'Historic Fight' with the EU
We have previously discussed Denmark's unique mortgage credit bubble (see 'Scandinavian Sorrows' and 'Danish Sorrows' for a detailed overview). In brief: household debt in Denmark is at 310% of GDP, a world record. A large part of this consists of mortgage debt. Per capita and relative to GDP, Denmark boasts the largest mortgage credit market in the world.
Why is it a problem? It is not only the sheer overwhelming size of the debtberg that gives cause for worries. As we pointed out, the governor of Denmark's central bank, Lars Rhode, has the serenity of a true Zen master. While his central bank has been instrumental in creating an explosion in Denmark's money supply by at one point imposing negative interest rates to keep the currency from appreciating (sounds familiar), he isn't worried at all about the debtberg of Denmark's households. He reckons that the mountain of debt is balanced by large pension assets and a strong social safety net, whereby the latter has some latitude due to Denmark's low public-debt-to-GDP ratio.
Of course what he ignores is that the value of assets is often ephemeral, something that cannot be said of the size of the debt, which doesn't change in the event of falling asset prices. Also, the governments of Spain and Ireland had very low public-debt-to-GDP ratios as well before the crisis motivated them to engage in serial bailouts while their tax revenues collapsed concurrently.
Let us say though that Rhode has a point regarding this balance. That still leaves a problem. Not only have real estate prices begun to fall (there was a big bubble in prices as well of course), but the funding arrangements of Denmark's mortgage credit market look decidedly unsafe. A lot of what is really very long-term debt is funded with bonds of a duration of just one year.
This is why the EU has now begun to put pressure on Denmark's government to alter the rules. It probably fears that the whole debt edifice could topple if short term funding dries up during a crisis. New EU regulations demand that banks must have stable funding of long-term obligations, and one-year bonds probably don't really qualify. However, no-one ever interfered with Denmark's mortgage market before, and it has worked quite well up until now. It seems likely that intervention will lead to unintended consequences. This is a general principle one must always keep in mind.
“Denmark is bracing itself for an historic showdown with the European Union as lawmakers in the Nordic country settle on a definition of stable funding for mortgage banks that Brussels has yet to accept.
For the first time in the history of Denmark’s two-century-old mortgage bond market, lawmakers proposed last week adding a trigger to extend maturities on one-year notes at risk of failing to meet stable funding requirements. Never before have investors in the $530 billion market for Danish mortgage bonds faced government intervention in securities funding existing loans, according to the Danish Mortgage Bankers’ Federation.
The government in Copenhagen now needs to convince European regulators the new maturity profile satisfies stable funding rules intended to protect against market freezes. The Danish Financial Supervisory Authority, which deems funding shorter than 12 months as unstable for commercial banks, says the EU should accept the new mortgage bonds. Denmark is waiting for a response from Brussels as lawmakers, led by Economy Minister Margrethe Vestager, say they’re willing to do whatever it takes to save the world’s biggest mortgage market per capita.
“The Danish FSA’s position in the future EU development of the Net Stable Funding Ratio is that the new one-year mortgage bonds should be considered as stable funding,” Kristian Vie Madsen, the FSA’s deputy director general, said in an e-mailed response to questions on Nov. 8.
Standard & Poor’s, which warned in July that a failure to reduce issuance of one-year bonds could lead to downgrades, said it is looking at the proposal. Moody’s Investors Service, which has also criticized Denmark’s short-term mortgage bonds for introducing refinancing risks, is analyzing the proposal, it said last week. Investors still need time to decide what the changes mean, according to Pacific Investment Management Co. “We are evaluating this development,” said Kristion Mierau, senior vice president for portfolio management at the Munich office of Pimco, the world’s largest bond fund.
Without European approval, banks in Denmark will have to slash sales of mortgages with rates that are reset annually. The one-year bonds make up about 40 percent of the market, comprising the single biggest category of mortgages.”
Adding a 'trigger' to one year bonds means mainly that they actually won't change the current financing model, except under duress. Here is what the trigger feature entails:
“Under the proposed legislation, an auction failure or interest rate increase of more than 5 percentage points would trigger conversion of one-year, three-year and five-year mortgage bonds, including index-linked notes, into callable, fixed-rate bonds with a maturity matching the underlying loans. That can be as long as 30 years, minus the maturity of the original loan. Yields would be set at the coupon plus 5 percentage points.”
Single family house prices in Denmark since 1994: the bubble has burst.
'Stable Funding' vs. Mortgage Costs
A number of important aspects of the debate are revealed in the excerpt below. We get the feeling that the new 'trigger feature' could well end up setting the very crisis in motion it is designed to avert:
“At Danske Bank A/S, chief bond analyst Jens Peter Soerensen said Denmark’s proposal “might be stretching the interpretation of the net stable funding ratio a bit far, but this is dependent on the interpretation of the local FSA, and so far they seem positive. I don’t think the EU would comment on a specific Danish mortgage bond and say that’s not stable funding.”
The FSA may still limit use of the extended maturity one-year bonds when it introduces new guidelines for mortgage bond issuance, recommended earlier this year by a government-appointed committee examining the roots of Denmark’s financial crisis. Madsen at the FSA said the Copenhagen-based agency will unveil its recommendations in the first half of next year.
“We fear there will be a run on one-year bonds, and that’s why we’re emphasizing that it’s still important to have a focus” on the volume,Karsten Beltoft, head of the Mortgage Bankers’ Federation, said in an interview. The greater the volume of one-year bonds, the more likely it is that the maturity option would have to be exercised, he said.
Though banks had tried to wean borrowers off one-year funding, households resisted those efforts after rates in AAA-rated Denmark sank to record lows. That helped cushion the blow to homeowners of a 20 percent slump in property prices since their 2007 peak.
Yields on one-year mortgage bonds may be as low as 0.55 percent in auctions this month to refinance loans with a Jan. 1 interest reset date, according to Christian Heinig, chief economist at Realkredit Danmark A/S.
“The FSA will fight for the new one-year constructions as being compliant,” said Soeren Holm, chief financial officer for Copenhagen-based Nykredit Realkredit A/S, Europe’s largest issuer of covered bonds backed by home loans.
“This really eliminates the refinancing risk and reduces the interest rate risk for the customer,” Holm said. “We expected it to be at a reasonable price, 5 to 10 basis points.”
So on the one hand, a 'run on one year bonds' is feared, but on the other hand it is quite clear why Denmark's government is so eager to keep these bonds going. For mortgage debtors they currently guarantee extremely low interest rates, due to the central bank's de facto ZIRP. Of course frequent refinancing with one year debt harbors great risks for debtors should interest rates ever rise again.
On the other hand, once the bonds are enhanced with the new 'trigger' feature, sticker shock could come a lot earlier than that, namely if there really is a run on the one year bonds. Investors may well get worried about this trigger feature, since they are currently buying short term debt, which henceforth harbors the danger of suddenly being converted to long term debt. A great many mortgages may be reset to higher rates if bond maturities are extended to match the maturities of the underlying loans.
It is therefore not at all clear that this new feature will really 'remove the refinancing risk'. It may reintroduce risks, by a different avenue. For instance, if there really are many conversions forcing debtors to pay much higher rates, mortgage defaults may spike, especially in light of the decline in property prices. Banks would then be faced with unexpected losses, which could balloon if foreclosures pressure property prices further. If that were to happen, refinancing would definitely become more difficult, as investors would no longer fully trust the banks to be able to honor their commitments.
The Danish credit bubble remains a powder keg.
Danish house prices, year-on-year change, nominal and real.
Addendum: Iceland vs. Ireland
As a brief addendum to our recent article on Iceland's currency devaluation and capital controls (“Iceland – the Dark Side of Devaluation”), we want to point readers to a very interesting article by David Howden posted at Mises.org, which compares the inflationary recession in Iceland with the 'internal devaluation' of Ireland (“Inflation Has Not Cured Iceland's Economic Woes”).
As this article shows clearly, inflation merely masks the utter misery the average Icelandic citizen is facing. On the surface, Iceland's performance looks much better than Ireland's. But looking a bit more closely, by taking a peek beyond the veil of the aggregated data so to speak, it turns out that Icelanders are really far worse off than even the much imposed upon citizens of Ireland. The vaunted 'recovery' miracle of Iceland is really nothing but an inflationary Potemkin village.
Charts by Globalpropertyguide.com
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