Danish extension plan fails to fully resolve refi risk, says S&P

A proposal for conditional mandatory extension of some Danish covered bonds is a “step in the right direction” but does not fully eradicate mortgage banks’ refinancing risk, S&P said yesterday (Wednesday), and an issuer said the rating agency’s intervention could be helpful.

The rating agency said that changes to Denmark’s mortgage covered bond legislation proposed by the country’s authorities would alleviate S&P’s “immediate” concerns about mortgage banks’ refinancing risk, but do not neutralise what S&P perceives as “substantial, albeit latent” default risk in the event of market disruption given banks’ heavy reliance on short term funding.

The proposed amendment foresees the automatic extension of the maturity date of bonds funding adjustable rate mortgages (ARMs) in certain stressed market situations.

“If the law is enacted as drafted, we consider that it won’t fully address the fundamental issue of the annual refinancing of a large portion of the covered bond market,” said S&P. “The law, as we understand it, will not discourage the use of short term [one year] F1 mortgage loans.

“Therefore mortgage lenders’ dependence on short term liabilities will remain high, perpetuating the status quo. What’s more, the proposed extension of mortgage covered bonds’ maturity dates, in effect, passes the role of lender of last resort from the central bank to investors.”

The proposed amendment does, however, address S&P’s immediate concerns about refinancing risk, because it extends mortgage lenders’ short term liabilities if there is market stress, said the rating agency.

“Specifically, we understand it virtually eliminates Danish mortgage banks’ default risk from a failed mortgage covered bond auction,” it said.

Alexander Ekbom, associate at S&P, told Nordic FIs & Covered that the proposed legislation is also positive in that its implementation would give investors clarity on how bonds would be treated in an extreme situation, but that the core of the problem remains unresolved.

“What we are trying to communicate is that the proposal addresses the symptoms that would arise in an acute situation of market stress, but not the root causes, namely high annual refinancing needs.”

He noted that the rating agency’s comments are in line with statements it made in July, when it revised downward the outlooks on several Danish banks’ ratings.

S&P in late July revised the rating outlooks on Danske Bank and DLR Kredit from positive to stable, and on BRFkredit and Nykredit Realkredit from stable to negative.

An official at a Danish mortgage bank rated by S&P downplayed the rating agency’s comments, saying that it did not contain anything new, and said he preferred not to comment given that the government’s proposal is still under discussion.

An official at another issuer also noted that the draft legislation is a work in progress, with the timeline for the progression of the bill having been revised just this past Thursday (30 January).

He said that S&P’s comment was not surprising in terms of it not being fully satisfied by the draft legislation in its current form.

“The comments from S&P could be helpful in order to change the wording of the current bill,” he said.

According to a revised schedule published by the Danish parliament the deadline for amendments to the draft legislation is 7 February, with political discussion and a final report on the bill scheduled for 18 February. The bill is expected to come into force on 31 March, according to the parliament document.

Denmark’s mortgage model has come under increasing scrutiny in recent years, including from Denmark’s central bank. The latest initiative launched to address the issue of refinancing risk is the Danish government’s legislative proposal for the conditional forced maturity extension of ARM bonds in certain stressed scenarios.

Under the proposal, the maturity date of ARM bonds would be automatically extended by one year in the event of a failed refinancing auction or, for bonds with terms of up to three years, if the coupon rate increased by more than 5% compared with the coupon the previous year.