Danish government in forced extension ‘game changer’

The Danish government yesterday (Wednesday) moved decisively to address concerns about refinancing risks in its mortgage system by announcing that from 1 January many covered bonds, including those related to ARMs, will face forced extension in certain stressed scenarios.

Under the proposals — which the government intends to come into force from 1 January 2014 — bonds with a maturity shorter than the maturity of the underlying mortgage loan will be extendible up to the maturity of the loan in the event of either a failed refinancing auction or where the refinancing rate is more than 5 percentage points higher than the coupon of the bond being refinanced.

Christiansborg Castle, seat of the Danish government

While acknowledging moves taken by the mortgage industry, minister for business and growth Henrik Sass Larsen said that the government and Danmarks Nationalbank felt it necessary to take action.

“The government is acting in order to safeguard the Danish mortgage model as we know it today,” said Larsen. “The change should be seen in light of the increasing attention lately to the refinancing risk associated with adjustable rate mortgage (ARM) loans.

“With this bill, it is my expectation that the Danish mortgage credit institutions will be able to maintain short term adjustable rate mortgage loans which a lot of Danish borrowers appreciate. Therefore we introduce this protection of the loans which implies that borrowers are able to keep the loans as they know them today and which they appreciate.”

The model is based on a proposal from a working group comprising representatives of the Ministries of Business and Growth, Finance, and Economics and the Interior, as well as the central bank and Danish FSA (Finanstilsynet). Issuers and other market participants, however, said that the announcement took them by surprise.

Extended bonds will carry a coupon 5 percentage points higher than the maturing bonds, with the cashflows matching that of the underlying bond. The proposal covers the non-callable bonds used for ARMs financing, as well as short and medium term capped floaters, Cibor floaters and new Cita floaters.

“The bill implies that investors will carry the risk for a term extension,” said the Ministry of Business and Growth. “However, this risk is likely to be low. Therefore, the assessment is that the interest rate on the relevant mortgage bonds will not be significantly affected.

“With this bill the only risk mortgage credit institutions can take going forward is credit risk which was also originally the intention with the balance principle.

Industry representatives reacted positively to the plan.

“We have to bear in mind that there are a lot of technical details involved and the legislative proposal is still underway, but if we take the model as described, we recognise and acknowledge the effort from the government and the national bank to remove the refinancing risk,” said Ane Arnth Jensen, managing director of the Association of Danish Mortgage Banks. “The rating agencies have been very concerned in this area, being very afraid that a situation could occur where the mortgage banks would not be actually able to sell the ARMs. You can always discuss how large or small this risk is — it’s an academic discussion — but we are now very satisfied that it is being removed.

“And the result is very good because it means that we are able to continue offering ARMs for Danish borrowers.”

Morten Bækmand Nielsen, head of investor relations at Nykredit Realkredit, said that the issuer is positive about the proposals, although it will need to go over the details when a draft law is available.

The move is a “major game changer” for the Danish mortgage market, according to Jens Peter Sørensen, chief analyst at Danske Bank.

“We have not seen such a move by either regulators or lawmakers in other European covered bond markets where the refinancing risk is moved away from the borrower/mortgage bank and to the investor,” he said. “We have seen some pass-through deals most lately from the Netherlands, but this is a different case.”

He said that he expects the proposal to be implemented, with the central bank very positive about the proposal, the mortgage banks also positive, and ATP — the biggest institutional investor in Denmark — also very positive, even if other investors are more sceptical. The proposal will also have to pass parliament, although analysts said they expect broad support.

As mentioned by Jensen, the proposal is not clear on how all elements of the changes will work, and analysts also said that they would reserve judgement on the full implications of the plan. However, they stressed the uncertainty and complexity it will introduce into the pricing of bonds facing the new conditions.

“We first have to calculate the probability that the option triggers which is doable, but we also have to calculate the fair value of the continuing fixed rate callable bond in forward space without knowing the underlying cashflow,” said SEB analysts. “This obviously requires a number of assumptions.

“The good news is that the trigger is set so high that the fair value of the embedded option probably would be close to zero and hence not in itself be a significant driver of pricing.”

They said that the introduction of the extended legal maturity could be a challenge for some investors whose prefer to play at the short end of the Danish market, for example treasury functions and hedge funds, with the uncertainty also potentially affecting international investors faced with another idiosyncrasy of the Danish system.

Another analyst said that the risk premium is likely to be more than a 5bp level suggested by some market participants, based on experience with other new products in the Danish market.

The extension proposal will not apply to outstanding bonds or those to be sold in the latest auctions starting later this month. Analysts said that this grandfathering is positive for exempt issues given that these lines will then be closed and the uncertainties surrounding future issuance.

“We strongly expect a continuation of the tightening spread development seen in the last part of yesterday’s trading session,” said SEB’s analysts. “We expect that demand for existing bonds which do not have the maturity extension feature will be high.

“Moreover, we expect strong bids at the forthcoming auctions starting on 18 November where the bonds sold are exempt from the new initiative.”