By Hamlin Lovell, NordicInvestor

Danish mortgages literally had a baptism of fire, as the market was conceived after Copenhagen’s Great Fire of 1795, but it has seen no defaults on covered bonds since then.

Finans Danmark argues that the Danish Mortgage Model is “probably the best in the world”, borrowing the slogan from Danish brewer Carlsberg. It has survived multiple crises and shocks over centuries.

Jyske Capital’s Allan Willy Larsen joined Jyske in 2011 but has been involved in Danish mortgages for nearly 30 years since the mid-1990s, also at Sydbank. “I have seen 8% coupons in the late 1990s, zero yields more recently and even a ten year issue with negative coupons five years ago. After the Russian crisis in 1998 callable bonds had huge volatility and at that time the Danish sovereign was only rated double A+, which also capped the rating on the mortgages. The GFC in 2008 provided the ultimate test with a huge 20% drop in real estate prices, which led some borrowers to default but there was no default on the mortgage bonds,” he recalls.

The Danish mortgage market sounds enormous by any measure: it is Europe’s largest covered bond market, is larger than Denmark’s GDP, overall bank lending, and also several times bigger than the Danish government bond market. This can lead to a perception that Danes are dangerously over-leveraged, but in fact the unique structure of the Danish mortgage market provides the foundation for financial stability. In a world of ever more complex derivatives and other instruments, Denmark’s mortgage market stands out for its elegant simplicity, which has attracted not only Danish pension funds and banks but also foreign investors such as insurers from Germany , Austria, the Netherlands, the US and Japan.

Match Funding  in the Danish Mortgage System

The “In Princip” balance structure aligns the assets and liabilities of mortgage banks. “A mortgage has the same maturity, coupon and cashflows as the associated mortgage bond, and this means that the mortgage bank has no interest rate risk. Match funding means that the repayment cashflows are directly transferred from the borrower, to the mortgage bond and the mortgage bank. In addition, mortgage banks do not accept deposits, and must hold hefty reserves,” says Larsen.

All of this means that mortgage banks avoid the various asset/liability mismatches that have caused many banking crises in other countries. A run on deposits could not kill a mortgage bank since it has no deposits! A change in the shape of the yield curve term structure also does not matter – because maturities are aligned. Though some sorts of banks need to play a role in liquidity transformation in the financial system, by taking in short term deposits and providing longer term credit, mortgage banks in Denmark deliberately avoid liquidity mismatches and do not fulfil the liquidity transformation function.

There is also no possibility of the foreign currency mismatch risks that have caused problems for both borrowers and banks in Eastern Europe, where people took out Swiss Franc mortgages on low interest rates and then watched the Swiss Franc double in value against the Hungarian Forint or Polish Zloty, also doubling the principal value of their mortgage. If the Danish Krona did ever de-peg from the Euro this should not cause problems for mortgage banks, since their assets and liabilities are both in Danish Krona.

Fixed rate mortgages contribute to financial, social and economic stability in a special, but also very simple, way. If interest rate increases lead both house prices and fixed rate mortgage bonds to decline in value, mortgage borrowers may well avoid the “negative equity” problem, so long as their house price has not fallen much further than the mortgage bond. Moreover, they may have the option of repaying part of the reduced mortgage balance.  “In 2022 a lot of homeowners were able to buy back part of their mortgage and reduce the debt by up to 25%,” says Larsen.

This, combined with some moderate house price appreciation, helps to explain why the average loan to value ratio across the Danish mortgage market is 55% as of April 2024, well below the 80% cap on loan to value ratios when the mortgages are first taken out.

Affordability criteria

In addition to the 80% loan to value cap, borrowers cannot borrow more than 4 their annual income, and affordability is stress tested 1% above the current interest rate subject to a minimum assumed 4% interest rate, which means that the affordability stress test is at least 5%. This also makes it less likely that they cannot afford repayments. In Sweden it is very different. “All loans are floating rate, typically fixing at 3, 6 or 12 month. Short term rates are (normally) lower, so many people may get a loan on a low rate that suddenly can end up rising,” points out Faro.

High earners who have a career change might perhaps struggle in some cases, but income differences in Denmark are much smaller than in many other countries outside the Nordics, and some unskilled workers can earn almost as much as a nurse. And a banker who becomes a teacher or academic will not see such a large drop in income as they might do in the US or UK. If people lose their job or become sick, generous state welfare payments can cover a high proportion of their income. There are also stricter rules on affordability in large cities such as Copenhagen.

Full recourse

Negative equity and/or inability to service the loan costs is in fact a risk for the individual borrower, but it is a much smaller risk for mortgage banks or mortgage bonds, because the lenders and bondholders have full recourse to other assets and future income of the borrower. In theory if a house price dropped below the loan value, and a forced sale did not recover the loan value, the borrower could be pursued for the shortfall, subject to certain limits. Individuals would be allowed a certain level of income and assets for their spending, families and so on.

These rules have helped to restrain house price rises in Denmark, which have risen by much less than in Sweden or Germany or  Norway, where it is possible to borrow 5-6 times income. “This was a deliberate policy to reduce house price volatility and avoid the 25% drops in house prices seen after the GFC,” says Larsen.

Of course some individuals, farmers, companies and certain types of banks have gone bankrupt in Denmark. “In the noughties there were problems with development related mortgages. Danes had borrowed to buy apartments not yet built, and some banks with a lot of exposure to developers went bust as there was no recourse on development related loans,” says Larsen.

In theory, if defaults wiped out the cover pool, a mortgage bank would need to be liquidated and restructured by the regulator, but this has never happened.

Liquidity

Since Danish mortgages are a larger market than Danish governments, it is not entirely surprising that the mortgages stayed liquid during the GFC even when there were no bids for government bonds. “Prepayments from homeowners flowing through to the mortgage bond market also help to maintain high volumes of trading, since the borrowers are buying back part of the mortgage bonds. Since 2022, the major buybacks were in the 1% 30-year callables and have been about DKK 350 billion,” says Larsen.

During Covid in 2020, house prices actually rose 20%, partly due to buying of holiday homes. Stress tests for mortgage repayments under a crisis could include super high inflation, interest rates of 10% or more or a world war 3 scenario. “These would create problems for Adjustable Rate Mortgages, but callables would be fine because higher rates would also reduce the value of the mortgage,” says Larsen.

Spreads

In the start of 2022, mortgage spreads over swap rates increased, but have now tightened again in 2023 due to very low rates of issuance and a lot of buybacks. “In April 2024 spreads are as low as 25 basis points on callables, and 15 basis points above swaps on 5 year bullet loans. The CIBOR fixing is used for swaps,” says Larsen.

Many types of mortgages

Denmark has about 3,000 mortgage bonds, and the market is associated with residential housing but in fact all pools, owner occupied housing may only account for 55% or so of the total mortgages.

There have been default problems in specific areas in the past, such as commercial and development property, not unlike the problems seen with certain CMBS (commercial mortgage backed securities) in the US in recent years. However CMBS per se do not exist in Denmark, since they are part of larger pools combining residential, commercial, industry, agriculture, solar and wind farms. Incidentally, shipping finance is done by a special credit institute, and is not part of the pools or Jyske’s portfolio.

Pools vary in their composition. For instance, “the DLR pool is 50% agriculture and 50% offices, because that particular pool does not contain residential mortgages. DLR is owned by a group of smaller banks in Denmark, including Jyske. The larger mortgage banks, Nordea, Danske and Nykredit, also issue some agricultural loans, but a smaller percentage, perhaps around 5-10%, which also feed into the mortgage bonds”.

If some individual farmers may default this is manageable within the overall pool. Combining these multiple types of mortgages is a kind of social solidarity pact, since if there are problems in one part of the economy, such as commercial offices which are perhaps under-utilised due to home or hybrid home/office working, this shock can be absorbed by the pool since the another part of the economy, such as agriculture, may be performing well.

Outlook

The composition of the market changes over time. “Now in 2024 Danes have converted mortgages from fixed 30 year to floating rate notes, in the expectation of rates falling,” says Senior Client Relationship Manager, Christian Faro.

This market should last at least another few centuries.