The hidden contingent sovereign liability of Danish mortgage bonds

By Claus Vistesen

Not too long ago, I compared the Japanese economy to a bumblebee because of the economy’s ability to keep on chucking along even as the government debt/GDP ratio stormed above the 200% mark. I am starting to think that the same comparison might be warranted too in the case of my home country.

One striking aspect of the Danish economy that any economist following the discourse on Denmark must be pondering is that despite the widespread idea that Denmark has a serious productivity problem relative to its peers, it has not yet shown up in the data. Denmark is still running a sizeable trade as well as income surplus which together adds up to a tasty current account surplus.

So what gives and can this situation be maintained?

The reason that I have been forced to think about this was today’s report by Bloomie that the Danish bank and mortgage originator Nykredit announced that it would actively seek to widen its international investor base for covered bonds backed by mortgages of which the bank is Europe’s largest holder and which contributes to making the Danish market for mortgages one of the world’s biggest.

Basically, the problem for Danish financial institutions is that under the new Basel rules, covered bonds backed by mortgages will be treated as less liquid than government bonds (and thus less liquid than is currently the case) and thus Nykredit et al will be left holding way too many of these securities. The problem in a nutshell is this;

Denmark is leading efforts to persuade the European Union to ease liquidity rules set by the Basel Committee on Banking Supervision that the Nordic country says penalize the world’s third-largest mortgage-bond market. While the EU has signaled it may accommodate some of the demands, standards scheduled to take effect by 2015 are still likely to treat covered bonds as less liquid assets than government debt, Engberg Jensen said.

“I don’t think we can totally avoid a haircut” on how banks treat covered bonds in their liquid assets, he said. “I don’t think that we’ll end up with rules where covered bonds and government bonds are equal.” This means “we need to find a broader investor base. We want to be stronger in Europe and we have also started in the Middle East and the Far East. We’ve had investors for many years in the U.S. and Europe.”

Under the new rules, banks must abide by a limit of 40% in terms of how much of the securities portfolio that can be composed of (mortgage) covered bonds which leads to the obvious result that …

“If we get the new rules, most Danish banks will have to restructure to sell mortgage bonds and buy government bonds,” Engberg Jensen said. While Danish banks have relied on the country’s covered bonds to generate liquid assets, lenders in Germany and Asia have room to purchase the securities without breaching Basel’s 40 percent limit, Nykredit estimates. The company wants to sell its bonds to banks in those regions to make up for the selloff it expects to see in Denmark, Nykredit Group Managing Director Karsten Knudsen said in the same interview.

Denmark has a problem here – a big one in my opinion – and the only chart you need to look at is the following.

(click on picture for better viewing)

Despite the crisis, Denmark has not delevered substantially and mortgage debt remains a sizeable portion of GDP; 134% by my calculations in 2010. And this is mortgage debt alone and thus leaves out a large private debt burden, all corporate debt as well as a growing government debt.

It is important to understand where Denmark is here. Denmark is like Spain, Ireland and Australia with a large private debt burden which will only really make itself felt once the government has to assume the final bill (think Ireland here). Now, at this point my compatriots would no doubt file this post under the "one flew over the (…)’s nest" folder, as comparing Denmark with the countries above seems more than outrageous. But try to get the main point here: Denmark’s main debt problem is in the private sector. Given the Irish experience, once the sovereign has to plug a hole in the domestic financial system, it is the total debt that matters and not merely the government debt.

Recently, the commission issued a report with a stark warning to Danish policy makers that both the size and structure of the housing market with the majority of loans made up by variable interest rate and no-amortisation/down payment (often both in the same loan!) represented a current and future source of instability. The Danish central bank has even suggested phasing out these loans entirely, even if it seems that such a proposal doesn’t have political backing in the Danish parliament regardless of the result of this year’s election.

According to Bloomberg, Nykredit and others have noted that they will try to separate the way they fund their adjustable rate mortgage portfolio from the way they fund their fixed rate portfolio. This is almost hilarious in its uselessness in my opinion since the main problem here is not a flow issue but a stock issue as evidenced by the chart above.

When all is said, I think you should take away the following point from this.

If Danish mortgage originators start selling bonds to foreign investors for the obviously rational reason that they need to abide by new capital requirement rules, it will mean a de facto deterioration of the current account (not necessarily a problem, just a fact when you sell securities abroad). So, the question is: how willing will foreigners be to finance one of the most overlevered housing markets in the world and at what yields?

When I run the scenario in my head, I end up in a situation where it might be quite difficult to push Danish covered bonds onto foreigners at acceptable prices; liquidity will dry up and re-financing will get more difficult. In addition, if yields go up, prices (i.e. house prices) will fall and exacerbate the difficulty in pushing the securities since the prices on the underlying collateral (i.e. property will go down).

Now, far be it from me to attempt to put Denmark in a club to which it does not belong. But think about it for a minute. The road map for how a Danish government might be forced to issue government bonds and swap them for unsalable covered bonds in order to allow its financial institutions to abide by the Basel rules is an almost sinister way in which the Danish sovereign may end up being on the hook for the total stock of debt in the society, just as we have seen elsewhere.

Am I seeing ghosts? Perhaps, but consider yourself warned.

This article first appeared at Alpha.Sources.