial banks assumed to have “high general risk”) due to legal and regulatory limitations on risks.
- Supervisory tools and indicators:
  - The supervisor’s internal rating system estimates specific risk using ratios related to solvency, growth in loan portfolios, and evolution of market risks to set supervision intensity.
  - For MCIs, indicators based on issuance of mortgage bonds and origination of loans assess implementation of the balance principle.
  - Analysis of loans by property type and comparative reports on late payments and losses monitor credit risk evolution.
  - Specific on-site inspection programs focus on property valuation practices and complement off-site supervision.

*Source: _cr07123 - References..............................................................................................................*

### 16.      The balance principle and the tight regulatory framework in which mortgage credit

### 16.      The balance principle and the tight regulatory framework in which mortgage credit

### A. The Product Side: Mortgage Loans
- Fixed rate callable annuity loans remain the dominant mortgage loans.
- New loan types since the mid-90s respond to changing borrower and investor demand:
  - Adjustable interest rate loans reintroduced in 1996, with maturity up to 30 years. Associated mortgage bonds have a shorter maturity than the corresponding loans. The entire remaining debt, or a specific fraction of it, is refinanced at periodic intervals. At the time of refinancing, the interest on the loan is adjusted to the market level.
  - Adjustable interest loans can be granted in a series of installments over a specified number of years.
  - Loans with an installment free period of up to 10 years (interest-only loans) introduced in 2003, as adjustable interest loans or fixed rate loans.
  - Mortgage loans with interest rate guarantees introduced in 2004 in two main forms:
    - floating-to-fixed loans: conversion takes place when the 6-month CIBOR rate reaches the cap, then remain fixed even if the market rate later declines;
    - capped-floater loans: interest rate is reduced if the rate later declines again; combine a fixed-interest rate loan with interest reset features and are based on variable interest bonds, adjusted over CIBOR every 6 months.
  - Maturities of the underlying bonds for these products range from 5 to 30 years; the entire loan is refinanced when the bond matures.
- Balance principle effect:
  - Thanks to the balance principle, these new types of loans do not result in additional large funding or liquidity risk for the mortgage banks.
  - However, some loans (interest-only loans) may prove more risky for borrowers and may strain repayment ability of residential and corporate borrowers, potentially contributing to a more general increase in non-performing loans when the credit cycle deteriorates.
- Market trends and statistics:
  - Mortgage loans with interest rate fixation periods of less than a year (including capped loans) in Denmark grew from 4.2 percent to about 37 percent between 1999 and Q2 2006.
  - In the UK, their market share declined from 80.5 percent to 75 percent over the same reference period.
- Call and delivery option features:
  - Standard Danish mortgage loans embed call and delivery options enabling borrowers to pre-pay or buy-back loans at par or at prevailing market price.
  - Outside Denmark, only U.S. fixed-rate mortgage contracts offer penalty-free prepayment (but no delivery option).
  - Fixed-rate mortgage loans can be callable or non-callable. Callable loans may be prepaid at par before maturity, either on a payment date or “at once” (i.e., before the next payment date).
  - Adjustable interest rate loans (and index-linked loans) are always non-callable and can only be redeemed at par at the time of adjustment; they can be prepaid at any time by delivering the underlying bonds.
  - In high interest rate environments, borrowers can cancel loans by buying back equivalent bonds in the market rather than prepaying at a loss; buying back below par and refinancing closer to par can allow capital gains in return for accepting larger coupon payments.
- Bond loans vs cash loans (Box 1):
  - Bond loan: loan principal matches volume of issued bonds; amount paid to borrower corresponds to market value of issued bonds; interest rate on loan equals coupon rate on underlying bonds.
  - Cash loan: principal corresponds to proceeds effectively paid to borrower; face value of the loan corresponds to market value of underlying bonds; interest rate equals yield to maturity of underlying bonds and is higher than coupon rate since bonds are usually issued below par.
  - Compared to bond loans, non-deductible capital loss in bond loans is transformed into higher, tax deductible, interest payments in cash loans; prepayment of cash loans leads to taxation of investment gains.
  - Fixed Price Agreements and guarantees allow borrowers to hedge uncertainty associated with bond and cash loans.
- Remortgaging dynamics:
  - Increased variety of loans contributed to higher remortgaging activity during periods of declining long-term interest rates.
  - Remortgaging into lower nominal interest rate loans usually yields lower future net payments but often increases overall outstanding debt.
  - In rising long-term interest rate environments, redeeming at a lower market price and refinancing can reduce outstanding debt at the cost of higher future interest payments.
  - Introduction of adjustable interest rate loans expanded remortgaging strategies: in a steepening yield curve and rising long-term rates, borrowers with fixed-rate callable loans can refinance into shorter variable rate loans to reduce outstanding debt; in a flattening environment with declining long-term rates, holders of variable rate loans may refinance into long-term fixed mortgages.
  - Increased sophistication of advisory services at mortgage credit institutions led to more systematic monitoring of remortgaging opportunities.
  - Products such as capped loans are likely to lead, ultimately, to a decline in remortgaging over the longer term.
- Market completeness and cost-efficiency:
  - Danish mortgage system combines a relatively high degree of completeness and cost-efficiency compared to other European systems.
  - The 2003 Mercer Oliver Wyman and European Mortgage Federation study ranked the Danish market third out of a sample of eight European markets based on product variety, market access, distribution, and availability of information and advice.
  - According to Mercer Oliver Wyman computations for the 2003 mortgage study, mortgage costs in Denmark were the third lowest among a sample of eight European countries; fees and credit risk management represented less than 10 bp each.

### B. The Funding Side: The Danish Mortgage Bond Market
- Outstanding bond types and maturities:
  - Predominantly callable bonds with maturities comprised between 10 and 30 years.
  - Non-callable bullet bonds used to finance interest reset loans with maturities between 1 and 11 years.
- Table 3 summary (features preserved as in source):
  - Noncallable Bullet Bonds: Interest Payments Annual; Repayment Bullet; Coupon Fixed; Currency DKK and €; Maturities 1─11 years; Issuance Tap and auction, throughout maturity.
  - Callable Bonds: Interest Payments Quarterly; Repayment Annuity or IO; Coupon Fixed; Currency DKK and €; Maturities 10, 15, 20, 30 years; Issuance Tap, during the first 3 years.
  - Capped Floaters: Interest Payments Quarterly; Repayment Annuity or IO; Coupon Floating, capped; Currency DKK; Maturities 30 years; Issuance Tap, during the first 3 years.
  - Floating to Fixed Bonds: Interest Payments Quarterly; Repayment Annuity or IO; Coupon Floating, fixed; Currency DKK; Maturities 30 years; Issuance Tap, during the first 3 years.
- Market concentration and liquidity:
  - A small number of series (10─15) reach high outstanding amounts—the 10 largest mortgage bonds account for approximately 25 percent of total mortgage bond outstanding volumes—and are very liquid.
  - Mortgage banks enhance liquidity of these series by reusing bonds when refinancing mortgage loans and by issuing bonds identical to those issued by others.
  - Traditional mortgage bonds are traded in a uniform market; bonds with a given coupon and maturity have traditionally been regarded as (perfect) substitutes, including in the market making arrangement organized by the main dealers.
  - Capped rate and deferred amortization bonds lack the same degree of homogeneity and do not benefit from similar market making commitment, though market making activities have recently been organized for some of these issues.
  - Majority of mortgage bonds are traded primarily over-the-counter (OTC), by phone and electronically; mortgage bonds are also quoted on the Copenhagen Stock Exchange.
  - The market benefits from an active repo market and mortgage bonds are eligible collateral for the central bank.
- Investor base and holdings (Q1 2005 references and related figures):
  - Monetary institutions, including commercial banks and mortgage banks, represent the largest investor group, holding about 43 percent of mortgage bonds in circulation.
  - Pension funds and insurance companies together hold an estimated 25 percent of outstanding issues.
  - Direct holding by retail investors amounts to 5 percent.
  - Share of foreign investors close to 15 percent overall and has been increasing in recent years.
  - Foreign investors are especially present among the highest liquid bonds (of which they hold about 20 percent of outstanding amounts) and hold significant amounts of callable bonds (about 57 percent of total holdings of mortgage bonds by foreign investors).
  - Foreign holdings of short term non callable bullet mortgage bonds denominated in DKr: 6 percent; in euros: 22 percent at the end of 2004.

### C. Danish Mortgage Bonds and Evolution of the European Covered Bond Market
- Market importance and composition (2004 data):
  - Mortgage bonds (and bonds issued by special institutions) accounted for 71 percent of the market value of bonds listed on the Copenhagen Stock Exchange.
  - Government bonds accounted for 27.4 percent of total market value.
  - Asset-Backed Securities and corporate bonds represented 1.6 percent.
  - 1,673 mortgage bond issues were listed in the market, representing 75 percent of all listed bond issues.
- Size in European context:
  - Danish mortgage market is the second largest mortgage market in Europe: 14.2 percent of outstanding covered bonds, and 29.3 percent of covered bonds backed by mortgage loans.
  - Germany (pfandbrief market) remains the largest (Germany: 61.4 percent of total outstanding covered bonds; 32.4 percent mortgage bonds; 89.5 percent public sector bonds).
- Table 4 excerpted country market shares (end 2004, in % of total outstanding):
  - Germany: Total Covered Bonds 61.4; Mortgage Bonds 32.4; Public Sector Bonds 89.5
  - Denmark: Total Covered Bonds 14.2; Mortgage Bonds 29.3
  - France: Total Covered Bonds 6.1; Mortgage Bonds 8.2; Public Sector Bonds 4.2
  - Spain: Total Covered Bonds 6.1; Mortgage Bonds 11.9; Public Sector Bonds 0.7
  - Sweden: Total Covered Bonds 5; Mortgage Bonds 10.4
  - Ireland: Total Covered Bonds 1.9; Mortgage Bonds 0.3; Public Sector Bonds 3.4
  - Switzerland: Total Covered Bonds 1.8; Mortgage Bonds 3.6
  - Luxembourg: Total Covered Bonds 1.2; Public Sector Bonds 2.3
  - U.K: Total Covered Bonds 0.9; Mortgage Bonds 1.9
  - Netherlands: Total Covered Bonds 0.8; Mortgage Bonds 1.6
  - Others: Total Covered Bonds 0.7; Mortgage Bonds 1.4
  - Total: 100 (Total Covered Bonds); 100 (Mortgage Bonds); 100 (Public Sector Bonds)
  - Memo: in € million: 1,644,927 (Total Covered Bonds); 795,135 (Mortgage Bonds); 849,792 (Public Sector Bonds)
- Potential risks and concerns:
  - Increased diversity of mortgage loans may result in smaller and more heterogeneous bond issues and pricing conditions, making liquidity harder to maintain.
  - Reduced liquidity could affect appetite of foreign investors (mostly institutional investors and hedge funds) for Danish mortgage bonds and limit the ability to build a complete, homogeneous mortgage bond yield curve in the long run.

*IMF Staff Country Report (excerpt).*

### 28.      Danish mortgage bonds have been traditionally viewed as a variety of covered

### 28. Danish mortgage bonds have been traditionally viewed as a variety of covered bonds

### Overview and defining features
- Covered bonds: debt instruments secured on a specific pool of assets, on which investors have a senior claim; investors have recourse to both a pool of collateral and the issuing entity.
- Issuers monetize credit and liquidity risks of pooled loans (typically mortgage loans and public sector loans) by issuing covered bonds and gain spread income.
- Covered bonds typically benefit from high credit ratings, often higher than the issuing institution, providing lower funding costs than senior unsecured debt.
- Covered bonds share similarities with Asset and Mortgage-Backed Securities (ABS/MBS) but differ significantly in legal framework, eligible collateral, location of collateral, cash-flow sources, risks transferred to bondholders, and bondholder protection.

### Main structural contrasts (covered bonds, Danish mortgage bonds, ABS/MBS)
- Mortgage loan production: Covered Bonds and Danish Mortgage Bonds use a "Bundled Process"; Asset/Mortgage-Backed Securities use an "Unbundled Process".
- Type of securitization: Covered Bonds and Danish Mortgage Bonds are "On-Balance sheet"; Asset/MBS are "Off-Balance sheet Securitization".
- Source of cash flows: Covered Bonds and Danish Mortgage Bonds — "Issuer cash flows"; Asset/MBS — "Collateral cash flows".
- Risk exposures (credit, prepayment, market risk): assignment differs across issuer/investor roles for each product (as presented in source table).
- Structure of loan pools:
  - Covered Bonds: "Dynamic pool, with substitutable and mainly heterogeneous assets; Eligible assets defined by law".
  - Danish Mortgage Bonds: "Dynamic pool, with substitutable, and mainly heterogeneous assets; Eligible assets defined by law".
  - Asset/MBS: "Generally static pool, with not substitutable and mainly homogeneous assets; Eligible assets not necessarily defined by law".
- Over-collateralization:
  - Covered Bonds: "Usually defined by law".
  - Danish Mortgage Bonds: "Usually defined by law".
  - Asset/MBS: "Required to achieve high rating".
- Investor protection in issuer bankruptcy:
  - Covered Bonds and Danish Mortgage Bonds: "Bankruptcy privilege and asset segregation".
  - Asset/MBS: "Bankruptcy Remoteness".

### Covered bond legal frameworks and national differences
- Covered bonds are heterogeneous; characteristics depend on national legal frameworks (e.g., eligibility of public sector loans, inclusion of foreign assets in cover pools, valuation of collateral, balance principle management, legal treatment and requirement of over-collateralization).
- Country examples from the source table (selected entries and exact values preserved where given):
  - Denmark: Entry into force "1850/1989/2003"; Specialist Bank "Yes"; Authorized assets "Any loan mortgaged on real property"; Loan to value "40–80 percent"; Basis for Valuation "Market value"; Protection against mismatches "Currency, interest rate and liquidity, strict balance principle"; Over-Collateralization (pool level) "Coincidental, but protected by law"; Asset pool after bankruptcy "Continues, legal segregation"; Special pool administration (in bankruptcy) "No".
  - Germany: Entry into force "1900/2004"; Specialist Bank "No"; Authorized assets "PS, RM, CM"; Loan to value "60 percent"; Basis for Valuation "Long-term sustainable value"; Protection against mismatches "Currency, maturity (nominal and NPV cover)"; Over-Collateralization (pool level) "2 percent on a net present value basis"; Asset pool after bankruptcy "Continues, legal segregation"; Special pool administration "Yes".
  - France: Entry into force "1999"; Specialist Bank "Yes"; Authorized assets "PS, EM and CM"; Loan to value "60, 100 percent"; Basis for Valuation "Market value"; Over-Collateralization (pool level) "Mandatory (10 percent of cover assets)"; Asset pool after bankruptcy "Continues, insolvency privilege"; Special pool administration "No".
  - Spain: Entry into force "1981/2003"; Specialist Bank "No"; Authorized assets "PS, RM, CM"; Loan to value "70, 80 percent"; Basis for Valuation "Market value"; Over-Collateralization (pool level) "Mandatory (11-43 percent of cover assets)"; Asset pool after bankruptcy "Continues, insolvency privilege"; Special pool administration "No".
- Notes in source: PS–Public sector loans; RM–residential mortgages; CM–commercial mortgages; LTV– loan-to-value. Additional country-specific notes preserved in source.

### European Directives and changes (UCITS and Capital Requirement Directive)
- Revised UCITS Directive and the Capital Requirement Directive (CRD) provide a clearer definition of covered bonds and list classes of eligible collateral.
- Major changes introduced by the directives:
  - Additional minimum requirements on the type and credit quality of cover assets, and on valuation and monitoring of loan collaterals for privileged risk weighting.
  - The uniform 10 percent privilege risk weighting previously applied to covered bonds will be discontinued.
- UCITS Art. 22 (4) (as updated in 2001) definition preserved verbatim in the source:
  - Covered bonds defined by four conditions: (i) Issued by a credit institution (with registered offices in a member state); (ii) Subject by law to a special public supervision designed to protect bond holders; (iii) Proceeds invested in conformity with the law in assets capable of covering claims during full life of bonds; (iv) In issuer failure, these assets used on a priority basis for reimbursement of principal and payment of accrued interest.
- Preferential treatments under UCITS and related directives (preserved wording and numeric limits):
  - Member states can authorize UCITS to invest up to "25 percent" of their assets in covered bonds issued by the same issuer (instead of the standard "5 percent").
  - Life insurance directive authorizes life insurers to invest up to "40 percent" (rather than "5 percent") of “bound assets” in covered bonds issued by a single issuer.
  - Banking Coordination Directive permits member states to ascribe a "10 percent" risk weighting to bonds that fall within the UCITS definition (privileged treatment).
  - Capital Requirement Directive specifics:
    - In the RSA, a "50 percent" reduction is given to the risk weight of issuing institution.
    - In the Foundation Internal Risk-Based Approach, covered bonds are assigned LGD values of either "11.25 or 12.5 percent".
- Eligible collateral categories under CRD (exact text preserved):
  - (i) Exposures to (or guaranteed by) central banks, central and regional governments, local authorities and other public sector entities in the European Union,
  - (ii) Exposures to (or guaranteed by) non-EU central banks, central governments, public sector entities, regional government and local authorities, multilateral development banks, international organizations, with ratings equivalent to "AA-" or better. Exposures to issuers with lower ratings ("A") should not exceed "20 percent" of the nominal amount of outstanding covered bonds of issuing institutions,
  - (iii) Loans secured by residential real estate ... for up to "80 percent" of the value of the pledged properties,
  - (iv) Loans secured by commercial real estate ... for up to "60 percent" of the value of the pledged properties,
  - (v) Total exposure to financial institutions (rated between "AA-" and "AAA"), permitted as liquid, substitution assets, cannot exceed "15 percent" of the nominal amount of outstanding covered bonds of the issuing institution.

### Risk-weighting implications under the Capital Requirement Directive
- The CRD allows national supervisors and investing banks options that could result in risk-weightings for covered bonds ranging "from 3 percent to 20 percent".
- Summary of Table 7 (risk-weighting outcomes preserved exactly as given):
  - Standardized Approach (two options):
    - Option 1 and Option 2: For issuer ratings "AAA" and "AA+ to AA-" risk weight "10"; for "A+ to A-" Option 1 "10" and Option 2 "20"; for "BBB+ to BBB-" Option 1 "10" and Option 2 "20".
  - IRB Approach (ranges presented in source):
    - Foundation (assuming regulatory LGD of "11.25 percent"): AAA "3.5-4.5", AA+ to AA- "4.5-7.5", A+ to A- "7.5-12.5", BBB+ to BBB- "12.5-20".
    - Advanced (LGD estimated by investing bank; example LGD "9 percent" in source): AAA "3-4", AA+ to AA- "4-6.5", A+ to A- "6.5-10.5", BBB+ to BBB- "10.5-16".
- Practical consequences noted:
  - All banks and their covered bond issues are treated equally under some approaches, irrespective of issuer creditworthiness or cover quality.
  - Under credit assessment based method, covered bonds issued by banks with ratings below "AA-" will lose their "10 percent" risk weighting privilege status.
  - The CRD applies only to investing banks located in E.U. countries (with non-EU banks applying Basel II).

### Market and incentive effects
- The variety of risk-weighting options will affect relative demand for covered bonds and lead to increased spread differentiation between issues.
- Assessing the precise impact of CRD is difficult because:
  - Credit institutions subject to CRD are a major investor group (their share is estimated to represent around "40 percent"), but not the only investors.
  - CRD applies only to investing banks in EU countries; not all will adopt the IRB approach.
- Basel II/CRD framework provides little incentive to securitize residential mortgage loans; capital charges for low-rated securitization tranches are high under Basel II, discouraging originators from retaining subordinated tranches.
- Likely stronger incentives to securitize asset classes with more punitive treatment under Basel II (examples cited: "CMBS, SMEs, low-rated corporates").

### Implications for the Danish mortgage system and policy considerations
- Transitional challenges for Danish mortgage bonds from implementation of new European Directives:
  - To be recognized and given preferential treatment under the Directives, the Danish mortgage framework would need amendments.
  - Specific mismatches with Directives:
    - Danish loan-to-value (LTV) requirements are based on value of covered assets at origination; the Directive requires LTV calculations to be performed and respected "over the full life of the covered loan".
    - Danish regulatory framework currently recognizes only mortgage loans as eligible collateral; Directives recognize a wider range of possible collateral.
- Diverging stakeholder positions:
  - Commercial banks: seek a significant reshuffle to enter the covered bond market and create a level playing field with European competitors.
  - Mortgage banks: seek to preserve essential characteristics of the current mortgage system and advocate limited alterations.
- Trade-offs and risks of adapting the system:
  - The strict application of the Danish balance principle currently makes Danish mortgage bonds "true pass-through securities", transferring market risk from mortgage borrowers to mortgage bond investors and limiting mortgage banks' exposure largely to credit risk.
  - Amending the system to align with EU regulations may trade off some attractive features for potential benefits; careful attention needed to consumer protection, disclosure, transparency, and flexibility.
- Policy priorities emphasized in source:
  - Ensure continued effective disclosure and transparency.
  - Ensure a level playing field among market participants.

### Key numeric values and thresholds preserved from source
- UCITS investment limits: "25 percent" (covered bonds by same issuer) versus "5 percent" standard.
- Life insurers: "40 percent" vs "5 percent".
- Previous uniform privileged risk weighting: "10 percent".
- Capital Requirement Directive LGD values: "11.25 or 12.5 percent" (Foundation IRB example).
- Eligibility limits under CRD: exposures to lower-rated issuers ("A") should not exceed "20 percent" of nominal outstanding covered bonds; substitution assets exposure cap "15 percent".
- Possible risk-weighting range for covered bonds under CRD: "from 3 percent to 20 percent".
- Table 7 specific ranges and values:
  - Standardized Approach: typical "10" or "20" percent entries for various issuer ratings.
  - IRB Foundation example ranges: AAA "3.5-4.5"; AA+ to AA- "4.5-7.5"; A+ to A- "7.5-12.5"; BBB+ to BBB- "12.5-20".
  - IRB Advanced example ranges: AAA "3-4"; AA+ to AA- "4-6.5"; A+ to A- "6.5-10.5"; BBB+ to BBB- "10.5-16".
- Country-specific LTVs (selected): Denmark "40–80 percent"; Germany "60 percent"; France "60, 100 percent"; Spain "70, 80 percent"; Sweden "60–75 percent".
- Over-collateralization examples: France "Mandatory (10 percent of cover assets)"; Spain "Mandatory (11-43 percent of cover assets)"; Germany "2 percent on a net present value basis".
- Market investor share estimate: credit institutions subject to CRD estimated to represent around "40 percent" of covered bond investors.

*Source: IMF staff analysis in section 28–36 of the supplied document on Danish mortgage bonds and covered bond frameworks.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07123.pdf_