Danes tackle ARMs concerns via callable revival, new Cita loans

Danish lenders are responding to regulatory and rating agency pressures to reduce the share of adjustable rate mortgages (ARMs) with the launch of Cita-based loans and a revival of fixed rate callables, with Moody’s highlighting Nordea Kredit’s success in the latter as credit positive.Moody’s concerns about Danish banks and developments in the mortgage finance system have been well aired, particularly since they resulted in most of the country’s mortgage lenders ending their relationship with the rating agency because of fundamental disagreements with Moody’s opinions.

But on Wednesday of last week (23 October) the rating agency noted that after Nordea Kredit initiated a revival of callables late in 2012, 59% of new loans originated by the lender this year have been financed via callables, with short term bullet bonds with one to two year terms and “high refinancing risk” contributing only 16%, which the rating agency said is in “stark contrast” to earlier years.

“This step is credit positive for Nordea’s Danish covered bonds because the 30 year bonds, in contrast to short term bullet bonds, are substantially free of refinancing risk, one of the major risks for covered bond investors,” said Moody’s. “It also improves the collateral risk of Nordea’s cover pools.

“Nordea’s revival of callable bonds will result over time in a substantial reduction of the refinancing risk of its capital centre 2 covered bond programme, improving the chances of timely payments on the covered bonds. Nordea reviving callable bonds is also credit positive because it helps to reduce the sector’s high reliance on short term funding.”

The revival of fixed rate callables is not confined to Nordea. Morten Bækmand Nielsen, head of IR at Nykredit Realkredit, says the lender is seeing a revival of interest in the traditional product.

“About 45% of all new loan production that we are seeing going through our books is actually 10 to 30 year long term fixed rate callable bonds, in other words the traditional Danish mortgage product and hence also the traditional Danish covered bond product,” he says. “At the height of the crisis everybody opted for the one year ARMs and the fixed rate and other products were below 10%.

“So that’s quite a positive move. Overall our outstanding amount of these 30 year fixed are actually increasing again after a long, long period of decline.”

Klaus Kristiansen, RD

Meanwhile, Realkredit Danmark and Nordea Kredit have already launched Cita-based mortgage loans, while DLR Kredit has detailed its planned product and Nykredit is preparing to announce its version.

As a funding official at one Danish mortgage credit institution describes it, the lenders are trying to kill two birds with one stone. The first of these is the concerns over the high share of ARMs in mortgage lending, which Standard & Poor’s also voiced in July — albeit less dramatically than its peer.

Realkredit Danmark’s new product, “FlexKort”, is being financed via a three year bond referencing the Cita rate. Klaus Kristiansen, executive vice president at Realkredit Danmark, says that the new product meets the demand for floating rate loans in Denmark that is evident from the popularity of ARMS while addressing concerns about the one year bonds financing these.

“We have seen a strong demand for loans that are reset every year, but the main problem with these is that the funding structure relies on these one year bonds, so it implies a lot of refinancing risk,” he says. “And to curb that refinancing risk and still meet this demand for floating rate, we came up with this new bond structure, so it’s a floating rate product but based on a little bit longer term funding.

“We start out with three years, but we can hopefully go up to five years and eventually perhaps all the way to 10 year funding with this product structure. We need to comply with future stable funding requirements and also with some of the new methodologies that we have seen from S&P.”

Pernille Lohmann, investor relations manager, at DLR Kredit, echoes this.

“This comes from S&P’s announcement that they see an increased funding risk in the F1 product,” she says. “They have been telling us all that we have to do something about this, because of the imbalance between the funding and the lending.

“On the funding side there is more flexibility with the Cita-based lending.”

The second “bird” being “killed” by the Cita stone is a commitment to offer mortgages referencing Cita rates before the end of the year under an agreement made in September 2012 with the Ministry of Business & Growth. This agreement was made in the wake of the scandals around Libor and similar reference rates in the UK and elsewhere, even if a Danish investigation found nothing untoward.

“What we need for this product structure to work is confidence in the reference rate on a broad basis, and Cibor was somewhat stigmatised,” says Kristiansen. “The very definition of the Cibor rate was a little bit blurry, being defined as the rate a bank would offer to a prime bank on an unsecured basis, but with unsecured money markets having more or less vanished back in 2008.

“So what we were looking for was a reference rate that was backed by actual trades, and that is the case with the Cita rate. It is basically referring back to swap deals made by those banks quoting the Cita rate, so there is a link to something that has been traded — that’s quite important to us. It is also now supervised, and it is quite important that we can communicate that to our customers.”

S&P has questioned how popular the new loans will become given associated costs. But although RD and others have acknowledged this, they are hopeful that a shift can be made — and as with the increase in fixed rate callables, mortgage fee structures are being changed by banks to incentivise borrowers to switch away from, or into longer term, ARMs.

In an October presentation on its FlexKort, RD outlined how it could reduce an estimated NSFR deficit of Dkr105bn to Dkr29bn in the five years to the second quarter of 2018 assuming that 20% of one year ARMs can each year be refinanced by its new product or interest reset loans with a five year average term to maturity.

Kristiansen says that early signs suggest this is achievable. Since being launched on 23 September RD has made offers of close to Dkr500m of the new loans, with around Dkr200m having already been disbursed.

“If we look at the new business that we are generating, roughly 80% of the floating rate loans are this new product, which is a success and is quite convincing to us that there is demand for this product,” he says. “What’s more important to us is that we manage to encourage some of those loans that are to be refinanced based on the one year structure into this new product, and that is where we have set this 20% target.

“We have an upcoming refinancing, 1 January, and we are not at 20%, but we feel quite confident that we will get somewhere in the neighbourhood of 20%. And we have set up our pricing to build in an incentive to go for this product instead of the old one.”