## _cr14349

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### Executive summary — Overview
- Danish mortgage finance system operated for "literally hundreds of years" and performed well in extremely difficult circumstances.
- Covered bonds described as "of high credit quality; very liquid; and among the best investment alternatives to government bonds."
- Covered bond stock totaled "nearly €360 billion" at the end of 2013, equivalent to "143 percent of GDP" and nearly four times larger than the Danish government debt market.

### Legal and regulatory framework and Mortgage Credit Act
- Strong legal underpinnings:
  - Property rights clearly defined; foreclosure procedures "straightforward and efficient."
  - Effective land and mortgage registration (Cadastre, Land Book, Municipal Register of Real Properties).
  - Mortgage loan default declared after "3½ months" of non-payment; forced sale typically finalized within "no more than nine months" from declaration of default.
- Covered bond issuance safeguards:
  - Strict limits on loan-to-value (LTV) ratios; specific requirements for overcollateralization (OC); issuance subject to the balance principle limiting interest rate, foreign exchange, volatility, and liquidity risk.
- 2007 legislative changes to comply with EU CRD:
  - Continuous LTV compliance on an individual loan basis; universal banks access to covered bond market; choice between specific and general balance principles; junior covered bonds allowed in certain circumstances.
- Mortgage Credit Act specifics:
  - Lending maturities: may not exceed 35 years for loans guaranteed by municipalities and 30 years for all other mortgage loans.
  - Private mortgage loans repaid no more slowly than a 30-year annuity, with an IO period option up to 10 years; longer IO periods permitted for owner-occupied housing financed by covered bonds if LTV < 75 percent.
  - Maximum LTVs: Residential (RO / SDO/SDRO): 80 / 80 1/; Commercial (RO / SDO/SDRO): 60 / 60 2/; Agricultural (RO / SDO/SDRO): 70 / 60 2/; Un-built property sites (RO / SDO/SDRO): 40 / 40.
  - Valuation cannot exceed open market price reasonably achievable within a selling period of six months; exemptions possible when valuation models have satisfactory back tests.
- Prepayment, bond delivery option, and tax effects:
  - Fixed rate loans may be pre-paid at par at any time; adjustable rate loans may be pre-paid at par on any rate adjustment date.
  - All loans may be pre-paid by purchasing and delivering equivalent bonds (delivery option).
  - Differential tax treatment affects willingness to prepay; higher interest tax deduction for cash loans is lost upon prepayment and borrower must pay tax on any capital gains.

### Evolution of mortgage products, loan composition, and IO periods
- Product innovation timeline:
  - Adjustable interest rate loans introduced in 1996.
  - IO periods offered since 2003 (up to 30 years since 2007, though not offered in practice).
  - Interest rate caps and floating-to-fixed options introduced in 2004; ratchet coupons in 2007.
- Loan composition (end-2013):
  - Adjustable and variable interest rate loans (including index-linked loans) amounted to "75 percent" of total outstanding mortgage loans.
    - Index-linked loans accounted for "3 percent" of total outstanding mortgage loans at the end of 2013 (included in the 75 percent figure).
  - Loans with interest-only (IO) periods comprised "53 percent" of all mortgage debt.
  - About 65 percent of all adjustable rate loans at end-2013 were scheduled to be reset within one year.
  - Prepayments on fixed rate loans fell to "25 percent" of outstanding mortgage debt by the end of 2013.
- IO periods and amortization pressures:
  - As of end-2013: 65 percent of all variable rate loans included an IO period; 26 percent of all fixed rate loans included an IO period.
  - IO periods began to expire in late 2013: ~4,700 borrowers affected in 2013; nearly 36,000 borrowers in 2015; more than 84,000 borrowers in 2019.
  - If current LTV < 80 percent at end of IO period, institutions can offer a new IO loan; absent housing price recovery, about half of borrowers reaching end of IO in 2019 will be ineligible for a new IO loan.

### Covered bond market structure, types, and issuance mechanics
- Three senior covered bond types since July 2007:
  - ROs: issued exclusively by MCIs, not CRD-compliant, risk weighting 20 percent (10 percent if issued before January 2008).
  - SDROs: issued only by MCIs, CRD-compliant, risk weighting 10 percent.
  - SDOs: can be issued by MCIs or commercial banks, CRD-compliant, risk weighting 10 percent; cover pool may include claims on credit institutions (up to 15 percent).
- Cover pool composition high-level:
  - SDOs: Mortgage loans, Public agency loans, Shipping loans (commercial banks only), Claims on credit institutions (up to 15 percent).
  - SDROs: Mortgage loans, Public agency loans.
  - ROs: Mortgage loans, Public agency loans.
- OC and balance principles:
  - Mandatory OC computed per capital center; institutions choose general or specific balance principle.
  - OC must cover stress tests for interest rate, FX, volatility, and liquidity risks.
  - Interest rate risk limits and other risk limits specified as percent of OC, with distinct limits for commercial banks and mortgage banks.
  - Refinancing risk is not covered by the balance principle.
- Issuance mechanics:
  - Bonds normally issued on tap daily; adjustable/variable rate loans financed by short-term non-callable fixed rate bullet bonds (most often one-year maturities).
  - Refinancing auctions (quarterly; December auctions most important) used to refinance short-term bonds.
- Bankruptcy treatment:
  - Covered bonds enjoy senior claim on assets in relevant capital center/register; for MCIs, residual covered bond claims that cannot be met by capital center assets become senior claims on ordinary assets.
  - Trustee administers issuer and cover pools; may issue new bonds or unsecured debt as appropriate.
  - Failure to cover collateral shortfall results in loss of covered bond status for affected issue and suspension of covered bond license.

### Market concentration, investor composition, liquidity, and infrastructure
- Market concentration (end-2013):
  - Covered bonds issued by seven institutions.
  - Nykredit/Totalkredit and Realkredit Danmark accounted for more than 70 percent of all outstanding issues as of end-2013.
  - More than 1,500 different bond series outstanding; about two thirds of market accounted for by the 100 largest bond series.
- Outstanding covered bonds by issuer (December 2013):
  - BRFkredit: DKK 209.5 bn, 7.9 percent
  - Danske Bank: DKK 20.7 bn, 0.8 percent
  - DLR Kredit: DKK 136.5 bn, 5.1 percent
  - LR Kredit: DKK 15.6 bn, 0.6 percent
  - Nordea Kredit: DKK 370.6 bn, 13.9 percent
  - Nykredit/Totalkredit: DKK 1,162.4 bn, 43.6 percent
  - Realkredit Danmark: DKK 747.5 bn, 28.1 percent
  - Total: DKK 2,662.8 bn, 100.0 percent
- Investor composition (December 2013):
  - Domestic financial institutions: DKK 1,021.6 bn, 38.4 percent
  - Insurance and pension funds: DKK 701.1 bn, 26.3 percent
  - Mutual funds and asset managers: DKK 284.6 bn, 10.7 percent
  - Other domestic investors: DKK 240.4 bn, 9.0 percent
  - Foreign investors 1/: DKK 414.6 bn, 15.6 percent
  - Total: DKK 2,662.8 bn, 100.0 percent
  - Note: 1/ Estimated that foreign affiliates of Danish investors accounted for approximately DKK 100 billion of total holdings by foreign investors at end-December 2013.
- Market infrastructure and liquidity support:
  - Market making agreement among six Danish banks for standard transaction size DKK 200 million in several liquid series.
  - Large repo market accounts for more than 25 percent of total turnover.
  - Danmarks Nationalbank accepts Danish covered bonds as collateral at haircuts up to 11 percent depending on residual maturity.
  - NASDAQ OMX NORDIC offered covered bond futures since 2009 (20-year callable, 30-year callable, three-year non-callable).
  - Bid-ask spreads generally 10–20 basis points; spreads to benchmarks increased by only 100–150 basis points for most liquid bonds during the recent financial crisis.
- Ratings and investor behavior:
  - Danish covered bonds historically highly rated; rating agencies expressed concerns about refinancing risk, IO period expiries, and normalization of interest rates.
  - Failures of Amagerbanken and Fjordbank Mors led to re-evaluation of systemic support; rating actions sometimes under pressure or withdrawn at issuer request.

### Key risks to financial stability and scenario findings
- Core risk drivers:
  - Major maturity mismatch and refinancing risk from heavy reliance on short-term bonds to finance long-term adjustable/variable loans.
  - Increasing mortgage loan impairments and NPLs since 2007, albeit from a low level: impairment losses for mortgage banks were 0.19 percent of total lending in 2013; NPLs reached 1.7 percent at end-2013.
  - Large share of adjustable and variable rate loans and imminent end of IO periods could increase debt servicing pressure with normalization of European interest rates.
  - Implementation of Basel III liquidity reforms (LCR and NSFR) will alter portfolios; compliance with LCR may diversify portfolios away from own-issued bonds toward other institutions’ bonds, increasing interconnectedness.
- Refinancing risk specifics:
  - In 2013, maturing covered bonds financing adjustable rate loans were DKK 955 billion (EUR 128 billion), equivalent to about half of GDP and more than two thirds of the amount of such bonds outstanding at end-2012.
  - Quarterly auctions reduce but do not eliminate risk of failed refinancing auctions; large share of some series held by foreign investors (80–90 percent of some one-year non-callable and euro-denominated series) increases auction risk.
- Interest-rate normalization scenario:
  - A return to pre-crisis interest rate levels (e.g., 2005) would entail a near tripling of interest charges (and payments for IO period loans) for many adjustable rate borrowers, potentially causing widespread additional loan impairments, downward pressure on housing prices, increased LTVs, and additional collateral needs for issuers.
  - A jump in interest rates would be reflected in higher payment obligations for a large majority of borrowers and produce an increase "particularly sharp for loans in the IO period."
- IO expiries and collateral pressure:
  - Expiry of IO periods will increase payment obligations; absent housing price recovery, about half of borrowers reaching end of IO in 2019 will be ineligible for a new IO loan and will have to begin amortization.
  - Extensive IO use means housing price declines pressure MCI balance sheets due to need to provide additional collateral for continuous LTV compliance.
- Legislative mitigation:
  - Mandatory extension law (effective April 1, 2014 for one year bonds and January 1, 2015 for two year bonds) triggers when a refinancing auction fails or auction interest rate increases by more than 5 percentage points versus one year earlier: bonds extended by 12 months with interest raised by 5 percentage points; possible further 12 month extension at same rate if conditions not improved.
  - Estimated immediate market reaction to the legislation is five to ten basis points; extension risk increases valuation complexity and could be pro-cyclical.

### Policy recommendations and supervisory measures
- Overarching objective: mitigate systemic risks from adjustable-rate loans and IO periods while maintaining benefits to Danish homebuyers; address intertwined risks so policies reinforce each other.
- Reduce refinancing risk and maturity mismatch (Priority: Short-term):
  - Incentivize lengthening of bond maturities (DFSA, MoBG).
  - Options: higher capital requirements for short-term covered bond financing; direct restrictions; adjust balance principle to account for refinancing risk.
  - Favor loans and covered bonds attractive to long-duration investors (e.g., fixed interest rates, market-friendly rate reset mechanisms).
  - Use Pillar II reviews or systemic risk buffer to require MCIs to set aside additional capital when maturity mismatch is large.
  - Restrict maturity mismatch directly (e.g., Supervisory Diamond).
  - Modify balance principle to require additional OC for capital centers issuing short-term bonds.
  - Use tranching techniques to package longer maturity assets for investors.
- Limit impact of interest-rate normalization (Priority: Short-term):
  - Ensure credit risk is adequately priced and accounted for in loan approvals.
  - Promote longer fixed-rate periods on mortgage loans and increase pricing differential between adjustable/variable and fixed-rate loans.
  - Debt service-to-income filters could be stressed by requiring a higher fixed-rate hurdle.
- Realign incentives to reduce reliance on IO periods (Priority: Short-term):
  - Lower LTV limits for IO loans or require amortization to a lower ceiling.
  - Impose higher capital charges/credit loss provisions until IO periods expire.
  - Reduce tax deductions during IO periods.
  - Encourage lenders to limit IO length or price IO periods more appropriately via higher provisions.
- Strengthen supervisory oversight and market stability:
  - New supervisory diamond for MCIs to set risk parameters, including share of short-term bonds, to limit refinancing risk.
  - Manage portfolio adjustments driven by LCR and NSFR implementation to limit market disruptions.
  - Use current low interest rates and flat yield curve as a "window of opportunity" to lengthen covered bond maturities at minimal borrower cost.
  - Measures that reduce adjustable rates and IO use will reduce credit risk and reinforce reductions in refinancing risk.

### Interconnectedness and systemic implications
- High interconnectedness through large domestic holdings and cross-holdings means problems at one institution or in one refinancing auction could more easily propagate system-wide.
- Policies addressing one risk (e.g., reducing IO loans) can mitigate other risks (maturity mismatch, refinancing risk, need for additional OC).
- Central role of mortgage finance and covered bonds in the financial system makes these policies "vital to the future health of the Danish economy."

*Executive Summary, IMF staff note _cr14349 – EXECUTIVE SUMMARY_*

### EXECUTIVE SUMMARY __________________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### Overview
- The Danish mortgage finance system has operated for "literally hundreds of years" and has performed well in extremely difficult circumstances.
- Danish covered bonds backed by mortgage loans are described as: "of high credit quality; very liquid; and among the best investment alternatives to government bonds."
- Covered bond stock totaled "nearly €360 billion" at the end of 2013, equivalent to "143 percent of GDP" and nearly four times larger than the Danish government debt market.

### Legal and regulatory framework
- Strong legal underpinnings:
  - Property rights clearly defined; foreclosure procedures "straightforward and efficient."
  - Effective land and mortgage registration (Cadastre, Land Book, Municipal Register of Real Properties).
  - Mortgage loan default declared after "3½ months" of non-payment; forced sale typically finalized within "no more than nine months" from declaration of default.
- Covered bond issuance safeguards:
  - Strict limits on loan-to-value (LTV) ratios of underlying mortgage loans.
  - Specific requirements for overcollateralization (OC).
  - Issuance subject to the balance principle, which limits interest rate, foreign exchange, volatility, and liquidity risk.
- Regulatory changes:
  - 2007 modifications to Mortgage Credit Act and Financial Business Act to comply with EU CRD:
    - Required continuous LTV compliance on an individual loan basis.
    - Allowed universal banks access to the covered bond market.
    - Issuers choose between a specific balance principle and a general balance principle.
    - Allowed junior covered bonds in certain circumstances.

### Evolution of mortgage products and covered bonds
- Product innovation since the late 1990s:
  - Adjustable interest rate loans introduced in 1996.
  - Loans with interest-only (IO) periods offered since 2003 (up to 30 years since 2007, though not offered in practice).
  - Interest rate caps and floating-to-fixed options introduced in 2004; ratchet coupons in 2007.
- Changes in loan composition (end-2013):
  - Adjustable and variable interest rate loans (including index-linked loans) amounted to "75 percent" of total outstanding mortgage loans.
    - Index-linked loans accounted for "3 percent" of total outstanding mortgage loans at the end of 2013 (included in the 75 percent figure).
  - Loans with interest-only periods comprised "53 percent" of all mortgage debt.
- Covered bond market evolution:
  - Traditional covered bonds were callable annuities matching fixed-rate loan maturities.
  - Adjustable/variable rate loans are financed by non-callable bullet bonds with short maturities (mostly one year, up to five years).
  - By end-2013, non-callable short-term bonds had risen to "more than half of total covered bonds outstanding."
  - Refinancing auctions historically held annually in December until 2006; auctions in March and September introduced in 2006; a June auction began in 2014.

### Key risks to financial stability
- Major maturity mismatch and refinancing risk due to heavy reliance on short-term bonds to finance long-term adjustable/variable loans.
- Increasing mortgage loan impairments and nonperforming loans (NPLs) since 2007, albeit from a low level.
- Large share of adjustable and variable rate loans and imminent end of IO periods could increase debt servicing pressure with normalization of European interest rates.
- Implementation of Basel III liquidity reforms (LCR and NSFR) will alter portfolio allocations:
  - Compliance with LCR may diversify portfolios away from own-issued bonds toward other institutions’ bonds.
  - This could increase interconnectedness among Danish financial institutions, making shocks (e.g., a failed refinancing auction) more likely to propagate system-wide.
- Current low interest rates and flat yield curve present a window of opportunity to reduce maturity mismatch by lengthening covered bond maturities at minimal borrower cost.

### Policy recommendations (summarized from Table 1 and text)
- Reduce refinancing risk by incentivizing lengthening of bond maturities (DFSA, MoBG) — Priority: Short-term
  - Options include higher capital requirements for short-term covered bond financing or direct restrictions.
  - Adjusting the balance principle to account for refinancing risk.
  - Regulation could favor loans and covered bonds with characteristics attractive to long-duration investors (e.g., fixed interest rates, market-friendly rate reset mechanisms).
- Limit impact of interest rate normalization by ensuring credit risk is adequately priced and accounted for in loan approvals (DFSA, MoBG) — Priority: Short-term
  - Promote longer fixed-rate periods on mortgage loans and increase pricing differential between adjustable/variable and fixed-rate loans.
  - Debt service-to-income filters could be stressed by requiring a higher fixed-rate hurdle.
  - Reducing IO loan use would limit additional OC requirements for covered bonds in the event of housing price declines from rising interest rates.
- Realign incentives to reduce reliance on IO periods (DFSA, MoBG) — Priority: Short-term
  - Lower LTV limits for IO loans or require amortization to a lower ceiling.
  - Impose higher capital charges/credit loss provisions until IO periods expire.
  - Reduce tax deductions during IO periods.
- Strengthen supervisory oversight:
  - New supervisory diamond for Mortgage Credit Institutions (MCIs) to set risk parameters, including the share of short-term bonds, providing a tool to limit refinancing risk.
- Ensure market liquidity and stability of covered bond market given high interconnectedness; consider measures to lengthen covered bond maturities while rates are low and to reduce the attractiveness of adjustable/variable and IO loan structures.

### Interconnectedness and systemic implications
- High degree of interconnectedness through covered bonds means a problem at one institution or in one refinancing auction could more easily spread.
- Policies addressing one risk (e.g., reducing IO loans) can help mitigate other risks (maturity mismatch, refinancing risk, need for additional OC).
- Recent legislative amendment provides a mechanism for mandatory extension of existing bond maturities in case of a failed refinancing or a large increase in bond interest rates.

*Executive Summary, IMF staff note _cr14349 – EXECUTIVE SUMMARY_*

### 11.      The Danish mortgage system is further strengthened by the Mortgage Credit Act,

### 11.      The Danish mortgage system is further strengthened by the Mortgage Credit Act

### Mortgage Credit Act: lending periods, LTVs, and repayment features
- Lending maturities:
  - May not exceed 35 years for loans guaranteed by municipalities and 30 years for all other mortgage loans.
  - Private mortgage loans must be repaid no more slowly than a 30-year annuity, with an option for an IO period of up to 10 years.
  - Longer IO periods are permitted for loans for owner-occupied housing financed by covered bonds, provided that the LTV is less than 75 percent.
- Maximum LTVs (Table 2):
  - Residential (RO / SDO/SDRO): 80 / 80 1/
  - Commercial (RO / SDO/SDRO): 60 / 60 2/
  - Agricultural (RO / SDO/SDRO): 70 / 60 2/
  - Un-built property sites (RO / SDO/SDRO): 40 / 40
  - Note: 1/ The maximum LTV is 75 percent if the IO period is longer than 10 years. 2/ The maximum LTV is 70 percent if supplementary collateral is provided to cover the amount in excess of 60 percent.
- Any financing in excess of these amounts must be provided from sources other than covered bonds.

### Property valuation and exemptions
- Valuation cannot exceed the open market price reasonably achievable within a selling period of six months.
- Valuations must take into account risk of changes in market conditions and disregard factors that result in an exceptionally high price.
- Valuations are carried out by experienced professionals not involved in the loan approval process.
- DFSA may grant an exemption from physical inspections for properties meeting certain criteria if valuations are determined by models with satisfactory back test results.

### Prepayment, bond delivery option, and tax effects
- Borrowers can pre-pay or buy back loans:
  - Fixed rate loans may be pre-paid at par at any time.
  - Adjustable rate loans may be pre-paid at par on any rate adjustment date.
  - All loans may be pre-paid at any time by purchasing bonds equivalent to those financing the loan and delivering them to the lender (the delivery option).
- Bonds are considered equivalent if they have a corresponding (but not necessarily identical) payment structure; deviations are limited to insignificant amounts by the risk limits of the balance principle.
- Tax effects:
  - Differential tax treatment of bond loans and cash loans affects willingness to prepay.
  - Higher interest tax deduction for cash loans is lost upon prepayment and borrower must pay a tax on any capital gains.

### Loan product evolution, prepayment rates, and loan composition
- Until 1996 loans were fixed rate callable annuity loans with maturities up to 30 years.
- From 2003 borrowers were offered IO periods up to 10 years, reducing annuity repayment portion to 20 years.
- Decline in interest rates since 2000 led to high prepayments on fixed rate loans, which fell to only 25 percent of outstanding mortgage debt by the end of 2013.
- Adjustable and variable interest rate loans:
  - Reached 75 percent of total mortgage debt by the end of 2013.
  - Include index-linked loans, which accounted for 3 percent of total outstanding mortgage loans at the end of 2013.
  - An initial fixed interest rate period of one year is most popular; increasing number selecting up to five years.
  - About 65 percent of all adjustable rate loans at end-2013 were scheduled to be reset within one year.
  - Interest on variable rate loans is reset each three or six months with reference to CIBOR or CITA (or Euribor if denominated in euros); spread revised to a market clearing rate on each refinancing date.
  - About half of such loans have interest rate caps that apply for the entire term of the loan.
- Prepayment risk:
  - On adjustable and variable rate loans, prepayment risk is mainly retained by lenders who finance them with short-term non-callable fixed rate bonds and refinance the remaining balance periodically.

### Interest-only (IO) periods and upcoming amortization pressures
- As of end-2013:
  - 65 percent of all variable rate loans included an IO period.
  - 26 percent of all fixed rate loans included an IO period.
- IO periods were initially for a maximum of ten years and began to expire in late 2013.
  - About 4,700 borrowers were affected in 2013; this number will rise to nearly 36,000 borrowers in 2015 and to more than 84,000 borrowers in 2019.
- If current LTV on the property is less than 80 percent at end of IO period, lending institutions can offer a new loan with an IO period to avoid increased monthly payments.
- Housing price dynamics and implications:
  - Housing prices rose sharply during 2004–07 and subsequently declined substantially.
  - Although housing prices increased slightly during 2013, they remain nearly 20 percent below the level of 2007.
  - LTVs have correspondingly increased; in the absence of a housing price increase, about half of borrowers reaching the end of their IO periods in 2019 will be ineligible for a new IO loan and will have to begin amortization payments.
  - Some borrowers may take out additional loans (mortgage loans if LTV limits met, or ordinary bank loans) to react to higher payments.
  - Individual household data indicate most would be able to continue service of debts even with higher interest rates and the prospective end of IO periods.

### Delinquencies, recoveries, and impairment
- Mortgage loan delinquencies and defaults have traditionally been low; recoveries have been high.
- Mortgage loans are full recourse in Denmark; borrowers remain personally liable for any shortfall between sale value of repossessed property and outstanding loan amount.
- Impairment losses for mortgage banks were 0.19 percent of total lending in 2013, up 23 percent from the previous year.

### Covered bonds: types and characteristics
- Three types of senior covered bonds since July 2007 (Table 3):
  - ROs (traditional mortgage bonds): issued exclusively by MCIs, not CRD-compliant, risk weighting 20 percent (10 percent if issued before January 2008). Origination LTV compliance.
  - SDROs (new mortgage bonds): issued only by MCIs, CRD-compliant, risk weighting 10 percent. Continuous LTV compliance.
  - SDOs (new covered bonds): can be issued by MCIs or commercial banks, CRD-compliant, risk weighting 10 percent. Continuous LTV compliance; cover pool may include exposures to other credit institutions.
- Junior covered bonds (Section 15 senior debt) permitted in certain circumstances; used to raise supplementary capital and secured by the cover pool but subordinated to other bonds.
- Cover pool compositions (high-level):
  - SDOs: Mortgage loans, Public agency loans, Shipping loans (commercial banks only), Claims on credit institutions (up to 15 percent of outstanding bonds).
  - SDROs: Mortgage loans, Public agency loans.
  - ROs: Mortgage loans, Public agency loans.
- For SDOs and SDROs, underlying loans must be assigned to the relevant capital center (or recorded in a special register for commercial bank issuers); for ROs, they may be assigned or held by the institution in its own name.

### Overcollateralization (OC), balance principles, and risk allocation
- For MCIs, mandatory OC is calculated for each capital center depending on risk weighting of underlying loans; additional OC determined by LTV evolution and balance principle calculations.
- Institutions choose general or specific balance principle:
  - General balance principle similar to ALM requirements in other European countries.
  - Specific balance principle effectively requires most risks be passed through to bond investors.
- Both principles operationalized by requirement that OC must be sufficient to cover stress tests for several risks.
- Interest rate risk limits (as percent of OC in the capital center/cover register) differ by issuer type and balance principle (see Table 4 excerpt):
  - Examples:
    - +/- 100 bp parallel shift: Commercial banks 10%; Mortgage banks General 3% 1/ Specific 1%.
    - +/- 100 bp twist: Commercial banks 100%; Mortgage banks General 15% 2/ Specific 1%.
    - +/- 250 bp parallel shift: Commercial banks 100%; Mortgage banks General 15% 2/.
    - EUR interest rate risk: Commercial banks 50% offset; Mortgage banks 50% offset; No offset for some cases.
  - Foreign exchange, volatility, and liquidity risk limits also vary; MCIs generally face more restrictive requirements.
  - Footnotes specify calculation methods and allocations (e.g., 1/ 1% of mandatory OC plus 2% of additional OC; 2/ 5% of mandatory OC plus 10% of additional OC; 3/ 10% of mandatory OC plus 10% of additional OC; etc.).
- Risk allocation:
  - Prepayment risk other than for short periods is passed through to bond investors for fixed rate mortgage loans.
  - For adjustable and variable rate loans, interest rate risk associated with maturity mismatch is considered to revert back to the borrower as interest and spread on the loan are re-set when the bond is refinanced.
  - General credit risk, including payment shock on interest-rate reset dates or from end of IO periods, remains with the issuer.
  - Issuers also retain other risks (payment date/coupon reset mismatch, basis risk on interest rates or exchange rate).
  - Refinancing risk is not covered by the balance principle.

### Covered bond issuance mechanics and bankruptcy treatment
- Covered bonds normally issued on tap daily; each new mortgage loan origination or refinancing funded by specified amount of one or several bonds whose ISIN codes are open for issuance.
- Long-term bonds generally have an open period of three years to enable issuers to build large bond issues over time.
- Adjustable/variable rate loans funded by short-term non-callable bonds (most often one-year maturities); refinancing operations are very large and occur through periodic auctions (quarterly; December auctions most important) of new short-term fixed rate bullet bonds.
- In issuer bankruptcy:
  - Covered bonds enjoy senior claim on all assets in relevant capital center or register.
  - Covered bonds rank pari passu with counterparties of derivative contracts hedging imbalances.
  - Payments due to bondholders or derivative counterparties are not accelerated but remain scheduled.
  - A trustee appointed by bankruptcy court administers issuer and assets of cover pool(s); trustee can issue new bonds if existing bonds mature before mortgage loan assets and can issue unsecured debt if appropriate.
  - Other creditors may not be paid before covered bond investors.
  - For MCIs (but not commercial banks), if cover pool assets are insufficient to cover outstanding bonds, covered bondholders have a senior claim on ordinary assets of the issuer.
  - Excess cover pool assets after repaying senior and junior covered bonds become part of ordinary assets and are used first to satisfy senior bondholders of other capital centers and then other unsecured creditors and junior covered bondholders.
  - Unsecured creditors cannot be repaid or the institution wound up until all covered bondholder claims satisfied or all assets liquidated.

### Refinancing risk mitigation: mandatory extension law
- Law requiring mandatory extension of covered bond maturities in certain circumstances:
  - Became effective April 1, 2014 for one year bonds and January 1, 2015 for two year bonds.
  - Trigger conditions:
    - Failure of a refinancing auction; or
    - Interest rate at an auction increases by more than 5 percentage points compared with one year earlier.
  - Consequences:
    - Term of bonds reaching maturity at that time will be extended by 12 months and the rate of interest on the bonds and corresponding mortgage loans will be raised by 5 percentage points.
    - If at end of the 12 month extension conditions have not improved so that refinancing can take place, even at higher interest rates, the term of the bonds will be extended by a further 12 months at the same rate of interest.
  - New rules apply to new covered bond issues or in cases of bankruptcy of the issuer.

### Issuers and market concentration
- Market characteristics as of end-2013:
  - More than 1,500 different bond series outstanding.
  - About two thirds of the market was accounted for by the 100 largest bond series.
- Issuers have used tap issues to build large benchmark bonds with uniform properties.
- Covered bonds may be used as joint funding vehicles for two or more institutions; first such issue took place in 2012 (first joint funding agreement included BRFkredit, Jyske Bank and Sydbank).
- Institutions frequently issue bond series of the same type as others; covered bonds of same type with same rating from different issuers traditionally regarded as near-perfect substitutes and trade at identical or nearly identical prices.

*Source: _cr14349 - 11.      The Danish mortgage system is further strengthened by the Mortgage Credit Act*

### 27.      The Danish covered bond market is also highly concentrated among issuers, reflecting

### _cr14349 - 27.      The Danish covered bond market is also highly concentrated among issuers, reflecting

### Market concentration and issuer structure
- Covered bonds are issued by only seven institutions.
- Nykredit/Totalkredit and Realkredit Danmark accounted for more than 70 percent of all outstanding issues as of the end of 2013.
- The market is split relatively evenly between independent MCIs and commercial banks or their subsidiaries.
- MCIs often have strategic alliances with smaller banks or estate agency chains as sources of new loan business.
- Subsidiaries of commercial banks generally source loans through the branch network of the owner.

### Outstanding covered bonds by issuer (December 2013) — key figures
- BRFkredit: DKK 209.5 bn, 7.9 percent, Ownership: General, Nonbank Foundation 1/
- Danske Bank: DKK 20.7 bn, 0.8 percent, Ownership: General, Commercial bank 2/
- DLR Kredit: DKK 136.5 bn, 5.1 percent, Ownership: Specific, Danish universal banks
- LR Kredit: DKK 15.6 bn, 0.6 percent, Ownership: Specific, Danish universal banks
- Nordea Kredit: DKK 370.6 bn, 13.9 percent, Ownership: Specific, Commercial bank
- Nykredit/Totalkredit: DKK 1,162.4 bn, 43.6 percent, Ownership: General, Nonbank Associations
- Realkredit Danmark: DKK 747.5 bn, 28.1 percent, Ownership: Specific, Commercial bank
- Total: DKK 2,662.8 bn, 100.0 percent
- Notes from table:
  - 1/ Jyske Bank became the majority shareholder of BRFkredit in February 2014.
  - 2/ Includes only issues registered with VP Securities, which are traded domestically.
- Table source: Danish FSA and Danmarks Nationalbank.

### Regulatory differences: MCIs vs commercial banks
- MCIs:
  - Specialized banks limited to mortgage banking (mortgage loans on real property, unsecured loans to public authorities or guaranteed by them, and senior claims against credit institutions).
  - Cannot accept deposits and rely on covered bonds, unsecured loans and capital or retained earnings for funding.
  - Subject to more restrictive requirements for covered bond issuance: higher capital, more OC in each capital center.
  - Loans are matched to specific bond issues; bulk of reserves must be invested in government debt, covered bonds, or deposits at the central bank.
  - Because MCIs cannot accept deposits and borrow only very limited amounts on an unsecured basis, the high level of encumbrance associated with covered bond issuance is not material.
- Commercial banks:
  - Engage in a wide range of financial businesses; mortgage banking is normally relatively small.
  - Rely mainly on deposits for funding.
  - Requirements for issuance of covered bonds are based on broader business models and access to wider funding sources.
- Bankruptcy/suspension implications:
  - For MCIs, residual covered bond claims that cannot be met by assets of a capital center become senior claims on ordinary assets.
  - For commercial banks, such residual claims do not enjoy preferential status.
  - MCIs have mandatory additional OC requirements; commercial banks are not required to inject additional capital in such situations.
  - Failure by either to cover a collateral shortfall immediately will result in loss of covered bond status of the affected issue and suspension of the covered bond license of the issuer; status of existing unaffected issues remains unchanged.

### Issuance practices and product innovation
- Several MCIs have begun to issue junior covered bonds (Nykredit, BRF, Realkredit, DLR).
- One MCI has issued senior covered bonds (SDROs or SDOs) at LTVs significantly lower than the 80 percent maximum (example: 60 percent), with a subordinated loan covering the difference used as collateral for an RO from a separate capital center.
- ROs are not subject to continuous observance of LTV criteria; additional collateral to compensate for asset price declines is not required.

### Investor market, liquidity, and market infrastructure
- Historical features:
  - High daily turnover reflecting regular tap issues; turnover peaks each quarter with refinancing auctions for fixed rate bullet bonds.
  - Daily turnover reduced significantly during the 2008–09 financial crisis, but regular tap issuance continued.
- Market making and repo support:
  - Market making agreement supported by six Danish banks (Danske Bank, Jyske Bank, Nykredit Bank, SEB Nordea, Spar Nord Bank and Sydbank) to offer bid and ask prices for a standard transaction size of DKK 200 million in several liquid series (currently 12).
  - Large repurchase market accounts for more than 25 percent of total turnover.
  - Danmarks Nationalbank accepts Danish covered bonds as collateral for lending to MCIs and commercial banks at a haircut (up to 11 percent depending on residual maturity) from the official price on NASDAQ OMX NORDIC (previous day average of all trades).
  - Bid-ask spreads generally remained at 10–20 basis points and spreads to benchmarks increased by only 100–150 basis points for the most liquid bonds during the recent financial crisis.
- Futures and hedging:
  - NASDAQ OMX NORDIC has offered covered bond futures since 2009.
  - Three covered bond futures: 20-year callable, 30-year callable, and three-year non-callable.
  - Futures expire at end of each calendar quarter; settled daily marked-to-market with netting; each future is a basket of at least two bonds.
  - Futures popular with foreign investors.
- Ratings:
  - Danish covered bonds historically received high ratings based on balance principle, low expected probabilities of default and loss, and expected systemic support.
  - Rating agencies have expressed concern about market risk from recurring need to refinance large amounts of short-term bonds, higher payment requirements from end of IO periods, and possible normalization of interest rates.
  - Failures of Amagerbanken and Fjordbank Mors, where senior creditors and uninsured depositors were bailed in, led to re-evaluation of systemic support; ratings sometimes under pressure or withdrawn at issuer request, limiting investor participation.

### Investor composition (December 2013) — key figures
- Domestic financial institutions: DKK 1,021.6 bn, 38.4 percent
- Insurance and pension funds: DKK 701.1 bn, 26.3 percent
- Mutual funds and asset managers: DKK 284.6 bn, 10.7 percent
- Other domestic investors: DKK 240.4 bn, 9.0 percent
- Foreign investors 1/: DKK 414.6 bn, 15.6 percent
- Total: DKK 2,662.8 bn, 100.0 percent
- Note: 1/ It is estimated that foreign affiliates of Danish investors accounted for approximately DKK 100 billion of total holdings by foreign investors at end-December 2013.
- All Danish covered bonds are highly rated and enjoy a risk weighting of 10 percent when held by EU banks or credit institutions using the standardized approach, except ROs issued after 2008 which have a weighting of 20 percent.
- Outside the EU, highly rated covered bonds generally have a risk weighting of 20 percent.
- Under advanced IRB approach, risk weighting will generally be less.
- Covered bonds may be classified as Level 1 HQLA up to a ceiling of 70 percent with a haircut of 7 percent per EC specification; holdings of bonds issued by the institution itself cannot be included.

### Interconnectedness and systemic implications
- Large share of covered bonds held by domestic financial investors contributes to high interconnectedness; most institutions hold significant amounts of other domestic issuers’ bonds.
- Implementation of the LCR may lead banks to diversify portfolios by replacing own-issued covered bonds with those of other institutions, increasing cross-holdings and interconnectedness.
- Small number of issuers increases likelihood that problems in one institution will impact others.
- Covered bonds’ importance as a percentage of Danish GDP amplifies broader economic implications.

### Potential risks to financial stability — findings and scenarios
- Core observations:
  - Reliance on short-term bonds to finance adjustable and variable rate loans introduces major maturity mismatch.
  - Mortgage loan impairments and NPLs rose since 2007, reaching 0.19 percent and 1.7 percent, respectively, at end-2013.
  - A future normalization of European interest rates and the imminent end of IO periods could put pressure on borrowers, though household-level analyses indicate most affected borrowers would be able to continue servicing debts.
- Refinancing risk:
  - In 2013, maturing covered bonds financing adjustable rate loans were DKK 955 billion (EUR 128 billion), equivalent to about half of GDP and more than two thirds of the amount of such bonds outstanding at end-2012.
  - Quarterly auctions reduce but do not eliminate risk of a failed refinancing auction; consequences could be severe.
  - Large share of some bond series held by foreign investors (concentrated in non-callable one-year maturities and euro-denominated bonds where foreign investors hold as much as 80–90 percent of some series) increases auction risk.
- Rating downgrades and market liquidity:
  - Widespread credit rating downgrades could reduce participation by investors subject to rating limits.
  - Mark-to-market and stop-loss rules could exacerbate sell-offs, reduce liquidity, and depress prices.
- Legislative changes and maturity extension:
  - New legislation provides for mandatory extension of bond maturities in certain circumstances; immediate investor reaction limited but increases valuation complexity and extension risk.
  - Estimated market reaction to the legislation is five to ten basis points.
  - Potential for pro-cyclicality: prospect of extension could lead to price declines and contagion through cross-holdings.
- Interest rate normalization scenario:
  - Return to pre-crisis interest rate levels (e.g., 2005) would entail a near tripling of interest charges (and payments for IO period loans) for many adjustable rate borrowers.
  - Effects could be widespread and could lead to additional loan impairments; could also put downward pressure on housing prices, increase LTVs, and require issuers to post additional collateral.
  - Growing share of euro-denominated mortgage loans is theoretically important but limited by government commitment to fixed exchange rate between Danish kroner and the euro.
- IO periods and collateral pressure:
  - Extensive use of IO periods means housing price declines put pressure on MCI balance sheets due to need to provide additional collateral for continuous LTV compliance.
  - Expiry of IO periods will increase payment obligations for many borrowers; some rise in delinquency and default rates may ensue because housing price declines since origination limit borrowers’ ability to take new IO loans.
  - Alternatively, extending IO periods would require loan write-downs.
- Capital and resilience:
  - Danish financial institutions had comfortable core Tier 1 capital ratios at end-2013.
  - Stress tests suggest institutions are highly resilient and could easily absorb a rise in loan impairments of the magnitude foreseen.

*Source: Danish FSA and Danmarks Nationalbank.*

### 48.      The likelihood that the risks facing the Danish mortgage finance system will

### _cr14349 - 48.      The likelihood that the risks facing the Danish mortgage finance system will

### Risk assessment
- The likelihood that the risks facing the Danish mortgage finance system will materialize is described as "remote", but the risks are "substantial."
- Risks are "highly intertwined," so that the impact of one risk is exacerbated by the presence of others.
- A normalization of European interest rates could:
  - contribute to a further drop in housing prices;
  - because of the absence of amortization on loans with IO periods, result in the need for additional collateral for existing covered bonds;
  - put pressure on MCI balance sheets.
- A jump in interest rates would:
  - be reflected in higher payment obligations for a large majority of borrowers;
  - produce an increase "particularly sharp for loans in the IO period" and likely cause some pressure on default rates.
- Failure of a covered bond refinancing auction for one bond series would "almost certainly" contribute to difficulties refinancing maturing bonds issued by other institutions, resulting in a jump in interest rates across the board.

### Interconnectedness and systemic contagion
- High degree of interconnectedness means risks materializing in one institution would quickly spread across the entire mortgage finance sector.
- Example mechanisms of spread include refinancing auction failure and correlated increases in collateral needs for covered bonds.

### Policy recommendations — overarching
- The Danish covered bond framework has served the economy well, including during the recent global financial crisis, but "will need to adapt in response to recent product innovation."
- Policy objective: mitigate systemic risks associated with increased use of adjustable-rate loans and loans with interest-only (IO) periods while maintaining benefits to Danish homebuyers.
- Given intertwined risks, solutions addressing one risk component also help reduce stresses in other areas.

### Policy recommendations — addressing maturity mismatch and refinancing risk
- Challenge: reduce maturity mismatch and refinancing risk from financing long maturity adjustable and variable rate mortgage loans with short-term bonds.
- Recent legislation provides a mechanism to address the emergency of a failed refinancing auction, but incentives should be provided for banks to limit the risk of such destabilizing events.
- Possible regulatory adaptations:
  - Use Pillar II reviews or the systemic risk buffer to ensure lenders take refinancing risk into account by requiring MCIs to set aside additional capital when maturity mismatch is large.
  - Restrict maturity mismatch directly, perhaps through application of the Supervisory Diamond approach.
  - Modify the balance principle to include quantification of maturity/refinancing risk—for example, require additional OC of capital centers issuing short-term bonds.
  - Favor creation of longer maturity covered bonds by requiring higher risk weights on loans lacking certain characteristics (e.g., fixed interest rates or market-friendly rate reset mechanisms).
  - Use tranching techniques from securitizations to package longer maturity assets for investors.
  - Cover risks of such loans more easily in the options market.

### Policy recommendations — reducing attractiveness of adjustable/variable rate loans
- Adopt policies to reduce attractiveness of adjustable/variable rate mortgage loans to mitigate adverse effects on loan default risk and impairments; these measures would also reduce maturity mismatch and refinancing risk.
- Observed market pricing: administrative margins for adjustable/variable rate versus fixed rate loans were about "20 basis points higher" for adjustable/variable rate loans at the end of 2013.
- Borrower response: lengthening initial fixed rate period on loans, which cushions potential rapid rises in interest rates.
- Possible authority actions:
  - Encourage lenders to increase the pricing differential further by requiring higher credit provisions or additional capital so that the additional risk of adjustable/variable rate loans is fully taken into account.
  - Increase parameters of the stressed debt service-to-income criteria that supervisors already require for loan approval for such loans.

### Policy recommendations — addressing interest-only (IO) loans
- Consider limitation or guidance on conditions of loans with IO periods:
  - Eligibility could be limited to loans with LTVs substantially below "80 percent."
  - Alternatively, require borrowers to amortize the portion of the loan above a lower LTV ceiling.
  - Such provisions would reduce credit risk and diminish the need for additional collateral for covered bonds in the event of a housing price decline.
- Encourage lenders to limit length of IO periods (or price them more appropriately) by requiring higher credit loss provisions for loans with longer IO periods.
- Consider ending or reducing tax deductibility of interest payments on loans with IO periods, even if only during the IO period, to discourage use.

### Regulatory and market-structure adjustments
- Implementation of the LCR in the EU will require adjustment of financial portfolios; it is important to manage this adjustment to limit impact on market conditions during the transition phase.
- Similar issues are likely with the future implementation of the NSFR.
- Current low interest rates and a flat yield curve provide a "window of opportunity" to implement measures aimed at reducing maturity mismatch by lengthening the maturity of covered bonds when borrower cost is minimal.
- Measures that reduce use of adjustable rates and/or IO periods will reduce credit risk and reinforce measures lowering refinancing risk.
- The central role of mortgage finance and covered bonds in the financial system makes these policies "vital to the future health of the Danish economy."

*From: _cr14349 - 48.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14349.pdf_