By Hamlin Lovell, NordicInvestor

NordicInvestor interviewed Rens Ramaekers, portfolio manager in the European ABS and Mortgages team, at Aegon, one of the largest non-bank originators of Dutch mortgages, to find out why they offer a yield premium, how to quantify their liquidity and valuation risks and why the credit risk has historically been so low.

Dutch mortgage borrowers pay some of the highest mortgage rates in Western Europe, where only Portugal has comparable mortgage rates. According to data that Aegon gathered from the ECB and other sources, as of October 2021, the mortgage rates were between 40 and 70 basis points higher than in other comparable Eurozone countries. There have even been reports of negative mortgage interest rates in countries such as Denmark, something that has never been seen in the Netherlands, where mortgage rates are clustered in a relatively tight band.

The Dutch mortgage market does not display the wide range of spreads seen in some other markets. All borrowers are underwritten using strict affordability criteria set by an independent institute. Therefore, no competition on underwriting criteria takes place between the several mortgage originators and all mortgages are prime residential loans. “There is one pricing grid across all mortgages and the three main variables are its LTV, the fixed rate term, and whether the mortgage is repaying or interest only,” says Ramaekers.

Investors can choose their investment vehicle based on their liquidity appetite and accounting treatment.

Yield Pickup

Investors can choose from securitized bonds, structured credit, or direct investments into loans. Roughly 30% of the Dutch mortgage market is turned into covered bonds or RMBS, versus over 80% of the Danish mortgage market.

First of all, to draw a like for like comparison with mortgage bonds in other countries it makes sense to identify the universe of Dutch mortgage bonds, which have a market price and a liquid secondary market for trading on exchanges with banks and brokers, an ISIN code, and can be deposited with the ECB. “Dutch covered bonds backed by mortgages pay between 0 and 40 basis points over swap rates,” says Ramaekers. This is actually broadly comparable to mortgage bonds in some other countries. Structured credit backed by Dutch mortgages (RMBS) also offers similar yields, according to Ramaekers.

Direct investments yield much more: “At the same time, investment in Dutch mortgage loans gives you a spread above swap of 160 basis points.”

Due to illiquidity, the market for Dutch mortgage loans is less crowded than other, more traditional, asset classes. This is one simple factor explaining the yield pickup.

Liquidity

As there is no broad secondary market for the loans, liquidity comes mainly from the cash generation of the underlying mortgage loans which add up to roughly 10% per year. “The breakdown is typically 2% interest payments, 3% contractual prepayments of capital, and 5% other prepayments mainly due to borrowers moving,” says Ramaekers. These cashflows would allow the fund to facilitate redemption requests. “As most of our investors are long term investors we do not see a lot of redemption requests,” according to Ramaekers.

“In case the cash generated by the fund isn’t sufficient to facilitate redeeming clients, something that we haven’t seen over the past 9 years, we can facilitate redemption requests with matching entering participants with exiting participants,” he adds

Mark to model valuations

Valuations for direct pools of whole loans Dutch mortgages are based on fair value, or “mark to model”, which is performed on a monthly basis. 

In the case of Aegon’s mortgage product, the valuation methodology is based on a discounted cash flow model where comparable Aegon mortgage rates are used as discount factor.

Interest Rate Duration

The estimated interest rate sensitivity, including prepayment assumptions, on Aegon AM’s pools of Dutch mortgages, is around 8 years, which is the main factor explaining some negative performance in late 2021 and early 2022. Yields on Dutch mortgage rose from 1.6% to 3.2% over the first 4 months of 2022.

Prepayment risk

Interest rate sensitivity is only a central or base case estimate, because prepayment risk can extend or reduce the life of a pool of mortgages. The probable range of prepayments on Dutch mortgages is likely to be narrower than on some other mortgages, such as some Danish and German loans, that allow unlimited prepayments. “Dutch borrowers can only prepay without penalty up to annual limits, typically 10%, or when they move house. They cannot prepay through refinancing the mortgage with another mortgage without paying a penalty, which means there is no incentive to refinance when rates fall, where penalties would be likely to eliminate any benefit from doing so,” says Ramaekers.

Overall, moving house is the main reason for prepayments, which tend to be in a range between 5% and 10% per year, which is lower than on some Danish or German mortgages The economic environment is in turn the main reason for moving house.

Near Zero Credit Losses

Since 2013, total cumulative credit losses on Aegon AM’s Dutch mortgage strategies have been less than one basis point. The annual average is about one seventh of a basis point, or 0.0015%, though in some years such as 2020, credit losses were zero.

“Since 2004, the highest loss rate we observed on Dutch mortgages in any single year was only 5 basis points or 0.05%”, according to Ramaekers. These have to be seen in the context of the prevailing mortgage and property markets. “At that time loan to value ratios were higher, there were more interest only loans, and property prices declined by about 25% between about 2008 and 2013. Now, since average LTV is lower, currently roughly 65%, and there are more repaying loans it is likely that credit losses will be lower in a potential crisis”.

“The reason for these low losses during the financial crisis is mainly driven by the strict underwriting criteria, some government guaranteed mortgages, the strong social security system in the Netherlands and the full recourse the investor has on the borrower,” according to Ramaekers.

Affordability

In the US, the sub-prime mortgage crisis partly arose from so called “liar loans” where individuals self-certified their income as being higher than it really was, in order to get one or more loans that they could not ultimately afford. Strict affordability criteria are one reason for the low credit risk on Dutch mortgages.

“The Netherlands has a strict code of conduct set up by the mortgage originators and embedded in Dutch law. Maximum mortgage payments are set by an independent institute, Nibud, based on a borrower’s salary, average living costs and so on,” says Ramaekers.

Borrowers typically get a mortgage for between 3.5 and 5 times their income, with an average multiple of 4 times. “Average debt servicing is 14% of a borrower’s income, showing the strong affordability of Dutch mortgages,” says Ramaekers.

For borrowers who chose a short term fixed rate, a stress tests for interest rate rises is designed to ensure that borrowers could afford to pay as much as 5%, although it would actually take many years for any such rise to percolate into the vast majority of the mortgage market. “Currently 95% of the mortgages in our strategies have a fixed rate period of more than 15 years. This means that higher interest rates have very little impact on most existing mortgages, and only really affect borrowers coming to the end of their fix, or new mortgages,” says Ramaekers.

As aforementioned, higher European interest rates in late 2021 and early 2022 are being reflected in mortgage rates, which had risen by about 70 basis points as of February 2022. “The typical mortgage spread is 160 basis points over Euribor interest rates,” reiterates Ramaekers.

NHG Insurance

Part of the Dutch mortgage market has another safety valve, from the NHG guarantee. Though some managers’ marketing literature implies that all Dutch mortgages are covered by the NHG, in fact only around 30% of outstanding mortgages and 20% of new loans have the NHG guarantee. It covers 90% of losses on capital and interest, which is ultimately backed by the Dutch government. The NHG can pay out in the event of unemployment, disability, separation/divorce, or death of partners, and some borrowers also have private insurance for some of these risks.

The NHG guarantee is available for mortgages up to the average house price in the Netherlands, which is currently EUR 355,000. This is reset annually.

The value of the NHG guarantee is reflected in yields: “NHG loans have a yield 20-30 basis points lower than loans without the NHG and borrowers pay an up-front premium of 70 basis points for the NHG insurance,” says Ramaekers.

Recourse

Whereas US mortgages are non-recourse, which can lead some borrowers to opportunistically default, Dutch mortgages have full recourse not only to the property, but also to other assets, and all income, of the borrower. This is however rare. “Foreclosing a property is not something we like to do. We prefer to find a borrower and investor friendly solution and also help the borrower with a jobcoach and budget coach,” explains Ramaekers.

Loan to Value ratios

Recoveries in the event of foreclosures would be high in most cases because house price appreciation has helped to reduce loan to value ratios down to around 65%. “Though first time buyers can borrow up to 100% (or 106% including energy efficiency measures) most mortgages are taken out by those moving house, and their average loan to value ratios at origination is roughly 75% due to rules requiring borrowers to move their home equity to the new house,” says Ramaekers.

Interest only mortgages are now only allowed up to 50% of property values.

Stress Testing Loss Scenarios

With so many layers and levels of defence for lenders, it is unexpected that large credit losses will occur. “A market scenario similar to the global financial crisis would only lead to ~3bps of credit loss, which investors are well compensated for with the current yield of 3.3%,” points out Ramaekers.

Why no triple A Credit Ratings?

Given how tiny the historical credit losses have been, it might seem intuitively surprising that direct portfolios of whole loan Dutch mortgages are rated as double A and not triple A by credit ratings agencies. The explanation is a technical one around credit ratings methodologies. “To get a triple A rating, you need to see a zero loss on a triple A loss scenario. This is not possible for Dutch mortgages as even the smallest possible loss on one mortgage would mean a small loss for the investor,” says Ramaekers. The current whole loan strategies on Dutch mortgages have an implicit rating of AA.

Outlook for Spreads

Dutch mortgage spreads have been in the range of 150 to 200 bps over the last few years. “These higher spreads are also one of the reasons why we have seen institutional interest in this asset class,” says Ramaekers. “It is expected that relative value will remain high as investors need to receive an attractive illiquidity premium.”