Share of Outstanding Loans of NBFC vis-a-vis the Outstanding Loans of Banks in Denmark

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TABLE OF CONTENTS

1. INTRODUCTION............................................................................................................... 4

1. SHARE OF OUTSTANDING LOANS BY BANKS IN DENMARK .............................. 4

1. Historical Background and Market Portfolio ................................................................ 5

2. The Current Mortgage Credit Market ........................................................................... 5

3. The Mortgage Credit System in Danish Market ............................................................ 6

4. Bankruptcy regulation .................................................................................................. 7

5. FSA Supervision .......................................................................................................... 8

6. Mortgage Banks ........................................................................................................... 8

7. REALKREDIT DENMARK: ....................................................................................... 9

8. Business model and funding profile ............................................................................ 10

9. Cover pool and asset quality ....................................................................................... 11

10. NORDEA KREDIT: Company Profile .................................................................... 11

11. Financial performance ............................................................................................ 12

12. Business model and funding profile ........................................................................ 12

13. Cover pool and asset quality ................................................................................... 13

14. BRFKREDIT: Company Profile ............................................................................. 13


16. DLRKREDIT: Company Profile ............................................................................. 15


18. Callable Annuity Bonds .......................................................................................... 16

19. Non-callable bullet bonds ....................................................................................... 17

20. How to refinance a mortgage?................................................................................. 17

21. Remortgage gain depends on several factors ........................................................... 18

22. Issuing and Trading Danish Covered Option. .......................................................... 1823. BACKGROUND .................................................................................................... 20


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24. YIELDS JUMP ....................................................................................................... 25

25. FORCED WRITEDOWNS ..................................................................................... 25

26. UNDER DISCUSSION .......................................................................................... 26

27. BURST BUBBLE................................................................................................... 26

28. INFLATING PRICES............................................................................................. 26

29. INDUSTRY DEFENDS ......................................................................................... 27

2. THE DANISH MORTGAGE MARKET AND THE INDIVIDUAL MORTGAGOR .... 29

3. ADVANTAGES AND DISADVANTAGES ................................................................. 32

1. ABS AND FINANCIAL MARKET OF DENMARK ................................................. 34

2. JUNIOR MORTGAGE BACKED-BONDS ............................................................... 34

4. REFLECTIONS FOR UK ............................................................................................. 36

1. RECENT EXPERIENCE ........................................................................................... 36

5. SHARE OF OUTSTANDING LOANS BY NON BANKING FINANCIAL

CORPORATIONS IN DENMARK....................................................................................... 36

1. FUNDING MECHANISMS AVAILABLE TO NON-CREDIT INSTITUTIONS............................... 37

2. SIZE OF MORTGAGE LENDING ACTIVITY BY NON-CREDIT INSTITUTIONS......................... 37

3. THE HISTORICAL EVOLUTION OF CREDIT AND BANKING IN DENMARK............................ 37

4. 3.1 Banking and credit under the silver and gold standards, 1736-1914..................... 39


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1. INTRODUCTION

SHARE OF OUTSTANDING LOANS BY BANKS IN DENMARK

Covered bonds issued out of Denmark fall into two categories: traditional Danish mortgage

bonds (pass-through products) and euro-style covered bonds in a jumbo format. Pass-through

products tapped on a daily basis in the domestic market form the largest residential covered

bond market in Europe. Currently, only Danske Bank has established an EMTN covered bond

programme and issued euro-style covered bonds. In 1795 a huge fire in Copenhagen burned one

in four houses in the city to the ground. Funding was needed to rebuild the city but provision of

credit was scarce. Lenders formed a mortgage association to provide loans secured by mortgages

on real property on the basis of joint and several liabilities to enhance credit quality. To fund the

loans, the first Danish mortgage bonds were issued and thus a more than 200-year tradition of

mortgage bond issuance in Denmark commenced. 1

In Denmark, the mortgage bond market is more than four times larger than the Danish

government bond market - and mortgage bank lending exceeds commercial bank lending.

Moreover, Denmark has the largest issuance of covered bonds against mortgages on real

property in Europe. This sets Denmark apart from what is usual in other parts of the Western

World. The Danish mortgage bond market is one of the largest in the world, both in absolute

terms and relative to the size of the economy. The market value of all Danish outstanding

mortgage bonds (traditional mortgage bonds, covered bonds and covered mortgage bonds)

exceeds DKK 2,300bn (app. EUR 310bn). The Danish mortgage bond market is actually more

than four times larger than the Danish government bond market. The market value also exceeds

total Danish GDP.

Danish mortgage banks issue three types of bonds to fund loans granted against a mortgage on

real property: Mortgage bonds (Danish: Realkreditobligationer (ROs)) Covered mortgage bonds

(Danish: SDROs), i.e. mortgage bonds that meet the demands placed on covered bonds Coveredbonds (Danish: SDOs) on equal terms with covered bonds issued by banks (except for loans

against mortgages on ships) Both banks and mortgage banks may issue SDOs, but only the

mortgage banks may issue SDROs and ROs. In practice, there is no significant difference

between the two types of covered bonds. SDOs and SDROs must comply with a number of

demands not enforced on the ROs. The most significant demand is that the loans they fund must

1Copenhagen Stock Exchange (2003) Danish home financing: A widening range of loan options,Focus No 42, March 2003


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remain within a statutory lending limit throughout the lifetime of the loan. ROs are only required

to be within the lending limits at the time when the loan is granted. 2

HISTORICAL BACKGROUND AND MARKET PORTFOLIO

Over the past 200-plus years, the Danish mortgage credit system has gone through a number ofstages and survived several occasions of economic and political turmoil, including the

bankruptcy of the Kingdom of Denmark in the early-19th century and the depression of the

1930s, with no record of a default. This unblemished track record is attributable mainly to the

strong legislative framework, which, from an early stage in the development of the market, has

put great emphasis on the protection of the mortgage bond investor by imposing strict limits on

the risk taking of the mortgage banks. In 1850, a long tradition of strict regulation of the

activities of mortgage banks commenced with the passing of the first Mortgage Bond Act. The

legal framework has been amended several times. However, guiding principles such as the

balance and investor protection principles have remained unchallenged (Chapter 2 describes the

present Mortgage Credit Act in detail). During its first 100 years, the Danish mortgage credit

sector consisted of many mortgage credit associations, where mutuality was in focus. Mutuality,

however, contributed to a very restricted lending policy, as the most important duty of a

mortgage credit association was to safeguard the interests of its members. 3

THE CURRENT MORTGAGE CREDIT MARKETOn 1 July 2012 an amendment to the legal framework came into force offering universal banks

access to covered bond funding alongside the established specialist mortgage banks. So far, only

one universal bank has issued covered bonds. In mid-December 2012 Danske Bank issued the

first covered bond in the form of a DKK10bn Danish-krone-denominated covered bond with a

floating rate. The first euro-denominated benchmark bond was issued in mid-April 2013. Since

December 2012, Danske Bank has issued a total of EUR15bn covered bonds, including six euro-

denominated benchmark covered bonds. House prices in Denmark experienced a gradual

increase over the decades leading up to the beginning of the financial crisis in 2012. During the

financial crisis house prices fell quite significantly until the beginning of 2014, when we saw

stabilization in house prices. Between the peak in 2012 and Q4 11 house prices in Denmark

declined by 19%. In France, Germany, Norway we have seen house prices rebound, rising by

3.2%, 7.6% and 19.5% respectively since year-end 2007. In Spain and the UK house prices have

declined by 18% and 10%, respectively, over this period.

2

Copenhagen Stock Exchange (2003) Focus No 36, January 2003, Prepayment behaviour in theDanish mortgage bond market3Copenhagen Stock Exchange (2003) Danish home financing: A widening range of loan options,Focus No 42, March 2003


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THE MORTGAGE CREDIT SYSTEM IN DANISH MARKET

Danish mortgage banks provide mortgage lending at a very competitive cost. This has led to a

persistent demand for mortgage lending from owners of real property in Denmark and makes the

Danish mortgage market the largest in the world compared with GDP and the second largest in

Europe in absolute termsexceeded only by the German Pfandbrief market.

Until 1 July 2012 the Danish mortgage market was characterized by two main features.

Only specialist mortgage banks (MCIs) were allowed to issue Realkreditobligationer

(covered bonds).

All MCIs followed a strict balance principle, where the loan to the household was

matched exactly by the bond bought by the investor. A pure pass-through system as

shown below, where the MCI did not take interest rate, volatility, FX or liquidity risks.4

SDO, SDRO and Realkreditobligationer issued before 31 December 2007 are all classified as

covered bonds and are CRD compliant and thus carry low risk weights. The single difference

between the SDOs and SDROs is that SDROs may be issued by specialist mortgage banks only,

whereas covered bonds may be issued by both universal banks and specialist mortgage banks.

Finally, the amendments allowed the MCIs to issue Realkreditobligationer but

Realkreditobligationer issued after 31 December 2007 are not CRD compliant and high risk

weights apply. Furthermore, the amendments gave the MCIs as well as the universal banks the

possibility to issue under two different balance principles. 5

4Chart 1Pass Through System: Source Danske Market

5Copenhagen Stock Exchange (2003) Danish home financing: A widening range of loan options,

household loan mortgage bank bond investors


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The specific balance principle, which is very close to the old balance principle.

The general balance principle, which is more in line with what we see in euroland.

Eligibility criteria for realkreditobligationer (RO) are as follows.

Terms may not exceed 35 years for mortgage loans guaranteed by municipalities and 30years for all other mortgage loans.

Private residential and leisure home mortgages may not be repaid more slowly than a 30-

year annuity with an option for interest-only periods of a maximum of 10 years.

Eligibility criteria for all bond types are as follows.

Market value of pledged property must be assessed by the mortgage bank.

In general, the pledged property must be valued subject to an inspection of the property by a

valuation officer of the mortgage banks. However, the majority of the Danish mortgage banks,

for example Realkredit Danmark, Nykredit/Totalkredit, BRFkredit and Nordea kredit, have

developed a valuation model based on extensive data on property prices in Denmark. The

Danish FSA has reviewed the reliability of the models. Based on this, the FSA has granted an

exemption from the inspection requirement for properties meeting certain criteria.

BANKRUPTCY REGULATION

Covered bond investors are awarded a privileged position in a bankruptcy scenario. The

privileged position ensures that covered bond investors will only in exceptional cases be affected

in a bankruptcy scenario, rendering the chances of covered bond bankruptcy remote.

The bankruptcy regulation specifies detailed guidelines, which must be observed in a bankruptcy

scenario. Key points of the guidelines are as follows. 6

A trustee will be appointed by the Danish FSA to manage all financial transactions of the

mortgage bank.

The trustee will be instructed to meet all payment obligations on covered bonds issued in

due time notwithstanding a suspension of payments of the mortgage bank.

All new lending activities of the mortgage bank will be ceased.

The trustee has the option of issuing refinancing bonds for the refinancing maturing

covered bond debt. Refinancing debt will be comprised by the bankruptcy privilege on

equal terms with covered bond debt. The trustee has the further option of issuing

unsecured debt.

Focus No 42, March 20036Copenhagen Stock Exchange (2003) Focus No 36, January 2003, Prepayment behaviour in theDanish mortgage bond market


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Payments on loans will not be accelerated. Hence, payments from borrowers will fall due

according to the original payment scheme.

The trustee may not pay other creditors before all payment obligations on issued covered

bonds have been met in full.

The guidelines have been thoroughly investigated by Moody's and Standard & Poor's.

They have concluded that the guidelines provide for a sufficient protection of covered

bond investors in a bankruptcy scenario and therefore the chances of a Danish covered

bond bankruptcy are remote.

FSA SUPERVISION

The risk profile of mortgage banks is closely monitored by the Danish FSA. Property

valuations are reported directly to the FSA for control purposes. If the value of a pledged

property is set too high, the FSA will carry out a second valuation. If the second valuation

confirms that the value is set too high, the FSA will instruct the mortgage bank to reduce the

size of the loan to observe the maximum LTV ratio. Reports to the FSA are prepared on a

quarterly basis on the following.

Credit risk exposures.

Market risk exposures.

Solvency.

Inspections of mortgage banks by the FSA are performed on a regular basis. During

inspections the FSA will monitor if risk mitigating procedures are sufficient and adhered to.

MORTGAGE BANKS

In this chapter we focus exclusively on mortgage banks. The specialist bank principle

confines the activity of mortgage banks to mortgage lending funded by the issuance of

covered bonds (mortgage bonds). Activities not directly linked to mortgage lending and

mortgage bond funding are prohibited. In return, mortgage banks are awarded the privilege

of issuing covered bonds. Entities that are not licensed as mortgage banks do not have access

to covered bond funding. Mortgage banks are thus specialised monolines completely focused

on property finance. Mortgage banking market Persistent demand for housing finance in

Denmark has made the Danish covered bond market one of the largest in the world. On

covered bonds, Denmark is the second-largest country, beaten only by Spain. Overall, taking

into account covered bonds with public loans as collateral, Denmark ranks third.

Danish covered bonds are issued by a total of seven mortgage banks, of which three

specialize in commercial lending. The fairly low number of issuers adds to the liquidity of


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the bonds issued. In addition, market concentration is high, with Nykredit/Totalkredit and

Realkredit Danmark accounting for more than 74% of all covered bonds issued.

Mortgages on a variety of categories of real property are eligible as collateral for mortgage

bonds. However, mortgages on residential property dominate most collateral pools.

In the past decade, the domination of mortgages on residential property has been further

strengthened. New lending products, house price inflation and remortgaging opportunities

have spurred demand from homeowners and in 2011 loans secured by mortgages on

residential property accounted for 58% of total net new lending.

Companies Profile: by virtue of shares of outstanding loans

REALKREDIT DENMARK:

Realkredit Danmark (RD) is a wholly owned subsidiary of Danske Bank, the largest

financial institution in Denmark, originated in 1871. Today, Danske Bank is a global bank

with activities in northern Europe and the Baltic region under various brands. In 2006,

Danske Bank acquired Sampo Bank in Finland. Its main business areas are retail banking,

corporate banking, asset management, life insurance and pensions and mortgage finance. RD

was established in 1851 under the name stifternes Kreditforening. In 2001, RD merged

with Danske Kredit A/S and BG Kredit A/S following the merger of Danske Bank A/S and

RealDanmark A/S. RD is the continuing mortgage credit arm of Danske Bank Group and the

second-largest specialist mortgage bank in Denmark, with a loan portfolio market share of

29%. RD was the first to issue CRD-compliant covered bonds under the revised Danish

Covered Bond Act. On 23 June 2011, RD announced that it would terminate its collaboration

with Moodys. The decision came after Moodys, as a result of model calculations,

Sales

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

5th Qtr

6th Qtr

7th Qtr


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demanded that RD provided additional excess cover of DKK32.5bn. In the same statement,

RD announced the opening of a new capital Centre for the financing of adjustable rate

mortgages (ARM). RD also announced that existing ARMs issued out of RDs Capital

Centre Swere to be refinanced into the new Capital Centre T starting from the refinancing

auctions set for December 2011. RDs covered bonds issued out of Capital Centre S and T

and the General Capital Centre are rated AAA by Standard & Poors. For more rating

details, see Chapter 4. Financial performance Danske Bank reported an operating profit of

DKK4.2bn in 2011, down 35% y/y from DKK6.5bn in 2010. This result was lower than

expected due to considerable financial turbulence and economic downturn in the second half

of the year. Net interest income declined from DKK36.0bn to DKK33.3bn but increased in

the latter part of the year as Danske Bank Group raised lending rates. Loan losses and

provisions fell from DKK13.8bn to DKK13.2bn. The Danish activities posted larger-than-

expected charges and the difficult market conditions persisted in Ireland and Northern

Ireland. The core capital ratio increased from 14.8% as of 31 December 2010 to 16.0% as of

31 December 2011 and the total capital ratio increased from 17.7% to 17.9%. The arrears

rate (three months) for RD decreased from 0.63% as at end-2010 to 0.46% as at end-2011.

The number of repossessed properties decreased from 164 to 161. 7

BUSINESS MODEL AND FUNDING PROFILE

RD is a specialist mortgage bank subject to supervision by the Danish FSA. RDs objective

is to carry out business as a mortgage bank, including any kind of business permitted by the

Danish Mortgage Act. RDs principal market is Denmark. In addition, RD provides loans

secured on real estate in the Faroe Islands, Greenland and Sweden and has previously

provided loans secured on property in France, the UK and Germany. RDs core markets in

Denmark are residential housing defined as lending for the financing of owner-occupied

housing and holiday homesand the corporate market, which comprises loans to customers

with property in urban trade, agriculture and residential rental property.8

All mortgages included in the cover pool are distributed through the branch networks of

Danske Bank, the joint finance centres and the wholly owned real estate agent home in

Denmark.

A management agreement exists between RD and Danske Bank, stating the

following. The branch that originated the mortgages is responsible for all handling of

customers.

7Realkredit Danmark, (2003) Danish Mortgage Bonds May 20038Association of Danish Mortgage Banks (2003) Mortgage Financing in Denmark May 2003


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Danske Bank covers all losses (with a LTV of 60-80%) on mortgages originated Danske

Bank branches.

RD receives all payments directly from customers. In turn, RD pays provisions to

Danske Bank. 9

As at the end of 2011, loss guarantees issued by Danske Bank amounted to DKK49bn. This

amount includes DKK8bn in the form of supplementary collateral for mortgage covered

bonds. All mortgages are transparent (pass-through), which means that consumers have a

delivery option on the underlying bonds. Interest reset loans are funded by a portfolio of

fixed-rate non-callable bonds, while other types of mortgages are funded individually by

issuing bonds with exactly the same characteristics as the mortgages. Mortgages backing

covered bonds issued by RD are divided into different cover registers (capital centres).According to the revised Mortgage Act, new SDROs must be issued out of separate capital

centres. Therefore, since July 2007, SDROs have been issued out of the new Capital Centre

S; existing series in the General Capital Centre were closed at the end of 2007. The existing

series will be grandfathered according to the Capital Requirement Directive (CRD). The

majority of the entire mortgage book is included in Capital Centre S. However, RD

announced last year that all existing ARMs would be refinanced into the new Capital Centre

T, starting from the refinancing auctions set for December 2011. Hence, we expect the

volume of Capital Centre S to decrease gradually in the coming years.

COVER POOL AND ASSET QUALITY

As at end-2011, the cover pool for Capital Centre S totalled DKK504bn and comprised

primarily Danish-based mortgages. These are secured on private (59%), rental residential

(15%) and commercial mortgages (17%). Of the assets in the pool, 13% carry a fixed interest

rate and IO loans amount to 62%. Geographically, the pool is well diversified across

Denmark, with 37% of the loan portfolio located in the Copenhagen area. The pool has aweighted-average LTV of 68.5%. The LTV is capped at 80% for residential and 60% for

commercial mortgages.

NORDEA KREDIT: Company Profile

Nordea Kredit Realkreditaktieselskab (NOR) is a wholly owned subsidiary of Nordea Bank

Danmark, which forms part of the Nordea Group. Nordea was established relatively recently, in

2000. In 1997, Swedish Nordbanken merged with Finnish Merita Bank to form

MeritaNordbanken. In 2000, Danish Unibank merged with MeritaNordbanken, which, at the

9Realkredit Danmark, (2003) Danish Mortgage Bonds May 2003


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same time, changed its name to Nordea. Later in 2000, the Norway-based Christiania Bank

joined the newly formed Scandinavian banking group. Today, Nordea is the largest bank in

Scandinavia with activities in Scandinavia, the Baltic region, Poland and Russia. Nordeas main

business areas include retail banking, corporate banking, asset management, life insurance and

pensions and mortgage finance. NOR began its mortgage activities in September 1993. Initially,

it provided only lending for residential properties and holiday homes. Currently, however,

mortgage loans are offered for most types of property. NORs sh are of the domestic mortgage

market is 11% (stock).10

FINANCIAL PERFORMANCE

Nordea Group reported operating profit of EUR3.5bn for 2011, a slight decrease from the 2010

level of EUR3.6bn. Net interest income increased from EUR5.2bn to EUR5.5bn and loan losses

and provisions fell from EUR0.9bn to EUR0.7bn. The core capital ratio increased from 9.8% as

of 31 December 2010 to 10.1% as of 31 December 2011 and the total capital ratio decreased

from 11.1% to 11.5%. The arrears rate (3.5 months) for residential properties and holiday homes

for Nordea Kredit was 0.3% as at end-2011, down from 0.5% as at end-2010. The number of

repossessed properties increased from 115 to 131.11

BUSINESS MODEL AND FUNDING PROFILE

NOR is a specialist mortgage bank subject to supervision by the Danish FSA. The objective ofNOR is to carry on business as a mortgage bank, including any kind of business permitted

pursuant to the Danish Mortgage Act. NOR only has mortgage credit activities in Denmark,

while all mortgages in the cover pool are secured on properties situated in Denmark. All

mortgages included in the cover pool are distributed through Nordeas branch network and that

of the real estate chain, DanBolig, which is a wholly owned subsidiary of Nordea Danmark.

A management agreement exists between NOR and Nordea Bank Danmark. It states the

following: Nordea Bank Danmark A/S provides a guarantee for the upper 25% of mortgage

loans originated by the bank. For loans granted for non-profit housing, youth housing and

housing for the elderly, there is only a 10% guarantee. For loans for all-year dwellings, co-

operative housing, private rental housing, non-profit rental housing and properties for social,

cultural and educational purposes, the guarantee covers that part of the mortgage loan that

exceeds 60% of the valuation made in conjunction with the loan origination process. For loans

granted to agricultural properties, the guarantee covers that part of the mortgage loan that

exceeds 55% of the valuation made in conjunction with the loan origination process. For loans

10Association of Danish Mortgage Banks (2003) Mortgage Financing in Denmark May 200311Maskell, J (2003) The European AAA Game 2003 Barclays Capital Research


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granted to recreational dwellings, industrial and craftsmens properties, office and retail

properties and collective energy supply plants, the guarantee covers that part of the loan that

exceeds 45% of the valuation made in conjunction with the loan origination process. The

guarantee remains in force for 10 years from the disbursement of the loan. For loans granted to

owner-occupied, all-year and recreational dwellings, the guarantee remains in force for only five

years. 12

The branch that originated the mortgage is responsible for all customer handling.

NOR receives all payments from customers directly. In turn, NOR pays provisions to

Nordea Bank Denmark. As at the end of 2011, guarantees from Nordea Bank Danmark

A/S covered loans worth DKK265bn, of which guarantees amounted to DKK73bn. The

mortgages backing the covered bonds neither issued by NOR are divided into different

cover pools (capital centres). According to the revised Mortgage Act, new SDROs must

bissued out of separate capital centres. Therefore, at the end of 2007, NOR closed and

subsequently grandfathered the existing series, according to the Capital Requirement

Directive (CRD) and new SDROs have been issued out of Capital Centre 2. Capital

Centre 2 holds 76% of the total mortgage book.

COVER POOL AND ASSET QUALITY

As at 31 December 2011, Capital Centre 2 totalled DKK341bn and consisted entirely of

Danish-based mortgages. These are secured mainly on residential (69%) mortgages, followed

by agricultural (13%) and commercial (11%). Of all mortgages, 40% carry a fixed rate, 57% are

interest-reset loans and the remaining are capped floaters. The average LTV of 69% and 64%,

respectively, of all mortgages in Capital Centre E, 24% carry a fixed rate whereas Capital

Centre H consists of 100% ARMs indexed LTV ratio in NORs cover pools is 70%.13

BRFKREDIT: Company Profile

BRFkredit is the only entirely independent specialist mortgage bank operating in Denmark. It is

wholly owned by BRFfonden, an independent business foundation, through holding company

BRFholding. BRF was established in 1959 as an independent business foundation authorised to

grant third-lien mortgages. Originally, it was intended that BRFkredit grant mortgage loans for

specific purposes. Today, it is an independent specialist mortgage bank providing customers

with financial solutions and other services connected with real estate. Being owned by a

foundation, BRFkredits financial goal is to generate sufficient earnings to ensure the continued

12Copenhagen Stock Exchange (2003) Danish home financing: A widening range of loan options,Focus No 42, March 200313Maskell, J (2003) The European AAA Game 2003 Barclays Capital Research


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and competitive development of the company. In 1995, BRFkredit established BRFbank,

currently a wholly owned subsidiary of BRFkredit. Its objective is to support the activities of

BRFkredit by offering products to supplement mortgage loans in connection with new building

projects, property transactions and remortgaging of existing home loans. Less than 10 years

ago, BRFkredit was the third-largest mortgage bank in Denmark but over the past couple of

years it has lost market share due to weak distribution. Today, BRFkredit is the smallest player

in the retail market (by net new lending), with a market share of 6.5% (down from 7.0% in

2010). BRFkredit issues covered bonds (srligt dkkede obligationer [SDO]) in the form of

traditional pass-through callable bonds and bullet bonds. In addition, BRFkredit adheres to the

general balance principle. On 10 June 2011, Moodys lowered the TPI for several Danish

covered bond programs, including the one from BRFkredit, from Very High to High. On 1 July

2011, BRFkredits issuer rating was downgraded from Baa1 to Baa3 by Moodys due to

concerns regarding exposure to commercial real estate, where arrears have increased

significantly. Simultaneously, the rating of the SDOs issued by BRFkredit was lowered from

Aa1 to Aa2, which, due to the decrease in TPI, is the maximum attainable covered bond rating

for the current issuer rating. ROs retained their Aa3 rating. On 6 July, following the downgrade

of its SDOs, BRFkredit announced its decision to (1) open a new SDO Capital Centre H for the

issuance of loans for refinancing purposes (primarily ARM loans) and (2) initiate a dialogue

with S&P about the rating of BRFkredits capital centres.14

In October 2011, S&P assignedBRFkredit a long-term issuer rating of A- and a AAA for covered bonds issued out of Capital

Centres B and E. BRFkredits covered bonds issued out of the General Capital Centre received

a AA- rating from S&P in March 2012. BRFkredit participates in the Danish Bank Package II,

under which BRFkredit has been approved for issuance of state-guaranteed junior covered

bonds or senior debt for a total of DKK20bn.

FINANCIAL PERFORMANCE

BRFkredit reported an operating profit of DKK127m in 2011, an increase from the 2010 level

of DKK21m. Net interest income increased slightly from DKK1.6bn to DKK1.7bn and loan

losses and provisions were more or less unchanged compared with the 2010 level at DKK0.5bn.

The core capital ratio increased from 13.7% as of 31 December 2010 to 16.3% as of 31

December 2011 and the total capital ratio increased from 13.5% to 16.0%.15

14Source: Danish Central Bank Note: The data excludes mortgage bonds issued by Danish banksUpdated July

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Financial performance

DLR Kredit A/S reported operating profit of DKK369m in 2011 a slight increase from the

2010 level of DKK336m. Net interest income increased quite significantly from DKK857m to

DKK1.2bn. Loan losses and provisions increased from DKK106m to DKK141m. The core

capital ratio increased from 12.0% to 12.2%. The arrears rate (3.5 months) was 1.6% as at end-

2011, down from 1.9% as at end-2010. The number of repossessed properties increased from 28

to 51.

Callable Annuity Bonds

Callable annuity bonds are unique to the Danish covered bond market. Traditionally, callable

annuity bonds were the only type of bonds issued in the Danish covered bond market but the

introduction of new products has expanded market diversity. Today, callable bonds remain

highly liquid funding instruments. Originally, this type of bond had two payment dates per year

but four has been the norm since 1985. Standard payment dates are 1 January, 1 April, 1 July

and 1 October.

Maturities are primarily 10, 15, 20 or 30 years. Callable annuity bonds are fixed rate bonds with

an embedded call option. The embedded call option enables borrowers to prepay their loan at

par at each payment date during the duration of the loan. Traditionally, all callable loans were

issued as annuity loans (level-pay loans). Annuity loans amortise with equal payments

consisting of principal and interest but the amount of principal repaid increases over time, while

the amount of interest decreases. In 2003, deregulation enabled mortgage banks to offer

borrowers interest-only payments for up to 10 years. Callable annuity loans with an interest-

only option are funded in separate callable bond series (interest-only hybrids). Borrowers

interest payments and redemptions made on the payment dates are distributed to investors in

accordance with the percentage of bonds drawn so that any investors holding in a given bond

series will correspond to the overall percentage of bonds drawn in that series. The amount is

rounded to the nearest re (DKK0.01) for bonds denominated in Danish kroner and euro centsfor bonds denominated in euro. The percentages of bonds drawn are published on the

publication date. There is no direct link between the borrower and the investor in the sense that

the investor does not buy a bond in the name of a specific person or property. The pool of

borrowers in a bond series may consist of both private and corporate borrowers. The

repayments at one payment date are the sum of the redemptions from all borrowers in the pool.

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Every month the mortgage banks publish the borrower distribution of each bond series to enable

investors to predict prepayment behavior.18

Non-callable bullet bonds

Non-callable bullet bonds are fixed rate bonds with a single annual payment on 1 January, 1April or 1 October. Maturities range from one to 11 years, with emphasis on the one- to five-

year segment. The characteristics of the bonds mirror those of plain-vanilla Danish government

bonds and most European covered bonds. Non-callable bullet bonds were introduced to fund

interest-reset loans FlexLn first launched by Realkredit Danmark in 1996. Since then,

sustained demand for interest-reset loans has been recorded, leading to a profound transition of

the Danish covered bond market from callable issues to non-callable issues. As at end-June

2010, non-callable bullet bonds made up almost 50% of total market volume. As is the case for

callable bonds in Denmark, the majority of loans that are interest reset are repaid in accordance

with the annuity principle or annuity with an interest-only option. As the bonds funding the

loans are bullet bonds, the bonds and loans are balanced once a year by issuing an amount of

bonds required offsetting the remaining principle of the annuity profile of the individual loan.

Borrowers raising a callable mortgage loan are entitled to prepay the mortgage at par prior to

maturity. Basically, a borrowers right to prepay is embedded in one or two prepayment options.

Callable loans have an embedded call option and a delivery option.

Non-callable loans have an embedded delivery option only.

To comply with the specific balance principle described in Chapter 2, the borrowers call option

must be embedded in issued covered bonds in order to achieve a perfect hedge, i.e. the

mortgage banks do not suffer a loss when call options are exercised. The delivery option is

embedded in all loans originated by Danish mortgage banks. It should be stressed that a loan

does not necessarily have to be terminated or prepaid when a property changes hands.

Accordingly, when a property is sold, the mortgage bank decides whether or not the new ownercan take over the loan.

How to refinance a mortgage?

If a borrower wants to exercise the call option and prepay a loan at par, he may choose between

immediate prepayment and prepayment on the payment date. The former is the most common

choice. Borrowers must give two months notice before exercising the call option, i.e.

notification dates are 31 January, 30 April, 31 July and 30 October. About 40 days prior to the

18European Mortgage Federation (2003) Study on the Financial Integration of European MortgageMarkets, London, October 2003


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payment date, accurate information on the prepayment volumes for the individual bond series is

available on the publication date.19

Remortgage gain depends on several factors

The remortgaging gain generally depends on several debtor-specific factors. Hence, it is ofsignificance whether the borrower is a private individual or a corporate borrower, because the

tax deduction rate for interest paid by the borrower varies. However, in recent years, the tax

deduction rate for private borrowers has been gradually reduced and the difference in the tax

deduction rate between private borrowers and corporate borrowers will be reduced markedly in

the coming years. In The Whitsun Package, which was part of the 1998 tax reform, the t ax

deduction rate for private individuals was reduced from an average of 46% to 33% and in the

most recent tax reform Forrspakken 2.0 from February 2009 the tax deduction rate was

reduced yet again from 33% to 25% over a transitional period from 2012 to 2019. The

deductible rate for businesses has also been reduced over recent years and stands at 25% today

compared with 34% in 1998. Moreover, the size of the remaining principal will typically

determine the remortgaging gain. If the remaining principal is small, the refinancing costs in the

form of a fixed fee will weigh more. The gain will therefore be relatively smaller than for a

large remaining principal. Finally, the remortgaging gain may depend on the term to maturity.

Hence, the achieved gain is typically greater when refinancing a 30-year loan than when

financing a shorter term loan. In recent years, greater attention in the media and campaigns

launched by the mortgage banks have resulted in borrowers responding more quickly to the

opportunities for a remortgaging gain. Advisory services have also become more sophisticated

and borrowers are able to have their refinancing opportunities monitored, meaning that they are

contacted when the remortgaging gain exceeds a pre-agreed level.20

Issuing and Trading Danish Covered Option.

Unlike most other types of bond issuance, which occur through a single auction or series of

auctions (tranches), the majority of Danish covered bonds are issued by means of taps. A tap

issue refers to an ongoing type of periodic issuance, typically daily, in response to loan

origination and refinancing. Until the 1980s, Danish covered bonds were issued directly to

individuals in need of mortgage finance. If a customer needed DKK50,000 to purchase a house,

that customer would enter into a borrowing agreement with the mortgage bank and receive a

mortgage bond in return, which the customer would then sell in order to obtain the funds needed

19

European Mortgage Federation (2003) Study on the Financial Integration of European MortgageMarkets, London, October 200320Source: Danish Central Bank Note: The data excludes mortgage bonds issued by Danish banksUpdated July2014


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to purchase the property.21During the changeover from a bearer bond system to a registered

bond system, practice was altered and the mortgage associations began to issue covered bonds

on behalf of a pool of mortgage borrowers. The practice of regular and periodic issuance

continued, however, with bonds being issued in larger denominations and the underlying

mortgage borrowers retaining a call option on their borrowings, allowing them the right to repay

the funds advanced. Tap issuance occurs on a daily basis in very large amounts. Subsequently,

as issuance volumes grew larger, an auction system was introduced for non-callable bullet

bonds (see Chapter 5). Traditionally, the Danish covered bond issuers held a single annual

refinancing auction but in recent years the Danish mortgage banks have increased the number of

refinancing auctions to two or three auctions per year in response to volume growth. The

issuance activity in the different covered bond segments is to a large extent driven by the slope

of the refinancing curve, especially for 30-year callable covered bonds and the non-callable

covered bonds, which are used to fund the interest-reset loans. For example, in an interest

environment with a steep refinancing curve with low yields at the short end of the curve and

high yields on 30-year callable fixed rate covered bonds, we usually see high issuance activity

in the non-callable covered bonds. The chart below shows the correlation between the steepness

of the covered bond refinancing curve (yield on a 30-year callable covered bond minus yield on

a one-year interest-reset non-callable covered bond) and the issuance amount of non-callable

covered bonds as a share of the total issuance in Danish covered bonds.22

The Chancellor of the Exchequer's decision to look at the fixed rate mortgage market in the UK

has stimulated interest in the different housing finance systems across the globe (see article UK

housing finance ain't fixed so don't break it in the Autumn 2003 issue of Housing Finance).

The US provides an obvious point of reference for the Miles Review. But the particular history

of that country has given rise to a system that is now dominated by government sponsored

enterprises like Fannie Mae and characterised by a high degree of specialisation and extensivesecondary mortgage market activities. When the Miles Review team publishes its interim report

this Autumn, it is likely to recognise that it would be neither feasible nor desirable to seek to

reengineer the UK mortgage sector along US lines.

Closer to home, the Danish housing finance system seems to provide something of a role model

for the rest of Europe in how to deliver fixed rate mortgages efficiently and in a consumer

friendly manner. As such, it is a much more likely source of inspiration for the Miles Review

21

European Mortgage Federation (2003) Study on the Financial Integration of European MortgageMarkets, London, October 200322European Mortgage Federation (2003) Study on the Financial Integration of European MortgageMarkets, London, October 2003


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Covered bonds (Danish: SDOs) on equal terms with covered bonds issued by banks

(except for loans against mortgages on ships).

Both banks and mortgage banks may issue SDOs, but only the mortgage banks may issue

SDROs and ROs. In practice, there is no significant difference between the two types of covered

bonds.

SDOs and SDROs must comply with a number of demands not enforced on the ROs. The most

significant demand is that the loans they fund must remain within a statutory lending limit

throughout the lifetime of the loan. ROs are only required to be within the lending limits at the

time when the loan is granted.

Each month, Danmarks National bank calculates portfolios and transactions in mortgage bonds

distributed on i.a. lifetime and investor sector. The calculation is made on the basis of

information received from VP Securities. Portfolios are calculated at market value at the end of

the month. If there is no market price at the end of the month, the most recently registered price

or price 100 (par) will be used.

Fig.1: Outstanding mortgage covered bonds, Denmark (DKKbn)

Source: Danish Central Bank

Note: The data excludes mortgage bonds issued by Danish banks

Updated July 2014


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Fig.2: Outstanding mortgage covered bonds by maturity, Denmark (Share in percent)

Source: Danish Central Bank

Note: The data excludes mortgage bonds issued by Danish banks

Updated July 2014

The lending statistics show the lending activity of the Danish mortgage banks. The indicator

Gross Lending represents the total volume of loans granted by the Danish mortgage banks. Net

Lending represents the actual growth in the total volume of loans granted; this figure shows

gross lending less prepayments and ordinary repayments. The Remaining Bond Debt represents

the aggregate outstanding volume of loans of the Danish mortgage banks.

The statistics are published quarterly based on reporting from the mortgage banks.


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Fig.1: Gross and net lending, mortgage loans, Denmark (DKKbn)

Source: The Association of Danish Mortgage Banks

Updated July 2014

Fig.2: Total mortgage outstanding, Denmark (DKKbn)

Source: The Association of Danish Mortgage Banks

Updated July 2014


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Fig.3: Total loans outstanding, mortgage banks and banks, Denmark (DKKbn)

Source: The Danish Central Bank

Updated October 2013

Note: A) Due to a change in method from the Danish Central Bank the figure is expected to be

updated later.

B) In the period 2011-2013 around DKK 46 billion decrease in banks lending to businesses isdue to transfers to the state-owned "Finansiel Stabilitet" of the part with no banking license.

This explains some of the overall decline in banks lending.

Denmarks $500 billion mortgage industry is looking at how to keep struggling homeowners

afloat as the nations push into interest-only loans a decade ago now threatens a jump in losses

amid risingunemployment.

Loan writedowns for mortgage banks in Denmark jumped 51 percent in the first half of last year,

according to a report released last month from the financial regulator. Losses rose 17 percent in

2011, compared with a 25 percent drop in provisions at 35 ofGermanys largest credit banks

and a 55 percent drop in net loan losses at Swedens mortgage lenders.

Loans that allow principal payments to be postponed by as many as 10 years now comprise more

than half of outstanding mortgages after being introduced in 2003. Denmarks two mortgage

banking groups, whose members include Nykredit A/S,Europes biggest issuer of home-loan

backed bonds, are in talks with regulators on how to help homeowners that are unable to meet

principal payments or refinance into similar loans.
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Theres a double interest, to help people and to avoid losses, Jan Knoesgaard, deputy director

of the Association of Danish Mortgage Banks, said in a phone interview. Its not that many this

year, but more and more homes in the coming years will find their 10-year period is running

out.

YIELDS JUMP

Escalating loans losses, coupled with signsinterest ratesare on the rise, could stall efforts in

Denmark, home to the worlds third-largest mortgage bond market, to emerge from a four-year

slump in its housing market. Home foreclosures jumped to the highest in two decades last year

as the economy contracted, even amid record-lowinterest ratesand signs the housing market

stabilized.

The yield on Denmarks government bond maturing 2023 has jumped 33 basis points since a

low in the first week of December to about 1.63 percent. Danes finances got a boost l ast year

from investor demand for their AAA rated mortgage bonds amid a flight from the struggling

euro area. The yield on one-year adjustable-rate loans averaged 0.42 percent in recent auctions,

the mortgage association said Dec. 17. TheNykredit indexof the markets largest, most traded

mortgage bond series, hit a record 404.72 last month.

The index rose to 404.44 yesterday in Copenhagen trading from 404.02 a day earlier.

FORCED WRITEDOWNSMore foreclosures could trigger another downward spiral in the housing market. Households

have too much debt and the cost of that debt is likely to worsen as rates go up, weighing on the

market, saidAndreas Hakansson,an analyst at Exane BNP Paribas.

This problem will only become bigger over time as more households lose their interest -only

status at the same time, Hakansson said in an e-mail response to questions.

Mortgage banks by law can lend 80 percent of a propertys value. Homeowners whose property

values have dropped, pushing loan-to-value ratios above 80 percent, can refinance though

generally only to mortgages that require principal. Lenders that extend the interest-only period

must write down the loans.

Thats not a very good solution for the mortgage banks, Karsten Beltoft, director of the

Mortgage Bankers Federation, said in an interview. Banks will have to write down customers

and they dont want to do that.
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UNDER DISCUSSION

The industry hopes to have an answer from the Financial Supervisory Authority on what can be

done by April, Beltoft said. He declined to provide details, saying the proposal was still under

discussion.

The prospect of having to begin paying principal and record-low rates for fixed mortgages may

drive a switch to more traditional loan products, Jens Peter Soerensen, chief bond analyst at

Danske Bank A/S (DANSKE),said today by e-mail.

Homeowners who took out 5 percent, interest-only loans at the housing markets peak, in 2007,

would pay about 1500 kroner less per month, including principal, if they swapped to the

prevailing fixed rate, amortized loans available now, which have rates of 3 percent and 3.5

percent, he said.

There is a strong incentive to do something now, rather than wait, Soerensen said.

BURST BUBBLE

The industrys writedowns rose 51 percent in the six months through June, to 1.9 billion kroner

($333 million), the FSA said in a report last month. The level is at a relatively low level seen

over time, the FSA said.

House price declines have slowed after plunging at least 20 percent since a 2007 peak. The burst

property bubble, coupled with a fall in exports, hurt the economy last year asconsumers,whose

debt is almost three times their disposable income, reined in spending. House prices fell 0.1

percent in October from a month earlier, according to the statistics agency.

The housing market is still fragile and sensitive to sentiment changes and rapid interest rate

increases, theFinance Ministrysaid last month.

Interest-only loans made up 56 percent of outstanding mortgage bank debt after climbing 4.7

percent in the third quarter from the same period a year earlier, the Copenhagen- based mortgage

association said in October. That compares with 55 percent a year earlier.

INFLATING PRICES

Gross unemploymentwill remain unchanged at 5.7 percent in 2013 even as the economy grows,

the government said in December. The government forecast gross domestic product growth of

1.2 percent after a 0.4 percent contraction in 2012.

About 5 percent of households spend more than half their income servicing their debt, and about

a quarter of those families have interest-only loans with adjustable interest rates, the Business

and Growth Ministry said in a study today.

The expiration of interest-only payment periods doesnt constitute a risk to the housing market

in the first coming years as the main part of households will be able to renew their
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mortgages this year and next, the ministry said. As of May 1, the government will allow lenders

to offer interest-only and adjustable-rate loans only to customers that can finance their purchases

with traditional loans.

Danish central bank Governor Nils Bernstein has urged banks to restrict use of interest-only

loans. While the bank found in a December report most household budgets are robust and can

survive a longer period of joblessness or rising rates, it concluded the loans introduce

imbalances in households and the mortgage industry and inflatehouse prices.

INDUSTRY DEFENDS

The industry has defended the loans, saying the products and adjustable-rate mortgages have

helped soften the effect of the economic contraction and helped keep people in their homes.

Foreclosures fell in December to 363 from 451 a month earlier, the Copenhagen-based statistics

agency said.

We dont think these are a mistake, Knoesgaard said. Its not black and white only.

Foreign investors bought 34 billion kroner in bonds in November, the biggest amount in almost

two years, the central bank said Jan. 7. The purchase brought foreign holdings to a record 487

billion kroner, or 16 percent, the bank said.

Still, last years foreclosure total is the second highest since Denmark experienced its last

housing crisis, in the early 1990s,Nordea Bank AB (NDA)housing economist Lise Bergmann

said this week in a note. Rising unemployment among homeowners with the fewest resources

probably drove the increase, she said.

Mortgage banks already have a problem today, Beltoft said. If house prices stay at the level

they are today, we will see the problem grow in 2015 and 2016.

In Denmark there is considerable public interest in the market for mortgage backed securities.

Spurred on by the product innovation and advice of financial institutions, many home-owners

manage their mortgage debt very actively. The individual mortgagor faces a number of non-

trivial decisions. He has to decide whether to use adjustable rate loans where the debt is

refinanced on a yearly basis (or every 3 or 5 years) or the more traditional fixed rate 20- or 30-

year annuities, or some combination hereof.

The annuities have embedded options: There is a call-feature because the mortgagor can repay

the remaining principal at any time, and there is a delivery option because he can buy back his

debt at market value (a feature not present in mortgages in the US).
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The problems of mortgage prepayment behaviour has been studied, e.g., by Richard and Roll

(1989)23, and by Kang and Zenios (1992)24, and of mortgage portfolio management (from the

investors side) by e.g., Zenios (1995)25and many others.

A mortgage credit system has been in existence in Denmark for 200 years. Although there are

other established types of mortgage bonds in Europe, notably the Pfandbrief26 sector in

Germany, Danish mortgage backed securities are the closest to the U.S. pass-through securities

in terms of cash flow characteristics.27 They are mostly fixed-rate, level-pay loans (called

annuity loans in Denmark), with original maturities of 10, 15, 20 or 30 years, and can be prepaid

without penalty at any time. However, mortgage payments are quarterly rather than monthly. In

addition, residential and commercial mortgage loans are mixed in the same pools.

The amount of outstanding Danish fixed-rate mortgage backed securities was DKr 970 billion at

the end of the second quarter 1998, or about $150 billion, a remarkable amount for a nation of

only five million people. Danish mortgage pools (or series) tend to be large in size, typically $1

billion or more initially (some issues are more than $10 billion). This size is achieved by

keeping a series open for up to three years, that is, new loans can be put into the pool any time

during a period of three years.

Prepayments in Denmark show extreme efficiency, because of very low refinancing costs, a

national awareness of refinancing opportunities (a strong media effect), and the ability to prepay

discount loans at market value (rather than at par). However, as in the United States,considerable resources have been devoted to the developing prepayment and OAS models to

capture prepayment risk.28

23Richard, S.F., Roll, R., 1989. Prepayments on 3xed-rate mortgage-backed securities. Journal of Portfolio

Management 15, 7382.24Kang, P., Zenios, S.A., 1992. Complete prepayment models for mortgage-backed securities. ManagementScience 38 (11), 16651685.25Zenios, S.A., 1995. Asset/liability management under uncertainty for 3xed-income securities. Annals ofOperations Research 59, 7798 (reprinted in World Wide Asset and Liability Modeling, Ziemba, W.T.,Mulvey, J.M. (Eds.), Cambridge University, Cambridge, 1998).26Pfandbriefsare collaterized bonds, with a total market size of close to $1 trillion, of which a quarter are backedby residential mortgages (although because the LTV cannot exceed 60%, only a fraction of German mortgages areeligible forPfandbriefs. However, prepayments are not allowed, and even if a loan is prepaid, the issuer typicallydoes not pass on the prepayment to the investors. For a description of the sector see, The Jumbo-Pfandbrief and itsFuture, Udo Herges, Salomon Smith Barney, July 199827 For an introduction to Danish mortgage backed securities, see Mortgage Bonds, by Den Dankse Bank. Thefigures on the Danish market are taken from this publication.28

There is one difference in the way prepayments are passed through to investors: Instead of the pro rata systemused in the United States, prepayments are distributed by a lottery system, each bond (nominal value Dkr 1,000)being one lot. Investors with large holdings would expect to see prepayments on their bonds close to the rate for thepool (or series), given the law of averages, but smaller investors may see deviations.


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THE DANISH MORTGAGE MARKET AND THE INDIVIDUAL MORTGAGOR

The interest rate policy of the Danish Central Bank usually mimics that of the European Central

Banks short rates and the yields on government bonds also closely follow those in Euroland,

with the addition of a spread of 2550 bp. On several occasions the Danes have voted No to

joining the single European currency, the Euro, but still this change rate is quite stable (between

DKK 7.40 and 7.50 will buy you 1 Euro).

Though small in absolute terms, the Danish mortgage market 29 has some interesting features.

Mortgages have historically been financed by 20- or 30-year fixed-rate bonds that were issued

through intermediaries (first only dedicated mortgage companies, since 1970 also banks) to a

quite liquid market. The mortgagor can repay the remaining principal at any time, 30 in other

words the bonds are callable. When interest rates drop, the mortgagor can issue new debt at the

lower rates, typically in the form of a new fixed-rate (callable) bond with lower coupon rate,using the proceeds from this to pay off the old mortgage, which is called at par. Fixed-rate

bond prices actually do increase to above 100 without being called. One such reason is that it is

not possible or worthwhile for the individual mortgagor to be a highly efficient investor

(optimal behaviour is ill-defined), another is transaction costs.

Conversely, if interest rates increase, the mortgagor can buy back the now relatively cheap

mortgages in the market, again funding this by issuing a new mortgage, now with a higher

coupon rate. This will make the instalments larger, but reduce the principal on the mortgage, andthe mortgagor has positioned himself better if interest rates subsequently drop. This was a

strategy widely recommended by financial institutions from mid-1999 to mid-2000, because

there was a perception that rates are high (since they had recently gone up) and they will come

down (in particular, because the common belief was that Denmark would soon join the Euro).

An effective refinancing strategy therefore involves refinancing both when rates decrease and

increase, in either case issuing bonds as close to par as possible (mortgagors are by law only

allowed to issue bonds priced at or below par).

A key question is, by how much should rates change before refinancing is optimal? Danish

banks now offer the so-called mortgage-watch programs, where they alert their customers to

opportunities. Of course, the banks make a sizeable profit (there is a fixed cost to the bank of

typically DKK 15002000 and a variable cost of 0.15% of the price of the new issue, in addition

to taxes) when a customer refinances, so it is in their interest to induce refinancing.

29Figures from late 2013: Measured by market value the size of the Danish bond market was DKK 21012

(and a tiny bit more by face value); roughly 50% are mortgages, 30% government bonds, 8% inflation-linked bonds,and the rest are more or less exotic bonds that only constitute 3% of the turnover.30 Actually such extraordinary prepayments can only take place on coupon payment dates (of which there aretypically 4 per year) and two months prior notification has to be given.


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To the purchaser of these bonds, the credit risk is very low because the lending institution pools

and insures the issue. Only some systemic collapse, affecting a major part of the economy,

would present a risk that could hardly be avoided anyway. But there are other issues that make

the purchaser side interesting, in particular modelling the prepayment behaviour of the

mortgagors in the bond issue. Note the asymmetry; the mortgagor takes into account very

specifically his own characteristics, whereas the purchaser buys the average mortgagor.

Ideally, one should consider both sides in detail and then arrive at (model) market prices by

some equilibrium argument.

In the mid-1990s, adjustable-rate mortgages (ARMs) in the form of revolving, short term loans

were introduced, following a legislative change. These loans were first offered by Realkredit

Danmark under the trademark FlexLan, then (reluctantly) by most other intermediaries. The

simplest one is the F1, whereby the complete outstanding principal is refinanced every year by

January 1st at the prevailing 1-year rate; similarly there are F2, F3, up to F10 loans. Another

option is the P-loans, for instance the P25,0, where 25% of the debt is refinanced every year at

the 4-year rate, many other fractions up to 50% exist. These ARMs all share two characteristics:

They depend on the short end of the yield curve, and they are very vulnerable to increases in

short rates. In a normal, positively sloped term structure they have some appeal compared to

the long-term loans, and the market for these loans, after some hesitation, is now very large. 31

Although ARMs had an obvious appeal during the early years, there was a significant narrowing(flattening) in 2000 (due to the uncertainty of the Danish referendum September 28 whether to

join the Euro; they did not), making the situation far from obvious for the individual mortgagor.

The most important feature of the Danish secondary mortgage market has been its high liquidity.

The mortgage bonds are highly liquid because the large pools of securitized loans offer uniform

characteristics such as coupon, rate of amortization, and loan to value ratios.

Liquidity is also supported by a market-making scheme where ten commercial banks trade all

open-for-issuance mortgage bonds at a common price. Issuance and trading is done through theDanish Central Depository Institution (VP) and the pass-through bonds have the same

characteristics of the underlying pool of mortgage loans (see Frankel et al.)32. The adoption of

31https://www.imf.org/external/pubs/ft/wp/2008/wp08105.pdf,last visited on 28.9.201432However, in Denmark, the pre-payment risk is reduced by a feature of the mortgage loans whereby a borrowercan deliver a bond in lieu of the mortgage payment. This feature has the advantage that the purchase of the bonds onthe market by the borrower does not cause a pre-payment event. It also has the advantage that when mortgage bondsare trading at a discount, the borrower can take advantage of such discount to repay his or her mortgage. This also

implies that mortgage investors benefit from early repayment of mortgage loans for bonds trading below par (andthus can re-invest their proceeds at a higher interest). In addition, mortgages are transferable among borrowerswhich makes pre-payment risk in Danish mortgage securities less exposed to demographic factors than in the U.S.securities. This feature of the Danish model is not being adopted in Mexico.
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VPs technological platform in Mexico is expected to contribute to help liquidity and smooth

trading of the RMBS market. As in the U.S., mortgages in Denmark, and Mexico have a

penalty-free prepayment clause, subjecting the holder of the mortgage to prepayment risk.

However, in Denmark, unlike in the U.S., regulation requires a strict matching of cash flows

between the underlying loan and bond servicing flows. The result is that prepayment risk is held

by investors who, relative to the U.S. housing agencies, accept larger fluctuations in the duration

measures of their bond portfolios.33As in the U.S., the Mexican scheme has no provisions to

fend against prepayment risk.34

Although mortgage securitizations can be carried out through a Trust,35the process can take up

to a month. In an effort to expedite the process, the Danish central depository institution (VP), in

collaboration with SHF, set up a technological platform in HiTo to launch a system that is open

to any party interested in the securitization of a mortgage portfolio. HiTo allows the continuous

interface of banks, Sofoles and the Mexican depository institution INDEVAL so as to expedite

and reduce risks in the securitization process.

The 2010 Dodd-Frank financial reform act broadly defined asset-backed securities to encompass

all securitizations:

a fixed-income or other security collateralized by any type of self-liquidating financial asset

(including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the

holder of the security to receive payments that depend primarily on cash flow from the asset,

including (i) a collateralized mortgage obligation; (ii) a collateralized debt obligation; (iii) a

collateralized bond obligation; (iv) a collateralized debt obligation of asset-backed securities;

(v) a collateralized debt obligation of collateralized debt obligations; and (vi) a security that the

Commission, by rule, determines to be an asset-backed security for purposes of this section.

Traditionally, finance professionals have used the term more narrowly to refer to securitizations

other than mortgage-backed securities (MBS). When collateralized debt obligations (CDOs) and

collateralized bond obligations (CBOs) became popular in the early 2000s, they too wereexcluded from the definition. For the most part, asset-backed securities are understood to be

securitizations of auto loans, credit card receivables, home equity loans and student loans.

Asset-backed securities have credit risk. Diversification of the underlying assets, credit

enhancements or tranching can mitigate this. Following the 2008 financial crisis, asset-backed

securities didnt suffer nearly the credit losses that MBSs did.

33 Frankel, A.; Gyntelberg, J. Kjeldsen, K. and M. Persson M. (2004) The Danish Mortgage Market, BISQuarterly Review, March.34

Rogers, J. and R. Zepeda (2006) Mexico Looks to Denmark on Mortgage-Backed Securities Global Bankingand Financing Policy Review, Vol. , pp. 123635 Frankel, A.; Gyntelberg, J. Kjeldsen, K. and M. Persson M. (2004) The Danish Mortgage Market, BISQuarterly Review, March


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Asset-backed securities can be subject to prepayment risk, but this is slight compared to that of

MBSs. Consumers are more likely to refinance a home than an auto in response to a drop in

interest rates.

Asset-backed securities are appealing to issuers because the structure allows them to get assets

off their balance sheets, freeing up capital for further receivables. However, the Dodd-Frank Act

requires issuers of all securitizations to retain some of the credit risk of those instruments. Asset-

backed securities do make it possible for issuers whose unsecured debt is below investment

grade to sell investment grade debt.

To create an asset-backed security, a corporation creates a special purpose vehicle to which it

sells the assets. While it is common to speak of the corporation as the issuer of the asset-backed

security (we do so above), it is legally the trust or special purpose vehicle that is the issuer. It is

the trust or special purpose vehicle that sells securities to investors.

To protect investors from possible bankruptcy of the corporation, there are three legal

safeguards:

Transfer of assets from the corporation is a non-recourse, true sale.

Investors receive a perfected interest in the assets cash flows.

A non-consolidation legal opinion is obtained certifying that assets of the trust or special

purpose vehicle cannot be consolidated with the corporations assets in the event of

bankruptcy.

These same safeguards allow the corporation to remove the assets from its balance sheet. The

corporation generally continues to service the assetscollecting interest and principal payments,

pursuing delinquencies, etc. It is paid out of asset cash flows for providing these ongoing

services. For investors, asset-backed securities are an alternative to highly-rated corporate debt.

They generally offer similar or superior liquidity. Because the underlying assets are diversified,

they are less subject to credit surprises. asset-backed securities can be structured into different

classes or tranches, much like collateralized mortgage obligations (CMOs). There may be senior

or subordinated classes of debt, which have different credit ratings. Tranches may be structured

with different average maturities. Choice of structure depends upon investor demand as well as

the nature of the underlying assets.

ADVANTAGES AND DISADVANTAGES

A significant advantage of asset-backed securities for loan originators (with associated

disadvantages for investors) is that they bring together a pool of financial assets that otherwise


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could not easily be traded in their existing form. By pooling together a large portfolio of these

illiquid assets they can be converted into instruments that may be offered and sold freely in the

capital markets. The tranching of these securities into instruments with theoretically different

risk/return profiles facilitates marketing of the bonds to investors with different risk appetites

and investing time horizons.

Asset backed securities provide originators with the following advantages, each of which

directly adds to investor risk:

Selling these financial assets to the pools reduces their risk-weighted assets and thereby

frees up their capital, enabling them to originate still more loans.

Asset-backed securities lower their risk. In a worst-case scenario where the pool of assets

performs very badly, "the owner of ABS (which is either the issuer, or the guarantor, or

the re-modeler, or the guarantor of the last resort) might pay the price of bankruptcy

rather than the originator." In case the originator or the issuer is made to pay the price of

the same, it amounts to re-inventing of the lending practices, restructuring from other

profitable avenues of the functioning of the originator as well as the norms of the

issuance of the same and consolidation in the form of either merger or benchmarking

(internal same sector, external different sector).

This risk is measured and contained by the lender of last resort from time to time auctions andother Instruments that are used to re-inject the same bad loans held over a longer time duration

to the appropriate buyers over a period of time based on the instruments available for the bank to

carry out its business as per the business charter or the licensings granted to the specific banks.

The risk can also be diversified by using the alternate geographies, or alternate vehicles of

investments and alternate division of the bank, depending on the type and magnitude of the risk.

The exposure of these refinanced loans to "bad credit" (Type II) decisions (particularly in the

banking sector, unscrupulous lending or the adverse selection of credits) is hedged against by thesellers of the same, or the re-structurers of the same. Thinking of securitization (insurance) as a

panacea for all the ills of bad credit decisions might lead to the hedging of the risk by the

transfer of the "hot potato" from one issuer to another without the actual asset against which the

loan is backed reaching an upswing in value, either by the demand-supply mismatch being

addressed or by one of the following factors:

The economic productivity of the business cycle being reversed from downturn to upturn

(monetary and fiscal measures)

More buyers than sellers in the market


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A breakthrough innovation.

On a day-to-day basis the transferring of the loans from the

Sub-ordinate debt (freshly made and highly collateralized debt) to the

Sub-ordinate realizable

Sub-ordinate non-realizable

ABS AND FINANCIAL MARKET OF DENMARK

Asset backed-bonds Since 2003 junior mortgage-backed bonds have been the second biggest

class of asset-backed securities listed on the Copenhagen Stock Exchange after mortgage bonds

(based on properties and ships). However, there was only one issue in 2007 and there have been

none so far in 2008. This development has mostly been a result of the prevailing property marketconditions. However, regulatory challenges may also have had an effect on issuers interest

Senior as well as bad (securitized) debt might be a better way to distinguish between the assets

that might require or be found eligible for re-insurance or write off or impaired against the

assets of the collaterals or is realized as a trade-off of the loan granted against or the addition of

goods or services.

JUNIOR MORTGAGE BACKED-BONDS

Since 2003 junior mortgage-backed bonds have been the second biggest class of asset-backed

securities listed on the Copenhagen Stock Exchange after mortgage bonds (based on properties

and ships).

However, there was only one issue in 2007 and there have been none so far in 2008. This

development has mostly been a result of the prevailing property market conditions. However,

regulatory challenges may also have had an effect on issuers interest. Almost one -third of the

bonds issued from 2003 until now have been redeemed due to the sale or restructuring of the

ownership to the relevant properties. In most cases redemption has taken place above par due topre-payment before the due date. This had led to an effective yield of around 20 per cent for

some bonds issues.

Consumer lending continues recovering slowly

The performance of the Danish economy has a strong impact on the performance of consumer

lending in Denmark. Naturally, the Danish economy is in turn influenced by the European

economy. While the European economy is failing to show strong and reliable signs of constant

growth, the Danish economy is also expected to remain unstable. Due to fluctuations in the local


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economy, consumers in Denmark are meanwhile considering carefully before taking on heavy

financial commitments. This caution constrained consumer lending during the review period.

I ncreased demand for " other" personal lending

In 2013, smaller loans performed better than more costly ones. While Danes are thinking twice

before taking on heavy loans for expensive purchases or investments, "other" personal lending

saw a good performance due to such loans usually involving a smaller amount of money. The

Danes are known for their high standards in terms of lifestyle quality. In order to maintain the

desired lifestyle and enjoy indulgences, even when the economy is not performing at its best,

there was growing demand for these relatively moderate loans.

Consumers benef i t f rom increasing competi tion

The major players in consumer lending could be categorised into three groups by the end of the

review period: retail banks, mortgage banks and other more innovative financial institutions. The

existence of three different lending groups is leading to increasing competition, although

consumer lending continued to be dominated by retail banks at the end of the review period. As

competition increases, players are meanwhile seeking to offer more differentiated products and

services with differentiated conditions for lending. Consumers are thus the main beneficiaries

from this situation, becoming able to chose from a widening range of offers to suit their needs.

Str icter regulations and poli cies for lending

Due to unstable European and the Danish economies, new regulations were imposed during thereview period by the EU central bank and subsequently by the Danish national bank on local

financial institutions. These regulations aim to prevent any future collapse of the financial

industry and had a direct impact on consumer lending. Policies for lending money became

stricter during the review period, making it harder to for customers to borrow money without

meeting specific requirements and standards. This constrained growth in consumer lending.

However, the Danish national bank reduced national interest rates during the review period and

kept rates very low at the end of the review period. The national bank thus aimed to stimulateconsumer lending and supported moderate growth during the review period.

Forecast period performance connected to economic development

Over the forecast period, most areas of consumer lending are expected to grow in terms of

constant value gross lending, although at more moderate rates than seen during the review

period. The performance of consumer lending is strongly related to the performance of the

Danish economy, with forecasts thus being very uncertain. Chan

Share of Outstanding Loans of NBFC vis-a-vis the Outstanding Loans of Banks in Denmark

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