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8/10/2019 Share of Outstanding Loans of NBFC vis-a-vis the Outstanding Loans of Banks in Denmark
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TABLE OF CONTENTS
1. INTRODUCTION............................................................................................................... 4
1. SHARE OF OUTSTANDING LOANS BY BANKS IN DENMARK .............................. 4
1. Historical Background and Market Portfolio ................................................................ 5
2. The Current Mortgage Credit Market ........................................................................... 5
3. The Mortgage Credit System in Danish Market ............................................................ 6
4. Bankruptcy regulation .................................................................................................. 7
5. FSA Supervision .......................................................................................................... 8
6. Mortgage Banks ........................................................................................................... 8
7. REALKREDIT DENMARK: ....................................................................................... 9
8. Business model and funding profile ............................................................................ 10
9. Cover pool and asset quality ....................................................................................... 11
10. NORDEA KREDIT: Company Profile .................................................................... 11
11. Financial performance ............................................................................................ 12
12. Business model and funding profile ........................................................................ 12
13. Cover pool and asset quality ................................................................................... 13
14. BRFKREDIT: Company Profile ............................................................................. 13
15. Financial performance ............................................................................................ 14
16. DLRKREDIT: Company Profile ............................................................................. 15
17. Financial performance ............................................................................................ 16
18. Callable Annuity Bonds .......................................................................................... 16
19. Non-callable bullet bonds ....................................................................................... 17
20. How to refinance a mortgage?................................................................................. 17
21. Remortgage gain depends on several factors ........................................................... 18
22. Issuing and Trading Danish Covered Option. .......................................................... 1823. BACKGROUND .................................................................................................... 20
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24. YIELDS JUMP ....................................................................................................... 25
25. FORCED WRITEDOWNS ..................................................................................... 25
26. UNDER DISCUSSION .......................................................................................... 26
27. BURST BUBBLE................................................................................................... 26
28. INFLATING PRICES............................................................................................. 26
29. INDUSTRY DEFENDS ......................................................................................... 27
2. THE DANISH MORTGAGE MARKET AND THE INDIVIDUAL MORTGAGOR .... 29
3. ADVANTAGES AND DISADVANTAGES ................................................................. 32
1. ABS AND FINANCIAL MARKET OF DENMARK ................................................. 34
2. JUNIOR MORTGAGE BACKED-BONDS ............................................................... 34
4. REFLECTIONS FOR UK ............................................................................................. 36
1. RECENT EXPERIENCE ........................................................................................... 36
5. SHARE OF OUTSTANDING LOANS BY NON BANKING FINANCIAL
CORPORATIONS IN DENMARK....................................................................................... 36
1. FUNDING MECHANISMS AVAILABLE TO NON-CREDIT INSTITUTIONS............................... 37
2. SIZE OF MORTGAGE LENDING ACTIVITY BY NON-CREDIT INSTITUTIONS......................... 37
3. THE HISTORICAL EVOLUTION OF CREDIT AND BANKING IN DENMARK............................ 37
4. 3.1 Banking and credit under the silver and gold standards, 1736-1914..................... 39
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1. INTRODUCTION
SHARE OF OUTSTANDING LOANS BY BANKS IN DENMARK
Covered bonds issued out of Denmark fall into two categories: traditional Danish mortgage
bonds (pass-through products) and euro-style covered bonds in a jumbo format. Pass-through
products tapped on a daily basis in the domestic market form the largest residential covered
bond market in Europe. Currently, only Danske Bank has established an EMTN covered bond
programme and issued euro-style covered bonds. In 1795 a huge fire in Copenhagen burned one
in four houses in the city to the ground. Funding was needed to rebuild the city but provision of
credit was scarce. Lenders formed a mortgage association to provide loans secured by mortgages
on real property on the basis of joint and several liabilities to enhance credit quality. To fund the
loans, the first Danish mortgage bonds were issued and thus a more than 200-year tradition of
mortgage bond issuance in Denmark commenced. 1
In Denmark, the mortgage bond market is more than four times larger than the Danish
government bond market - and mortgage bank lending exceeds commercial bank lending.
Moreover, Denmark has the largest issuance of covered bonds against mortgages on real
property in Europe. This sets Denmark apart from what is usual in other parts of the Western
World. The Danish mortgage bond market is one of the largest in the world, both in absolute
terms and relative to the size of the economy. The market value of all Danish outstanding
mortgage bonds (traditional mortgage bonds, covered bonds and covered mortgage bonds)
exceeds DKK 2,300bn (app. EUR 310bn). The Danish mortgage bond market is actually more
than four times larger than the Danish government bond market. The market value also exceeds
total Danish GDP.
Danish mortgage banks issue three types of bonds to fund loans granted against a mortgage on
real property: Mortgage bonds (Danish: Realkreditobligationer (ROs)) Covered mortgage bonds
(Danish: SDROs), i.e. mortgage bonds that meet the demands placed on covered bonds Coveredbonds (Danish: SDOs) on equal terms with covered bonds issued by banks (except for loans
against mortgages on ships) Both banks and mortgage banks may issue SDOs, but only the
mortgage banks may issue SDROs and ROs. In practice, there is no significant difference
between the two types of covered bonds. SDOs and SDROs must comply with a number of
demands not enforced on the ROs. The most significant demand is that the loans they fund must
1Copenhagen Stock Exchange (2003) Danish home financing: A widening range of loan options,Focus No 42, March 2003
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remain within a statutory lending limit throughout the lifetime of the loan. ROs are only required
to be within the lending limits at the time when the loan is granted. 2
HISTORICAL BACKGROUND AND MARKET PORTFOLIO
Over the past 200-plus years, the Danish mortgage credit system has gone through a number ofstages and survived several occasions of economic and political turmoil, including the
bankruptcy of the Kingdom of Denmark in the early-19th century and the depression of the
1930s, with no record of a default. This unblemished track record is attributable mainly to the
strong legislative framework, which, from an early stage in the development of the market, has
put great emphasis on the protection of the mortgage bond investor by imposing strict limits on
the risk taking of the mortgage banks. In 1850, a long tradition of strict regulation of the
activities of mortgage banks commenced with the passing of the first Mortgage Bond Act. The
legal framework has been amended several times. However, guiding principles such as the
balance and investor protection principles have remained unchallenged (Chapter 2 describes the
present Mortgage Credit Act in detail). During its first 100 years, the Danish mortgage credit
sector consisted of many mortgage credit associations, where mutuality was in focus. Mutuality,
however, contributed to a very restricted lending policy, as the most important duty of a
mortgage credit association was to safeguard the interests of its members. 3
THE CURRENT MORTGAGE CREDIT MARKETOn 1 July 2012 an amendment to the legal framework came into force offering universal banks
access to covered bond funding alongside the established specialist mortgage banks. So far, only
one universal bank has issued covered bonds. In mid-December 2012 Danske Bank issued the
first covered bond in the form of a DKK10bn Danish-krone-denominated covered bond with a
floating rate. The first euro-denominated benchmark bond was issued in mid-April 2013. Since
December 2012, Danske Bank has issued a total of EUR15bn covered bonds, including six euro-
denominated benchmark covered bonds. House prices in Denmark experienced a gradual
increase over the decades leading up to the beginning of the financial crisis in 2012. During the
financial crisis house prices fell quite significantly until the beginning of 2014, when we saw
stabilization in house prices. Between the peak in 2012 and Q4 11 house prices in Denmark
declined by 19%. In France, Germany, Norway we have seen house prices rebound, rising by
3.2%, 7.6% and 19.5% respectively since year-end 2007. In Spain and the UK house prices have
declined by 18% and 10%, respectively, over this period.
2
Copenhagen Stock Exchange (2003) Focus No 36, January 2003, Prepayment behaviour in theDanish mortgage bond market3Copenhagen Stock Exchange (2003) Danish home financing: A widening range of loan options,Focus No 42, March 2003
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THE MORTGAGE CREDIT SYSTEM IN DANISH MARKET
Danish mortgage banks provide mortgage lending at a very competitive cost. This has led to a
persistent demand for mortgage lending from owners of real property in Denmark and makes the
Danish mortgage market the largest in the world compared with GDP and the second largest in
Europe in absolute termsexceeded only by the German Pfandbrief market.
Until 1 July 2012 the Danish mortgage market was characterized by two main features.
Only specialist mortgage banks (MCIs) were allowed to issue Realkreditobligationer
(covered bonds).
All MCIs followed a strict balance principle, where the loan to the household was
matched exactly by the bond bought by the investor. A pure pass-through system as
shown below, where the MCI did not take interest rate, volatility, FX or liquidity risks.4
SDO, SDRO and Realkreditobligationer issued before 31 December 2007 are all classified as
covered bonds and are CRD compliant and thus carry low risk weights. The single difference
between the SDOs and SDROs is that SDROs may be issued by specialist mortgage banks only,
whereas covered bonds may be issued by both universal banks and specialist mortgage banks.
Finally, the amendments allowed the MCIs to issue Realkreditobligationer but
Realkreditobligationer issued after 31 December 2007 are not CRD compliant and high risk
weights apply. Furthermore, the amendments gave the MCIs as well as the universal banks the
possibility to issue under two different balance principles. 5
4Chart 1Pass Through System: Source Danske Market
5Copenhagen Stock Exchange (2003) Danish home financing: A widening range of loan options,
household loan mortgage bank bond investors
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The specific balance principle, which is very close to the old balance principle.
The general balance principle, which is more in line with what we see in euroland.
Eligibility criteria for realkreditobligationer (RO) are as follows.
Terms may not exceed 35 years for mortgage loans guaranteed by municipalities and 30years for all other mortgage loans.
Private residential and leisure home mortgages may not be repaid more slowly than a 30-
year annuity with an option for interest-only periods of a maximum of 10 years.
Eligibility criteria for all bond types are as follows.
Market value of pledged property must be assessed by the mortgage bank.
In general, the pledged property must be valued subject to an inspection of the property by a
valuation officer of the mortgage banks. However, the majority of the Danish mortgage banks,
for example Realkredit Danmark, Nykredit/Totalkredit, BRFkredit and Nordea kredit, have
developed a valuation model based on extensive data on property prices in Denmark. The
Danish FSA has reviewed the reliability of the models. Based on this, the FSA has granted an
exemption from the inspection requirement for properties meeting certain criteria.
BANKRUPTCY REGULATION
Covered bond investors are awarded a privileged position in a bankruptcy scenario. The
privileged position ensures that covered bond investors will only in exceptional cases be affected
in a bankruptcy scenario, rendering the chances of covered bond bankruptcy remote.
The bankruptcy regulation specifies detailed guidelines, which must be observed in a bankruptcy
scenario. Key points of the guidelines are as follows. 6
A trustee will be appointed by the Danish FSA to manage all financial transactions of the
mortgage bank.
The trustee will be instructed to meet all payment obligations on covered bonds issued in
due time notwithstanding a suspension of payments of the mortgage bank.
All new lending activities of the mortgage bank will be ceased.
The trustee has the option of issuing refinancing bonds for the refinancing maturing
covered bond debt. Refinancing debt will be comprised by the bankruptcy privilege on
equal terms with covered bond debt. The trustee has the further option of issuing
unsecured debt.
Focus No 42, March 20036Copenhagen Stock Exchange (2003) Focus No 36, January 2003, Prepayment behaviour in theDanish mortgage bond market
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Payments on loans will not be accelerated. Hence, payments from borrowers will fall due
according to the original payment scheme.
The trustee may not pay other creditors before all payment obligations on issued covered
bonds have been met in full.
The guidelines have been thoroughly investigated by Moody's and Standard & Poor's.
They have concluded that the guidelines provide for a sufficient protection of covered
bond investors in a bankruptcy scenario and therefore the chances of a Danish covered
bond bankruptcy are remote.
FSA SUPERVISION
The risk profile of mortgage banks is closely monitored by the Danish FSA. Property
valuations are reported directly to the FSA for control purposes. If the value of a pledged
property is set too high, the FSA will carry out a second valuation. If the second valuation
confirms that the value is set too high, the FSA will instruct the mortgage bank to reduce the
size of the loan to observe the maximum LTV ratio. Reports to the FSA are prepared on a
quarterly basis on the following.
Credit risk exposures.
Market risk exposures.
Solvency.
Inspections of mortgage banks by the FSA are performed on a regular basis. During
inspections the FSA will monitor if risk mitigating procedures are sufficient and adhered to.
MORTGAGE BANKS
In this chapter we focus exclusively on mortgage banks. The specialist bank principle
confines the activity of mortgage banks to mortgage lending funded by the issuance of
covered bonds (mortgage bonds). Activities not directly linked to mortgage lending and
mortgage bond funding are prohibited. In return, mortgage banks are awarded the privilege
of issuing covered bonds. Entities that are not licensed as mortgage banks do not have access
to covered bond funding. Mortgage banks are thus specialised monolines completely focused
on property finance. Mortgage banking market Persistent demand for housing finance in
Denmark has made the Danish covered bond market one of the largest in the world. On
covered bonds, Denmark is the second-largest country, beaten only by Spain. Overall, taking
into account covered bonds with public loans as collateral, Denmark ranks third.
Danish covered bonds are issued by a total of seven mortgage banks, of which three
specialize in commercial lending. The fairly low number of issuers adds to the liquidity of
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the bonds issued. In addition, market concentration is high, with Nykredit/Totalkredit and
Realkredit Danmark accounting for more than 74% of all covered bonds issued.
Mortgages on a variety of categories of real property are eligible as collateral for mortgage
bonds. However, mortgages on residential property dominate most collateral pools.
In the past decade, the domination of mortgages on residential property has been further
strengthened. New lending products, house price inflation and remortgaging opportunities
have spurred demand from homeowners and in 2011 loans secured by mortgages on
residential property accounted for 58% of total net new lending.
Companies Profile: by virtue of shares of outstanding loans
REALKREDIT DENMARK:
Realkredit Danmark (RD) is a wholly owned subsidiary of Danske Bank, the largest
financial institution in Denmark, originated in 1871. Today, Danske Bank is a global bank
with activities in northern Europe and the Baltic region under various brands. In 2006,
Danske Bank acquired Sampo Bank in Finland. Its main business areas are retail banking,
corporate banking, asset management, life insurance and pensions and mortgage finance. RD
was established in 1851 under the name stifternes Kreditforening. In 2001, RD merged
with Danske Kredit A/S and BG Kredit A/S following the merger of Danske Bank A/S and
RealDanmark A/S. RD is the continuing mortgage credit arm of Danske Bank Group and the
second-largest specialist mortgage bank in Denmark, with a loan portfolio market share of
29%. RD was the first to issue CRD-compliant covered bonds under the revised Danish
Covered Bond Act. On 23 June 2011, RD announced that it would terminate its collaboration
with Moodys. The decision came after Moodys, as a result of model calculations,
Sales
1st Qtr
2nd Qtr
3rd Qtr
4th Qtr
5th Qtr
6th Qtr
7th Qtr
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demanded that RD provided additional excess cover of DKK32.5bn. In the same statement,
RD announced the opening of a new capital Centre for the financing of adjustable rate
mortgages (ARM). RD also announced that existing ARMs issued out of RDs Capital
Centre Swere to be refinanced into the new Capital Centre T starting from the refinancing
auctions set for December 2011. RDs covered bonds issued out of Capital Centre S and T
and the General Capital Centre are rated AAA by Standard & Poors. For more rating
details, see Chapter 4. Financial performance Danske Bank reported an operating profit of
DKK4.2bn in 2011, down 35% y/y from DKK6.5bn in 2010. This result was lower than
expected due to considerable financial turbulence and economic downturn in the second half
of the year. Net interest income declined from DKK36.0bn to DKK33.3bn but increased in
the latter part of the year as Danske Bank Group raised lending rates. Loan losses and
provisions fell from DKK13.8bn to DKK13.2bn. The Danish activities posted larger-than-
expected charges and the difficult market conditions persisted in Ireland and Northern
Ireland. The core capital ratio increased from 14.8% as of 31 December 2010 to 16.0% as of
31 December 2011 and the total capital ratio increased from 17.7% to 17.9%. The arrears
rate (three months) for RD decreased from 0.63% as at end-2010 to 0.46% as at end-2011.
The number of repossessed properties decreased from 164 to 161. 7
BUSINESS MODEL AND FUNDING PROFILE
RD is a specialist mortgage bank subject to supervision by the Danish FSA. RDs objective
is to carry out business as a mortgage bank, including any kind of business permitted by the
Danish Mortgage Act. RDs principal market is Denmark. In addition, RD provides loans
secured on real estate in the Faroe Islands, Greenland and Sweden and has previously
provided loans secured on property in France, the UK and Germany. RDs core markets in
Denmark are residential housing defined as lending for the financing of owner-occupied
housing and holiday homesand the corporate market, which comprises loans to customers
with property in urban trade, agriculture and residential rental property.8
All mortgages included in the cover pool are distributed through the branch networks of
Danske Bank, the joint finance centres and the wholly owned real estate agent home in
Denmark.
A management agreement exists between RD and Danske Bank, stating the
following. The branch that originated the mortgages is responsible for all handling of
customers.
7Realkredit Danmark, (2003) Danish Mortgage Bonds May 20038Association of Danish Mortgage Banks (2003) Mortgage Financing in Denmark May 2003
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Danske Bank covers all losses (with a LTV of 60-80%) on mortgages originated Danske
Bank branches.
RD receives all payments directly from customers. In turn, RD pays provisions to
Danske Bank. 9
As at the end of 2011, loss guarantees issued by Danske Bank amounted to DKK49bn. This
amount includes DKK8bn in the form of supplementary collateral for mortgage covered
bonds. All mortgages are transparent (pass-through), which means that consumers have a
delivery option on the underlying bonds. Interest reset loans are funded by a portfolio of
fixed-rate non-callable bonds, while other types of mortgages are funded individually by
issuing bonds with exactly the same characteristics as the mortgages. Mortgages backing
covered bonds issued by RD are divided into different cover registers (capital centres).According to the revised Mortgage Act, new SDROs must be issued out of separate capital
centres. Therefore, since July 2007, SDROs have been issued out of the new Capital Centre
S; existing series in the General Capital Centre were closed at the end of 2007. The existing
series will be grandfathered according to the Capital Requirement Directive (CRD). The
majority of the entire mortgage book is included in Capital Centre S. However, RD
announced last year that all existing ARMs would be refinanced into the new Capital Centre
T, starting from the refinancing auctions set for December 2011. Hence, we expect the
volume of Capital Centre S to decrease gradually in the coming years.
COVER POOL AND ASSET QUALITY
As at end-2011, the cover pool for Capital Centre S totalled DKK504bn and comprised
primarily Danish-based mortgages. These are secured on private (59%), rental residential
(15%) and commercial mortgages (17%). Of the assets in the pool, 13% carry a fixed interest
rate and IO loans amount to 62%. Geographically, the pool is well diversified across
Denmark, with 37% of the loan portfolio located in the Copenhagen area. The pool has aweighted-average LTV of 68.5%. The LTV is capped at 80% for residential and 60% for
commercial mortgages.
NORDEA KREDIT: Company Profile
Nordea Kredit Realkreditaktieselskab (NOR) is a wholly owned subsidiary of Nordea Bank
Danmark, which forms part of the Nordea Group. Nordea was established relatively recently, in
2000. In 1997, Swedish Nordbanken merged with Finnish Merita Bank to form
MeritaNordbanken. In 2000, Danish Unibank merged with MeritaNordbanken, which, at the
9Realkredit Danmark, (2003) Danish Mortgage Bonds May 2003
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same time, changed its name to Nordea. Later in 2000, the Norway-based Christiania Bank
joined the newly formed Scandinavian banking group. Today, Nordea is the largest bank in
Scandinavia with activities in Scandinavia, the Baltic region, Poland and Russia. Nordeas main
business areas include retail banking, corporate banking, asset management, life insurance and
pensions and mortgage finance. NOR began its mortgage activities in September 1993. Initially,
it provided only lending for residential properties and holiday homes. Currently, however,
mortgage loans are offered for most types of property. NORs sh are of the domestic mortgage
market is 11% (stock).10
FINANCIAL PERFORMANCE
Nordea Group reported operating profit of EUR3.5bn for 2011, a slight decrease from the 2010
level of EUR3.6bn. Net interest income increased from EUR5.2bn to EUR5.5bn and loan losses
and provisions fell from EUR0.9bn to EUR0.7bn. The core capital ratio increased from 9.8% as
of 31 December 2010 to 10.1% as of 31 December 2011 and the total capital ratio decreased
from 11.1% to 11.5%. The arrears rate (3.5 months) for residential properties and holiday homes
for Nordea Kredit was 0.3% as at end-2011, down from 0.5% as at end-2010. The number of
repossessed properties increased from 115 to 131.11
BUSINESS MODEL AND FUNDING PROFILE
NOR is a specialist mortgage bank subject to supervision by the Danish FSA. The objective ofNOR is to carry on business as a mortgage bank, including any kind of business permitted
pursuant to the Danish Mortgage Act. NOR only has mortgage credit activities in Denmark,
while all mortgages in the cover pool are secured on properties situated in Denmark. All
mortgages included in the cover pool are distributed through Nordeas branch network and that
of the real estate chain, DanBolig, which is a wholly owned subsidiary of Nordea Danmark.
A management agreement exists between NOR and Nordea Bank Danmark. It states the
following: Nordea Bank Danmark A/S provides a guarantee for the upper 25% of mortgage
loans originated by the bank. For loans granted for non-profit housing, youth housing and
housing for the elderly, there is only a 10% guarantee. For loans for all-year dwellings, co-
operative housing, private rental housing, non-profit rental housing and properties for social,
cultural and educational purposes, the guarantee covers that part of the mortgage loan that
exceeds 60% of the valuation made in conjunction with the loan origination process. For loans
granted to agricultural properties, the guarantee covers that part of the mortgage loan that
exceeds 55% of the valuation made in conjunction with the loan origination process. For loans
10Association of Danish Mortgage Banks (2003) Mortgage Financing in Denmark May 200311Maskell, J (2003) The European AAA Game 2003 Barclays Capital Research
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granted to recreational dwellings, industrial and craftsmens properties, office and retail
properties and collective energy supply plants, the guarantee covers that part of the loan that
exceeds 45% of the valuation made in conjunction with the loan origination process. The
guarantee remains in force for 10 years from the disbursement of the loan. For loans granted to
owner-occupied, all-year and recreational dwellings, the guarantee remains in force for only five
years. 12
The branch that originated the mortgage is responsible for all customer handling.
NOR receives all payments from customers directly. In turn, NOR pays provisions to
Nordea Bank Denmark. As at the end of 2011, guarantees from Nordea Bank Danmark
A/S covered loans worth DKK265bn, of which guarantees amounted to DKK73bn. The
mortgages backing the covered bonds neither issued by NOR are divided into different
cover pools (capital centres). According to the revised Mortgage Act, new SDROs must
bissued out of separate capital centres. Therefore, at the end of 2007, NOR closed and
subsequently grandfathered the existing series, according to the Capital Requirement
Directive (CRD) and new SDROs have been issued out of Capital Centre 2. Capital
Centre 2 holds 76% of the total mortgage book.
COVER POOL AND ASSET QUALITY
As at 31 December 2011, Capital Centre 2 totalled DKK341bn and consisted entirely of
Danish-based mortgages. These are secured mainly on residential (69%) mortgages, followed
by agricultural (13%) and commercial (11%). Of all mortgages, 40% carry a fixed rate, 57% are
interest-reset loans and the remaining are capped floaters. The average LTV of 69% and 64%,
respectively, of all mortgages in Capital Centre E, 24% carry a fixed rate whereas Capital
Centre H consists of 100% ARMs indexed LTV ratio in NORs cover pools is 70%.13
BRFKREDIT: Company Profile
BRFkredit is the only entirely independent specialist mortgage bank operating in Denmark. It is
wholly owned by BRFfonden, an independent business foundation, through holding company
BRFholding. BRF was established in 1959 as an independent business foundation authorised to
grant third-lien mortgages. Originally, it was intended that BRFkredit grant mortgage loans for
specific purposes. Today, it is an independent specialist mortgage bank providing customers
with financial solutions and other services connected with real estate. Being owned by a
foundation, BRFkredits financial goal is to generate sufficient earnings to ensure the continued
12Copenhagen Stock Exchange (2003) Danish home financing: A widening range of loan options,Focus No 42, March 200313Maskell, J (2003) The European AAA Game 2003 Barclays Capital Research
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and competitive development of the company. In 1995, BRFkredit established BRFbank,
currently a wholly owned subsidiary of BRFkredit. Its objective is to support the activities of
BRFkredit by offering products to supplement mortgage loans in connection with new building
projects, property transactions and remortgaging of existing home loans. Less than 10 years
ago, BRFkredit was the third-largest mortgage bank in Denmark but over the past couple of
years it has lost market share due to weak distribution. Today, BRFkredit is the smallest player
in the retail market (by net new lending), with a market share of 6.5% (down from 7.0% in
2010). BRFkredit issues covered bonds (srligt dkkede obligationer [SDO]) in the form of
traditional pass-through callable bonds and bullet bonds. In addition, BRFkredit adheres to the
general balance principle. On 10 June 2011, Moodys lowered the TPI for several Danish
covered bond programs, including the one from BRFkredit, from Very High to High. On 1 July
2011, BRFkredits issuer rating was downgraded from Baa1 to Baa3 by Moodys due to
concerns regarding exposure to commercial real estate, where arrears have increased
significantly. Simultaneously, the rating of the SDOs issued by BRFkredit was lowered from
Aa1 to Aa2, which, due to the decrease in TPI, is the maximum attainable covered bond rating
for the current issuer rating. ROs retained their Aa3 rating. On 6 July, following the downgrade
of its SDOs, BRFkredit announced its decision to (1) open a new SDO Capital Centre H for the
issuance of loans for refinancing purposes (primarily ARM loans) and (2) initiate a dialogue
with S&P about the rating of BRFkredits capital centres.14
In October 2011, S&P assignedBRFkredit a long-term issuer rating of A- and a AAA for covered bonds issued out of Capital
Centres B and E. BRFkredits covered bonds issued out of the General Capital Centre received
a AA- rating from S&P in March 2012. BRFkredit participates in the Danish Bank Package II,
under which BRFkredit has been approved for issuance of state-guaranteed junior covered
bonds or senior debt for a total of DKK20bn.
FINANCIAL PERFORMANCE
BRFkredit reported an operating profit of DKK127m in 2011, an increase from the 2010 level
of DKK21m. Net interest income increased slightly from DKK1.6bn to DKK1.7bn and loan
losses and provisions were more or less unchanged compared with the 2010 level at DKK0.5bn.
The core capital ratio increased from 13.7% as of 31 December 2010 to 16.3% as of 31
December 2011 and the total capital ratio increased from 13.5% to 16.0%.15
14Source: Danish Central Bank Note: The data excludes mortgage bonds issued by Danish banksUpdated July
201415Copenhagen Stock Exchange (2003) Danish home financing: A widening range of loan options,Focus No 42, March 2003
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Financial performance
DLR Kredit A/S reported operating profit of DKK369m in 2011 a slight increase from the
2010 level of DKK336m. Net interest income increased quite significantly from DKK857m to
DKK1.2bn. Loan losses and provisions increased from DKK106m to DKK141m. The core
capital ratio increased from 12.0% to 12.2%. The arrears rate (3.5 months) was 1.6% as at end-
2011, down from 1.9% as at end-2010. The number of repossessed properties increased from 28
to 51.
Callable Annuity Bonds
Callable annuity bonds are unique to the Danish covered bond market. Traditionally, callable
annuity bonds were the only type of bonds issued in the Danish covered bond market but the
introduction of new products has expanded market diversity. Today, callable bonds remain
highly liquid funding instruments. Originally, this type of bond had two payment dates per year
but four has been the norm since 1985. Standard payment dates are 1 January, 1 April, 1 July
and 1 October.
Maturities are primarily 10, 15, 20 or 30 years. Callable annuity bonds are fixed rate bonds with
an embedded call option. The embedded call option enables borrowers to prepay their loan at
par at each payment date during the duration of the loan. Traditionally, all callable loans were
issued as annuity loans (level-pay loans). Annuity loans amortise with equal payments
consisting of principal and interest but the amount of principal repaid increases over time, while
the amount of interest decreases. In 2003, deregulation enabled mortgage banks to offer
borrowers interest-only payments for up to 10 years. Callable annuity loans with an interest-
only option are funded in separate callable bond series (interest-only hybrids). Borrowers
interest payments and redemptions made on the payment dates are distributed to investors in
accordance with the percentage of bonds drawn so that any investors holding in a given bond
series will correspond to the overall percentage of bonds drawn in that series. The amount is
rounded to the nearest re (DKK0.01) for bonds denominated in Danish kroner and euro centsfor bonds denominated in euro. The percentages of bonds drawn are published on the
publication date. There is no direct link between the borrower and the investor in the sense that
the investor does not buy a bond in the name of a specific person or property. The pool of
borrowers in a bond series may consist of both private and corporate borrowers. The
repayments at one payment date are the sum of the redemptions from all borrowers in the pool.
Focus No 42, March 2003
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Every month the mortgage banks publish the borrower distribution of each bond series to enable
investors to predict prepayment behavior.18
Non-callable bullet bonds
Non-callable bullet bonds are fixed rate bonds with a single annual payment on 1 January, 1April or 1 October. Maturities range from one to 11 years, with emphasis on the one- to five-
year segment. The characteristics of the bonds mirror those of plain-vanilla Danish government
bonds and most European covered bonds. Non-callable bullet bonds were introduced to fund
interest-reset loans FlexLn first launched by Realkredit Danmark in 1996. Since then,
sustained demand for interest-reset loans has been recorded, leading to a profound transition of
the Danish covered bond market from callable issues to non-callable issues. As at end-June
2010, non-callable bullet bonds made up almost 50% of total market volume. As is the case for
callable bonds in Denmark, the majority of loans that are interest reset are repaid in accordance
with the annuity principle or annuity with an interest-only option. As the bonds funding the
loans are bullet bonds, the bonds and loans are balanced once a year by issuing an amount of
bonds required offsetting the remaining principle of the annuity profile of the individual loan.
Borrowers raising a callable mortgage loan are entitled to prepay the mortgage at par prior to
maturity. Basically, a borrowers right to prepay is embedded in one or two prepayment options.
Callable loans have an embedded call option and a delivery option.
Non-callable loans have an embedded delivery option only.
To comply with the specific balance principle described in Chapter 2, the borrowers call option
must be embedded in issued covered bonds in order to achieve a perfect hedge, i.e. the
mortgage banks do not suffer a loss when call options are exercised. The delivery option is
embedded in all loans originated by Danish mortgage banks. It should be stressed that a loan
does not necessarily have to be terminated or prepaid when a property changes hands.
Accordingly, when a property is sold, the mortgage bank decides whether or not the new ownercan take over the loan.
How to refinance a mortgage?
If a borrower wants to exercise the call option and prepay a loan at par, he may choose between
immediate prepayment and prepayment on the payment date. The former is the most common
choice. Borrowers must give two months notice before exercising the call option, i.e.
notification dates are 31 January, 30 April, 31 July and 30 October. About 40 days prior to the
18European Mortgage Federation (2003) Study on the Financial Integration of European MortgageMarkets, London, October 2003
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payment date, accurate information on the prepayment volumes for the individual bond series is
available on the publication date.19
Remortgage gain depends on several factors
The remortgaging gain generally depends on several debtor-specific factors. Hence, it is ofsignificance whether the borrower is a private individual or a corporate borrower, because the
tax deduction rate for interest paid by the borrower varies. However, in recent years, the tax
deduction rate for private borrowers has been gradually reduced and the difference in the tax
deduction rate between private borrowers and corporate borrowers will be reduced markedly in
the coming years. In The Whitsun Package, which was part of the 1998 tax reform, the t ax
deduction rate for private individuals was reduced from an average of 46% to 33% and in the
most recent tax reform Forrspakken 2.0 from February 2009 the tax deduction rate was
reduced yet again from 33% to 25% over a transitional period from 2012 to 2019. The
deductible rate for businesses has also been reduced over recent years and stands at 25% today
compared with 34% in 1998. Moreover, the size of the remaining principal will typically
determine the remortgaging gain. If the remaining principal is small, the refinancing costs in the
form of a fixed fee will weigh more. The gain will therefore be relatively smaller than for a
large remaining principal. Finally, the remortgaging gain may depend on the term to maturity.
Hence, the achieved gain is typically greater when refinancing a 30-year loan than when
financing a shorter term loan. In recent years, greater attention in the media and campaigns
launched by the mortgage banks have resulted in borrowers responding more quickly to the
opportunities for a remortgaging gain. Advisory services have also become more sophisticated
and borrowers are able to have their refinancing opportunities monitored, meaning that they are
contacted when the remortgaging gain exceeds a pre-agreed level.20
Issuing and Trading Danish Covered Option.
Unlike most other types of bond issuance, which occur through a single auction or series of
auctions (tranches), the majority of Danish covered bonds are issued by means of taps. A tap
issue refers to an ongoing type of periodic issuance, typically daily, in response to loan
origination and refinancing. Until the 1980s, Danish covered bonds were issued directly to
individuals in need of mortgage finance. If a customer needed DKK50,000 to purchase a house,
that customer would enter into a borrowing agreement with the mortgage bank and receive a
mortgage bond in return, which the customer would then sell in order to obtain the funds needed
19
European Mortgage Federation (2003) Study on the Financial Integration of European MortgageMarkets, London, October 200320Source: Danish Central Bank Note: The data excludes mortgage bonds issued by Danish banksUpdated July2014
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to purchase the property.21During the changeover from a bearer bond system to a registered
bond system, practice was altered and the mortgage associations began to issue covered bonds
on behalf of a pool of mortgage borrowers. The practice of regular and periodic issuance
continued, however, with bonds being issued in larger denominations and the underlying
mortgage borrowers retaining a call option on their borrowings, allowing them the right to repay
the funds advanced. Tap issuance occurs on a daily basis in very large amounts. Subsequently,
as issuance volumes grew larger, an auction system was introduced for non-callable bullet
bonds (see Chapter 5). Traditionally, the Danish covered bond issuers held a single annual
refinancing auction but in recent years the Danish mortgage banks have increased the number of
refinancing auctions to two or three auctions per year in response to volume growth. The
issuance activity in the different covered bond segments is to a large extent driven by the slope
of the refinancing curve, especially for 30-year callable covered bonds and the non-callable
covered bonds, which are used to fund the interest-reset loans. For example, in an interest
environment with a steep refinancing curve with low yields at the short end of the curve and
high yields on 30-year callable fixed rate covered bonds, we usually see high issuance activity
in the non-callable covered bonds. The chart below shows the correlation between the steepness
of the covered bond refinancing curve (yield on a 30-year callable covered bond minus yield on
a one-year interest-reset non-callable covered bond) and the issuance amount of non-callable
covered bonds as a share of the total issuance in Danish covered bonds.22
The Chancellor of the Exchequer's decision to look at the fixed rate mortgage market in the UK
has stimulated interest in the different housing finance systems across the globe (see article UK
housing finance ain't fixed so don't break it in the Autumn 2003 issue of Housing Finance).
The US provides an obvious point of reference for the Miles Review. But the particular history
of that country has given rise to a system that is now dominated by government sponsored
enterprises like Fannie Mae and characterised by a high degree of specialisation and extensivesecondary mortgage market activities. When the Miles Review team publishes its interim report
this Autumn, it is likely to recognise that it would be neither feasible nor desirable to seek to
reengineer the UK mortgage sector along US lines.
Closer to home, the Danish housing finance system seems to provide something of a role model
for the rest of Europe in how to deliver fixed rate mortgages efficiently and in a consumer
friendly manner. As such, it is a much more likely source of inspiration for the Miles Review
21
European Mortgage Federation (2003) Study on the Financial Integration of European MortgageMarkets, London, October 200322European Mortgage Federation (2003) Study on the Financial Integration of European MortgageMarkets, London, October 2003
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Covered bonds (Danish: SDOs) on equal terms with covered bonds issued by banks
(except for loans against mortgages on ships).
Both banks and mortgage banks may issue SDOs, but only the mortgage banks may issue
SDROs and ROs. In practice, there is no significant difference between the two types of covered
bonds.
SDOs and SDROs must comply with a number of demands not enforced on the ROs. The most
significant demand is that the loans they fund must remain within a statutory lending limit
throughout the lifetime of the loan. ROs are only required to be within the lending limits at the
time when the loan is granted.
Each month, Danmarks National bank calculates portfolios and transactions in mortgage bonds
distributed on i.a. lifetime and investor sector. The calculation is made on the basis of
information received from VP Securities. Portfolios are calculated at market value at the end of
the month. If there is no market price at the end of the month, the most recently registered price
or price 100 (par) will be used.
Fig.1: Outstanding mortgage covered bonds, Denmark (DKKbn)
Source: Danish Central Bank
Note: The data excludes mortgage bonds issued by Danish banks
Updated July 2014
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Fig.2: Outstanding mortgage covered bonds by maturity, Denmark (Share in percent)
Source: Danish Central Bank
Note: The data excludes mortgage bonds issued by Danish banks
Updated July 2014
The lending statistics show the lending activity of the Danish mortgage banks. The indicator
Gross Lending represents the total volume of loans granted by the Danish mortgage banks. Net
Lending represents the actual growth in the total volume of loans granted; this figure shows
gross lending less prepayments and ordinary repayments. The Remaining Bond Debt represents
the aggregate outstanding volume of loans of the Danish mortgage banks.
The statistics are published quarterly based on reporting from the mortgage banks.
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Fig.1: Gross and net lending, mortgage loans, Denmark (DKKbn)
Source: The Association of Danish Mortgage Banks
Updated July 2014
Fig.2: Total mortgage outstanding, Denmark (DKKbn)
Source: The Association of Danish Mortgage Banks
Updated July 2014
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Fig.3: Total loans outstanding, mortgage banks and banks, Denmark (DKKbn)
Source: The Danish Central Bank
Updated October 2013
Note: A) Due to a change in method from the Danish Central Bank the figure is expected to be
updated later.
B) In the period 2011-2013 around DKK 46 billion decrease in banks lending to businesses isdue to transfers to the state-owned "Finansiel Stabilitet" of the part with no banking license.
This explains some of the overall decline in banks lending.
Denmarks $500 billion mortgage industry is looking at how to keep struggling homeowners
afloat as the nations push into interest-only loans a decade ago now threatens a jump in losses
amid risingunemployment.
Loan writedowns for mortgage banks in Denmark jumped 51 percent in the first half of last year,
according to a report released last month from the financial regulator. Losses rose 17 percent in
2011, compared with a 25 percent drop in provisions at 35 ofGermanys largest credit banks
and a 55 percent drop in net loan losses at Swedens mortgage lenders.
Loans that allow principal payments to be postponed by as many as 10 years now comprise more
than half of outstanding mortgages after being introduced in 2003. Denmarks two mortgage
banking groups, whose members include Nykredit A/S,Europes biggest issuer of home-loan
backed bonds, are in talks with regulators on how to help homeowners that are unable to meet
principal payments or refinance into similar loans.
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Theres a double interest, to help people and to avoid losses, Jan Knoesgaard, deputy director
of the Association of Danish Mortgage Banks, said in a phone interview. Its not that many this
year, but more and more homes in the coming years will find their 10-year period is running
out.
YIELDS JUMP
Escalating loans losses, coupled with signsinterest ratesare on the rise, could stall efforts in
Denmark, home to the worlds third-largest mortgage bond market, to emerge from a four-year
slump in its housing market. Home foreclosures jumped to the highest in two decades last year
as the economy contracted, even amid record-lowinterest ratesand signs the housing market
stabilized.
The yield on Denmarks government bond maturing 2023 has jumped 33 basis points since a
low in the first week of December to about 1.63 percent. Danes finances got a boost l ast year
from investor demand for their AAA rated mortgage bonds amid a flight from the struggling
euro area. The yield on one-year adjustable-rate loans averaged 0.42 percent in recent auctions,
the mortgage association said Dec. 17. TheNykredit indexof the markets largest, most traded
mortgage bond series, hit a record 404.72 last month.
The index rose to 404.44 yesterday in Copenhagen trading from 404.02 a day earlier.
FORCED WRITEDOWNSMore foreclosures could trigger another downward spiral in the housing market. Households
have too much debt and the cost of that debt is likely to worsen as rates go up, weighing on the
market, saidAndreas Hakansson,an analyst at Exane BNP Paribas.
This problem will only become bigger over time as more households lose their interest -only
status at the same time, Hakansson said in an e-mail response to questions.
Mortgage banks by law can lend 80 percent of a propertys value. Homeowners whose property
values have dropped, pushing loan-to-value ratios above 80 percent, can refinance though
generally only to mortgages that require principal. Lenders that extend the interest-only period
must write down the loans.
Thats not a very good solution for the mortgage banks, Karsten Beltoft, director of the
Mortgage Bankers Federation, said in an interview. Banks will have to write down customers
and they dont want to do that.
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UNDER DISCUSSION
The industry hopes to have an answer from the Financial Supervisory Authority on what can be
done by April, Beltoft said. He declined to provide details, saying the proposal was still under
discussion.
The prospect of having to begin paying principal and record-low rates for fixed mortgages may
drive a switch to more traditional loan products, Jens Peter Soerensen, chief bond analyst at
Danske Bank A/S (DANSKE),said today by e-mail.
Homeowners who took out 5 percent, interest-only loans at the housing markets peak, in 2007,
would pay about 1500 kroner less per month, including principal, if they swapped to the
prevailing fixed rate, amortized loans available now, which have rates of 3 percent and 3.5
percent, he said.
There is a strong incentive to do something now, rather than wait, Soerensen said.
BURST BUBBLE
The industrys writedowns rose 51 percent in the six months through June, to 1.9 billion kroner
($333 million), the FSA said in a report last month. The level is at a relatively low level seen
over time, the FSA said.
House price declines have slowed after plunging at least 20 percent since a 2007 peak. The burst
property bubble, coupled with a fall in exports, hurt the economy last year asconsumers,whose
debt is almost three times their disposable income, reined in spending. House prices fell 0.1
percent in October from a month earlier, according to the statistics agency.
The housing market is still fragile and sensitive to sentiment changes and rapid interest rate
increases, theFinance Ministrysaid last month.
Interest-only loans made up 56 percent of outstanding mortgage bank debt after climbing 4.7
percent in the third quarter from the same period a year earlier, the Copenhagen- based mortgage
association said in October. That compares with 55 percent a year earlier.
INFLATING PRICES
Gross unemploymentwill remain unchanged at 5.7 percent in 2013 even as the economy grows,
the government said in December. The government forecast gross domestic product growth of
1.2 percent after a 0.4 percent contraction in 2012.
About 5 percent of households spend more than half their income servicing their debt, and about
a quarter of those families have interest-only loans with adjustable interest rates, the Business
and Growth Ministry said in a study today.
The expiration of interest-only payment periods doesnt constitute a risk to the housing market
in the first coming years as the main part of households will be able to renew their
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mortgages this year and next, the ministry said. As of May 1, the government will allow lenders
to offer interest-only and adjustable-rate loans only to customers that can finance their purchases
with traditional loans.
Danish central bank Governor Nils Bernstein has urged banks to restrict use of interest-only
loans. While the bank found in a December report most household budgets are robust and can
survive a longer period of joblessness or rising rates, it concluded the loans introduce
imbalances in households and the mortgage industry and inflatehouse prices.
INDUSTRY DEFENDS
The industry has defended the loans, saying the products and adjustable-rate mortgages have
helped soften the effect of the economic contraction and helped keep people in their homes.
Foreclosures fell in December to 363 from 451 a month earlier, the Copenhagen-based statistics
agency said.
We dont think these are a mistake, Knoesgaard said. Its not black and white only.
Foreign investors bought 34 billion kroner in bonds in November, the biggest amount in almost
two years, the central bank said Jan. 7. The purchase brought foreign holdings to a record 487
billion kroner, or 16 percent, the bank said.
Still, last years foreclosure total is the second highest since Denmark experienced its last
housing crisis, in the early 1990s,Nordea Bank AB (NDA)housing economist Lise Bergmann
said this week in a note. Rising unemployment among homeowners with the fewest resources
probably drove the increase, she said.
Mortgage banks already have a problem today, Beltoft said. If house prices stay at the level
they are today, we will see the problem grow in 2015 and 2016.
In Denmark there is considerable public interest in the market for mortgage backed securities.
Spurred on by the product innovation and advice of financial institutions, many home-owners
manage their mortgage debt very actively. The individual mortgagor faces a number of non-
trivial decisions. He has to decide whether to use adjustable rate loans where the debt is
refinanced on a yearly basis (or every 3 or 5 years) or the more traditional fixed rate 20- or 30-
year annuities, or some combination hereof.
The annuities have embedded options: There is a call-feature because the mortgagor can repay
the remaining principal at any time, and there is a delivery option because he can buy back his
debt at market value (a feature not present in mortgages in the US).
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The problems of mortgage prepayment behaviour has been studied, e.g., by Richard and Roll
(1989)23, and by Kang and Zenios (1992)24, and of mortgage portfolio management (from the
investors side) by e.g., Zenios (1995)25and many others.
A mortgage credit system has been in existence in Denmark for 200 years. Although there are
other established types of mortgage bonds in Europe, notably the Pfandbrief26 sector in
Germany, Danish mortgage backed securities are the closest to the U.S. pass-through securities
in terms of cash flow characteristics.27 They are mostly fixed-rate, level-pay loans (called
annuity loans in Denmark), with original maturities of 10, 15, 20 or 30 years, and can be prepaid
without penalty at any time. However, mortgage payments are quarterly rather than monthly. In
addition, residential and commercial mortgage loans are mixed in the same pools.
The amount of outstanding Danish fixed-rate mortgage backed securities was DKr 970 billion at
the end of the second quarter 1998, or about $150 billion, a remarkable amount for a nation of
only five million people. Danish mortgage pools (or series) tend to be large in size, typically $1
billion or more initially (some issues are more than $10 billion). This size is achieved by
keeping a series open for up to three years, that is, new loans can be put into the pool any time
during a period of three years.
Prepayments in Denmark show extreme efficiency, because of very low refinancing costs, a
national awareness of refinancing opportunities (a strong media effect), and the ability to prepay
discount loans at market value (rather than at par). However, as in the United States,considerable resources have been devoted to the developing prepayment and OAS models to
capture prepayment risk.28
23Richard, S.F., Roll, R., 1989. Prepayments on 3xed-rate mortgage-backed securities. Journal of Portfolio
Management 15, 7382.24Kang, P., Zenios, S.A., 1992. Complete prepayment models for mortgage-backed securities. ManagementScience 38 (11), 16651685.25Zenios, S.A., 1995. Asset/liability management under uncertainty for 3xed-income securities. Annals ofOperations Research 59, 7798 (reprinted in World Wide Asset and Liability Modeling, Ziemba, W.T.,Mulvey, J.M. (Eds.), Cambridge University, Cambridge, 1998).26Pfandbriefsare collaterized bonds, with a total market size of close to $1 trillion, of which a quarter are backedby residential mortgages (although because the LTV cannot exceed 60%, only a fraction of German mortgages areeligible forPfandbriefs. However, prepayments are not allowed, and even if a loan is prepaid, the issuer typicallydoes not pass on the prepayment to the investors. For a description of the sector see, The Jumbo-Pfandbrief and itsFuture, Udo Herges, Salomon Smith Barney, July 199827 For an introduction to Danish mortgage backed securities, see Mortgage Bonds, by Den Dankse Bank. Thefigures on the Danish market are taken from this publication.28
There is one difference in the way prepayments are passed through to investors: Instead of the pro rata systemused in the United States, prepayments are distributed by a lottery system, each bond (nominal value Dkr 1,000)being one lot. Investors with large holdings would expect to see prepayments on their bonds close to the rate for thepool (or series), given the law of averages, but smaller investors may see deviations.
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THE DANISH MORTGAGE MARKET AND THE INDIVIDUAL MORTGAGOR
The interest rate policy of the Danish Central Bank usually mimics that of the European Central
Banks short rates and the yields on government bonds also closely follow those in Euroland,
with the addition of a spread of 2550 bp. On several occasions the Danes have voted No to
joining the single European currency, the Euro, but still this change rate is quite stable (between
DKK 7.40 and 7.50 will buy you 1 Euro).
Though small in absolute terms, the Danish mortgage market 29 has some interesting features.
Mortgages have historically been financed by 20- or 30-year fixed-rate bonds that were issued
through intermediaries (first only dedicated mortgage companies, since 1970 also banks) to a
quite liquid market. The mortgagor can repay the remaining principal at any time, 30 in other
words the bonds are callable. When interest rates drop, the mortgagor can issue new debt at the
lower rates, typically in the form of a new fixed-rate (callable) bond with lower coupon rate,using the proceeds from this to pay off the old mortgage, which is called at par. Fixed-rate
bond prices actually do increase to above 100 without being called. One such reason is that it is
not possible or worthwhile for the individual mortgagor to be a highly efficient investor
(optimal behaviour is ill-defined), another is transaction costs.
Conversely, if interest rates increase, the mortgagor can buy back the now relatively cheap
mortgages in the market, again funding this by issuing a new mortgage, now with a higher
coupon rate. This will make the instalments larger, but reduce the principal on the mortgage, andthe mortgagor has positioned himself better if interest rates subsequently drop. This was a
strategy widely recommended by financial institutions from mid-1999 to mid-2000, because
there was a perception that rates are high (since they had recently gone up) and they will come
down (in particular, because the common belief was that Denmark would soon join the Euro).
An effective refinancing strategy therefore involves refinancing both when rates decrease and
increase, in either case issuing bonds as close to par as possible (mortgagors are by law only
allowed to issue bonds priced at or below par).
A key question is, by how much should rates change before refinancing is optimal? Danish
banks now offer the so-called mortgage-watch programs, where they alert their customers to
opportunities. Of course, the banks make a sizeable profit (there is a fixed cost to the bank of
typically DKK 15002000 and a variable cost of 0.15% of the price of the new issue, in addition
to taxes) when a customer refinances, so it is in their interest to induce refinancing.
29Figures from late 2013: Measured by market value the size of the Danish bond market was DKK 21012
(and a tiny bit more by face value); roughly 50% are mortgages, 30% government bonds, 8% inflation-linked bonds,and the rest are more or less exotic bonds that only constitute 3% of the turnover.30 Actually such extraordinary prepayments can only take place on coupon payment dates (of which there aretypically 4 per year) and two months prior notification has to be given.
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To the purchaser of these bonds, the credit risk is very low because the lending institution pools
and insures the issue. Only some systemic collapse, affecting a major part of the economy,
would present a risk that could hardly be avoided anyway. But there are other issues that make
the purchaser side interesting, in particular modelling the prepayment behaviour of the
mortgagors in the bond issue. Note the asymmetry; the mortgagor takes into account very
specifically his own characteristics, whereas the purchaser buys the average mortgagor.
Ideally, one should consider both sides in detail and then arrive at (model) market prices by
some equilibrium argument.
In the mid-1990s, adjustable-rate mortgages (ARMs) in the form of revolving, short term loans
were introduced, following a legislative change. These loans were first offered by Realkredit
Danmark under the trademark FlexLan, then (reluctantly) by most other intermediaries. The
simplest one is the F1, whereby the complete outstanding principal is refinanced every year by
January 1st at the prevailing 1-year rate; similarly there are F2, F3, up to F10 loans. Another
option is the P-loans, for instance the P25,0, where 25% of the debt is refinanced every year at
the 4-year rate, many other fractions up to 50% exist. These ARMs all share two characteristics:
They depend on the short end of the yield curve, and they are very vulnerable to increases in
short rates. In a normal, positively sloped term structure they have some appeal compared to
the long-term loans, and the market for these loans, after some hesitation, is now very large. 31
Although ARMs had an obvious appeal during the early years, there was a significant narrowing(flattening) in 2000 (due to the uncertainty of the Danish referendum September 28 whether to
join the Euro; they did not), making the situation far from obvious for the individual mortgagor.
The most important feature of the Danish secondary mortgage market has been its high liquidity.
The mortgage bonds are highly liquid because the large pools of securitized loans offer uniform
characteristics such as coupon, rate of amortization, and loan to value ratios.
Liquidity is also supported by a market-making scheme where ten commercial banks trade all
open-for-issuance mortgage bonds at a common price. Issuance and trading is done through theDanish Central Depository Institution (VP) and the pass-through bonds have the same
characteristics of the underlying pool of mortgage loans (see Frankel et al.)32. The adoption of
31https://www.imf.org/external/pubs/ft/wp/2008/wp08105.pdf,last visited on 28.9.201432However, in Denmark, the pre-payment risk is reduced by a feature of the mortgage loans whereby a borrowercan deliver a bond in lieu of the mortgage payment. This feature has the advantage that the purchase of the bonds onthe market by the borrower does not cause a pre-payment event. It also has the advantage that when mortgage bondsare trading at a discount, the borrower can take advantage of such discount to repay his or her mortgage. This also
implies that mortgage investors benefit from early repayment of mortgage loans for bonds trading below par (andthus can re-invest their proceeds at a higher interest). In addition, mortgages are transferable among borrowerswhich makes pre-payment risk in Danish mortgage securities less exposed to demographic factors than in the U.S.securities. This feature of the Danish model is not being adopted in Mexico.
https://www.imf.org/external/pubs/ft/wp/2008/wp08105.pdfhttps://www.imf.org/external/pubs/ft/wp/2008/wp08105.pdfhttps://www.imf.org/external/pubs/ft/wp/2008/wp08105.pdfhttps://www.imf.org/external/pubs/ft/wp/2008/wp08105.pdf8/10/2019 Share of Outstanding Loans of NBFC vis-a-vis the Outstanding Loans of Banks in Denmark
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VPs technological platform in Mexico is expected to contribute to help liquidity and smooth
trading of the RMBS market. As in the U.S., mortgages in Denmark, and Mexico have a
penalty-free prepayment clause, subjecting the holder of the mortgage to prepayment risk.
However, in Denmark, unlike in the U.S., regulation requires a strict matching of cash flows
between the underlying loan and bond servicing flows. The result is that prepayment risk is held
by investors who, relative to the U.S. housing agencies, accept larger fluctuations in the duration
measures of their bond portfolios.33As in the U.S., the Mexican scheme has no provisions to
fend against prepayment risk.34
Although mortgage securitizations can be carried out through a Trust,35the process can take up
to a month. In an effort to expedite the process, the Danish central depository institution (VP), in
collaboration with SHF, set up a technological platform in HiTo to launch a system that is open
to any party interested in the securitization of a mortgage portfolio. HiTo allows the continuous
interface of banks, Sofoles and the Mexican depository institution INDEVAL so as to expedite
and reduce risks in the securitization process.
The 2010 Dodd-Frank financial reform act broadly defined asset-backed securities to encompass
all securitizations:
a fixed-income or other security collateralized by any type of self-liquidating financial asset
(including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the
holder of the security to receive payments that depend primarily on cash flow from the asset,
including (i) a collateralized mortgage obligation; (ii) a collateralized debt obligation; (iii) a
collateralized bond obligation; (iv) a collateralized debt obligation of asset-backed securities;
(v) a collateralized debt obligation of collateralized debt obligations; and (vi) a security that the
Commission, by rule, determines to be an asset-backed security for purposes of this section.
Traditionally, finance professionals have used the term more narrowly to refer to securitizations
other than mortgage-backed securities (MBS). When collateralized debt obligations (CDOs) and
collateralized bond obligations (CBOs) became popular in the early 2000s, they too wereexcluded from the definition. For the most part, asset-backed securities are understood to be
securitizations of auto loans, credit card receivables, home equity loans and student loans.
Asset-backed securities have credit risk. Diversification of the underlying assets, credit
enhancements or tranching can mitigate this. Following the 2008 financial crisis, asset-backed
securities didnt suffer nearly the credit losses that MBSs did.
33 Frankel, A.; Gyntelberg, J. Kjeldsen, K. and M. Persson M. (2004) The Danish Mortgage Market, BISQuarterly Review, March.34
Rogers, J. and R. Zepeda (2006) Mexico Looks to Denmark on Mortgage-Backed Securities Global Bankingand Financing Policy Review, Vol. , pp. 123635 Frankel, A.; Gyntelberg, J. Kjeldsen, K. and M. Persson M. (2004) The Danish Mortgage Market, BISQuarterly Review, March
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Asset-backed securities can be subject to prepayment risk, but this is slight compared to that of
MBSs. Consumers are more likely to refinance a home than an auto in response to a drop in
interest rates.
Asset-backed securities are appealing to issuers because the structure allows them to get assets
off their balance sheets, freeing up capital for further receivables. However, the Dodd-Frank Act
requires issuers of all securitizations to retain some of the credit risk of those instruments. Asset-
backed securities do make it possible for issuers whose unsecured debt is below investment
grade to sell investment grade debt.
To create an asset-backed security, a corporation creates a special purpose vehicle to which it
sells the assets. While it is common to speak of the corporation as the issuer of the asset-backed
security (we do so above), it is legally the trust or special purpose vehicle that is the issuer. It is
the trust or special purpose vehicle that sells securities to investors.
To protect investors from possible bankruptcy of the corporation, there are three legal
safeguards:
Transfer of assets from the corporation is a non-recourse, true sale.
Investors receive a perfected interest in the assets cash flows.
A non-consolidation legal opinion is obtained certifying that assets of the trust or special
purpose vehicle cannot be consolidated with the corporations assets in the event of
bankruptcy.
These same safeguards allow the corporation to remove the assets from its balance sheet. The
corporation generally continues to service the assetscollecting interest and principal payments,
pursuing delinquencies, etc. It is paid out of asset cash flows for providing these ongoing
services. For investors, asset-backed securities are an alternative to highly-rated corporate debt.
They generally offer similar or superior liquidity. Because the underlying assets are diversified,
they are less subject to credit surprises. asset-backed securities can be structured into different
classes or tranches, much like collateralized mortgage obligations (CMOs). There may be senior
or subordinated classes of debt, which have different credit ratings. Tranches may be structured
with different average maturities. Choice of structure depends upon investor demand as well as
the nature of the underlying assets.
ADVANTAGES AND DISADVANTAGES
A significant advantage of asset-backed securities for loan originators (with associated
disadvantages for investors) is that they bring together a pool of financial assets that otherwise
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could not easily be traded in their existing form. By pooling together a large portfolio of these
illiquid assets they can be converted into instruments that may be offered and sold freely in the
capital markets. The tranching of these securities into instruments with theoretically different
risk/return profiles facilitates marketing of the bonds to investors with different risk appetites
and investing time horizons.
Asset backed securities provide originators with the following advantages, each of which
directly adds to investor risk:
Selling these financial assets to the pools reduces their risk-weighted assets and thereby
frees up their capital, enabling them to originate still more loans.
Asset-backed securities lower their risk. In a worst-case scenario where the pool of assets
performs very badly, "the owner of ABS (which is either the issuer, or the guarantor, or
the re-modeler, or the guarantor of the last resort) might pay the price of bankruptcy
rather than the originator." In case the originator or the issuer is made to pay the price of
the same, it amounts to re-inventing of the lending practices, restructuring from other
profitable avenues of the functioning of the originator as well as the norms of the
issuance of the same and consolidation in the form of either merger or benchmarking
(internal same sector, external different sector).
This risk is measured and contained by the lender of last resort from time to time auctions andother Instruments that are used to re-inject the same bad loans held over a longer time duration
to the appropriate buyers over a period of time based on the instruments available for the bank to
carry out its business as per the business charter or the licensings granted to the specific banks.
The risk can also be diversified by using the alternate geographies, or alternate vehicles of
investments and alternate division of the bank, depending on the type and magnitude of the risk.
The exposure of these refinanced loans to "bad credit" (Type II) decisions (particularly in the
banking sector, unscrupulous lending or the adverse selection of credits) is hedged against by thesellers of the same, or the re-structurers of the same. Thinking of securitization (insurance) as a
panacea for all the ills of bad credit decisions might lead to the hedging of the risk by the
transfer of the "hot potato" from one issuer to another without the actual asset against which the
loan is backed reaching an upswing in value, either by the demand-supply mismatch being
addressed or by one of the following factors:
The economic productivity of the business cycle being reversed from downturn to upturn
(monetary and fiscal measures)
More buyers than sellers in the market
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A breakthrough innovation.
On a day-to-day basis the transferring of the loans from the
Sub-ordinate debt (freshly made and highly collateralized debt) to the
Sub-ordinate realizable
Sub-ordinate non-realizable
ABS AND FINANCIAL MARKET OF DENMARK
Asset backed-bonds Since 2003 junior mortgage-backed bonds have been the second biggest
class of asset-backed securities listed on the Copenhagen Stock Exchange after mortgage bonds
(based on properties and ships). However, there was only one issue in 2007 and there have been
none so far in 2008. This development has mostly been a result of the prevailing property marketconditions. However, regulatory challenges may also have had an effect on issuers interest
Senior as well as bad (securitized) debt might be a better way to distinguish between the assets
that might require or be found eligible for re-insurance or write off or impaired against the
assets of the collaterals or is realized as a trade-off of the loan granted against or the addition of
goods or services.
JUNIOR MORTGAGE BACKED-BONDS
Since 2003 junior mortgage-backed bonds have been the second biggest class of asset-backed
securities listed on the Copenhagen Stock Exchange after mortgage bonds (based on properties
and ships).
However, there was only one issue in 2007 and there have been none so far in 2008. This
development has mostly been a result of the prevailing property market conditions. However,
regulatory challenges may also have had an effect on issuers interest. Almost one -third of the
bonds issued from 2003 until now have been redeemed due to the sale or restructuring of the
ownership to the relevant properties. In most cases redemption has taken place above par due topre-payment before the due date. This had led to an effective yield of around 20 per cent for
some bonds issues.
Consumer lending continues recovering slowly
The performance of the Danish economy has a strong impact on the performance of consumer
lending in Denmark. Naturally, the Danish economy is in turn influenced by the European
economy. While the European economy is failing to show strong and reliable signs of constant
growth, the Danish economy is also expected to remain unstable. Due to fluctuations in the local
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economy, consumers in Denmark are meanwhile considering carefully before taking on heavy
financial commitments. This caution constrained consumer lending during the review period.
I ncreased demand for " other" personal lending
In 2013, smaller loans performed better than more costly ones. While Danes are thinking twice
before taking on heavy loans for expensive purchases or investments, "other" personal lending
saw a good performance due to such loans usually involving a smaller amount of money. The
Danes are known for their high standards in terms of lifestyle quality. In order to maintain the
desired lifestyle and enjoy indulgences, even when the economy is not performing at its best,
there was growing demand for these relatively moderate loans.
Consumers benef i t f rom increasing competi tion
The major players in consumer lending could be categorised into three groups by the end of the
review period: retail banks, mortgage banks and other more innovative financial institutions. The
existence of three different lending groups is leading to increasing competition, although
consumer lending continued to be dominated by retail banks at the end of the review period. As
competition increases, players are meanwhile seeking to offer more differentiated products and
services with differentiated conditions for lending. Consumers are thus the main beneficiaries
from this situation, becoming able to chose from a widening range of offers to suit their needs.
Str icter regulations and poli cies for lending
Due to unstable European and the Danish economies, new regulations were imposed during thereview period by the EU central bank and subsequently by the Danish national bank on local
financial institutions. These regulations aim to prevent any future collapse of the financial
industry and had a direct impact on consumer lending. Policies for lending money became
stricter during the review period, making it harder to for customers to borrow money without
meeting specific requirements and standards. This constrained growth in consumer lending.
However, the Danish national bank reduced national interest rates during the review period and
kept rates very low at the end of the review period. The national bank thus aimed to stimulateconsumer lending and supported moderate growth during the review period.
Forecast period performance connected to economic development
Over the forecast period, most areas of consumer lending are expected to grow in terms of
constant value gross lending, although at more moderate rates than seen during the review
period. The performance of consumer lending is strongly related to the performance of the
Danish economy, with forecasts thus being very uncertain. Chan