The regulator in charge of the world’s biggest covered-bond market wants issuers to rely less on derivatives to meet a key requirement.
The $490bn bond market behind Danish mortgages is famous for its resilience.
When Denmark went bankrupt during the Napoleonic wars, its mortgage market survived.
One of its key strengths has been its simplicity.
But of late, some issuers have started turning to derivatives to meet a key requirement: the balance principle, which ensures that the maturity and interest rates of bonds funding mortgages match those of the underlying loans.
The balance principle is designed to protect mortgage banks from market and interest-rate risks.
The setup is one of the reasons that Danish covered bonds carry the highest credit rating and are so coveted by investors from Japan to Germany.
The Danish Financial Supervisory Authority is now telling lenders they shouldn’t meet the balance principle through the routine use of derivatives.
Kristian Vie Madsen, the deputy director for banks at the FSA in Copenhagen, says using derivatives like interest-rate and currency swaps to meet the requirement “should not be the normal way of doing things.”
That’s why the FSA is now setting a limit so that derivatives aren’t used on more than 10% of issued bonds.
The new guideline also means that using derivatives on more than 5% of issued bonds requires greater involvement from top management and more risk controls.
If banks issue bonds that don’t have the same maturity as the mortgages, “then you end up having some refinancing risk and if you use derivatives as well, you also can get some liquidity risk,” Madsen said. “The further you go, the higher the risk.
And we think that it’s fair enough to take on some risk, because it can also be more effective, but on the other hand it’s good and sound to have some limits on your risk taking.”
The requirement sets limits on how much risk banks can take when it comes to interest rates, currency, options and liquidity.
It can be met by directly matching the maturities on bonds and loans (the traditional way) or by issuing bonds against pooled loans.
Mortgage banks in Denmark have increasingly been using the second option, which means they need to rely on derivatives to even out any mismatches.
Part of the reason they opt for pooling is to pump up the size of a bond issuance as much as possible, in order to make it more attractive to foreign investors.
The FSA’s crackdown on derivatives represents an extra layer of security that investors generally like.
Lars Peter Lilleore, head of fixed income for Sampension, says that “from a buyer’s point of view, while you cannot unequivocally say that the time-tested matching principle always is better, on average you’d expect it to be.”
“It’s a sign that the FSA would prefer to not deviate too much from the time-tested matching principle.
This I think is consistent with other regulation that aims to heighten transparency,” he said.
Lilleore says that, theoretically, derivatives may be better “in the case where the derivatives add to the efficiency of the institute,” but that’s “difficult to judge from afar.”
Denmark is home to a large derivatives market, with daily turnover of interest-rate-related instruments averaging 147bn kroner in April, making it the world’s 12th biggest, the central bank said last month.
But Denmark’s covered bonds make up the country’s biggest market by far, and are crucial to its economic health.
The regulator spent much of the past decade tidying up after previous financial innovations that threatened to muck up its otherwise smooth-running machinery of the market.
“If you issue a bond that matches the mortgage 100%, as has been the traditional way of doing mortgages in Denmark, you only have a credit risk, and that is of course a quite strong and prudent way of doing things,” Madsen said. “As a supervisory, we do have a preference for that.”
More than a decade ago, mortgage lenders and banks began offering interest-only loans and adjustable-rate mortgages financed with short-maturity bonds.
The products proved wildly popular, particularly after the financial crisis, as rates fell.
But they also introduced new risks to the market and the economy.A new study by Denmark’s central bank found that homeowners who were unable to get new interest-only loans started to cut back significantly on spending once they had to resume full payments on their debt.
More specifically, they reduced their consumption by an average of 3% of income, or roughly 14,000 kroner a year, the study found.
Madsen, who says the authorities were surprised at how quickly the interest-only loans caught on, is keen to avoid a repeat.
“They grew a lot faster than anticipated,” he said.
With derivatives, if “there’s going to be a development,” it needs to be one “that we choose ourselves,” he said.
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