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Danish Covered Bonds: Proposal Outlines Harmonization Plan

On Oct. 23, 2020, the Danish Financial Supervisory Authority (FSA) circulated a draft proposal and request for comments to amend the Danish Mortgage-Credit Loans and Mortgage-Credit Bonds etc. Act (lov om realkreditlån og realkreditobligationer m.v.), the Danish Financial Business Act (lov om finansiel virksomhed), and the Danish Act on a Ship Finance Institute (lov om et skibsfinansieringsinstitut). The request for comments period ends on Nov. 23, 2020. The aim of the amendments is to implement the EU directive 2019/2162 on the issuance of covered bonds (dækkede obligationer) and covered bond public supervision (see our report, "Harmonization Accomplished: A New European Covered Bond Framework," for our comments following the publication of the EU harmonization directive in 2019).

According to the request for comments, the current Danish covered bond law largely fulfills the requirements set out in the EU harmonization guidelines, and the draft aims to ensure fulfillment of the directive. Implementation will start upon the proposed ratification of the law on July 8, 2021, and the proposal foresees full implementation by July 8, 2022).

Overview Of The Proposal

The proposal differentiates between covered bonds issued by mortgage banks, financial institutions, and specialized ship finance institutions. It proposes to adopt two labels of European covered bonds: "premium" or "normal". It clarifies that mortgage covered bonds (Sœrligt dœkkede [Real]krediobligationer) can use European covered bonds with the premium designation, while mortgage bonds (Realkredit obligationer and Skibskreditobligationer) will not be eligible for the premium designation. Only European covered bonds (designated as premium) will maintain the current preferential capital and liquidity treatments.

Overcollateralization and eligible assets

The proposal includes a nominal overcollateralization requirement at 2%. It is the lowest permitted in the directive, and it is supported by formal risk-lowering requirements such as the balancing principle and the FSA's supervisory diamond. The supervisory diamond sets certain limits on risk for covered bond issuers, for example, limits for interest-only mortgages. The 2% overcollateralization does not include the cost of managing a cover pool that is winding down, which is proposed to be covered by the mortgage loan margins. Our covered bonds criteria consider a minimum overcollateralization of 2.5% for 'AAA' rated covered bonds, and therefore, we do not expect rated programs to be affected by the requirement.

Further, the proposal clarifies eligible asset types, and it supports the current use of mainly covered bonds as overcollateralization. It clarifies that market values must be the basis for all property valuations, which will only affect a small part of the collateral. In our view, the changes will not significantly affect our credit risk assessment of Danish covered bond programs.

Derivatives

The permitted purpose of derivatives in covered pools is defined as risk limitation only. The proposal does not further limit the current use of derivatives but clarifies how derivatives are to be considered in the overcollateralization and liquidity coverage tests.

Liquidity coverage

The proposal introduces a formal requirement for coverage of 180 days of liquidity needs. Matched-funded programs, only issued by mortgage banks, are exempt from the liquidity requirements. The current Danish covered bond law does not include requirements for coverage of 180 days' liquidity, but we currently consider the existing balancing principle, bond extension mechanisms, and soft-bullet structures to address 180 days' liquidity coverage following the insolvency of the issuer. We note that the liquidity test considers the final maturity of bonds (including any extension). We understand that assets covering the 180 days' liquidity requirement must have a minimum quality, cannot consist of exposure to related entities, and must remain covered after the insolvency of the issuer for the covered bonds to maintain their designation.

Extension mechanism

The existing Danish law includes extension triggers for most covered bonds issued by mortgage banks, while universal financial institutions issue soft-bullet covered bonds, and an insolvency administrator may extend bonds. Extension triggers do not apply to ship finance institutions, and they will not be required to introduce such bond extensions. The proposal considers that the current extension triggers utilized by mortgage banks are in line with the EU directive. It clarifies that the appointed administrator for universal banks is allowed a single one-year extension per covered bond, which may lead to future soft-bullet covered bonds to rely mainly on the law, while the individual issuance documents will specify the terms and conditions of the extension.

Questions regarding the maturity extensions

In our view, the proposal is less clear on how maturity extensions will leave the ranking of covered bond investors unaffected by changing the sequencing of the covered bond programs' original maturity schedules. For covered bonds issued by financial institutions, we understand that an administrator will be required to extend the maturity of covered bonds. However, we are not sure if an administrator must make any additional considerations before extending the bonds. We understand that single bond maturities can be extended independent of other outstanding bonds, though we believe the proposal is unclear on the considerations required by the administrator when choosing which bonds to extend.

Joint funding of covered bonds

The Danish covered bond legislation allows for the joint funding (intercompany funding) of covered bonds by mortgage banks. The proposal amends the current legislation to reflect the directive. It also includes a proposal to limit the internal joint funding to two issuers "instituter." We understand that the principles of joint funding in the directive largely reflects current Danish regulation, and the further proposed limit is intended to reduce complexity. Although the proposed limit will not affect our current ratings, we would like to better understand the risk the limit seeks to address.

Clarification of responsibilities

The proposal suggests the appointment of an administrator for universal banks issuing covered bonds, while an administrator is not proposed for mortgage banks. The proposal includes further issuer authorization requirements and clarifies the responsibilities and cooperation of the Danish resolution authorities and the FSA. The current Danish legislation does not include formal disclosure requirements, but the proposal calls for market-based solutions, which fulfill the requirements of the directive.

Proposed Amendments Pose No Immediate Rating Impact

The proposal will be implemented for all issuance starting on July 8, 2022. Issuance made before this date is not required to fulfill the requirements of the proposal, and outstanding bonds will be grandfathered with the original designation. However, if an issuer continues to issue covered bonds from an existing capital center (or register), the requirements are relevant for all loans in the capital center. Therefore, we expect issuers to open new capital centers for issuance after the implementation of the law. As a result, we expect the proposed requirements to cover most Danish covered bond issuance once existing borrowers have refinanced into bonds issued under the new regulation.

As we already consider the 180 days' liquidity requirement to be covered by the current legal setup, and the proposed regulatory overcollateralization is below our minimum levels for most of our current ratings, we do not expect these changes to affect our current ratings (see "Covered Bonds Criteria," published Dec. 9, 2014).

As the new legislation will likely lead to new covered bond programs (capital centers for mortgage banks and registers for financial institutions), investors should be aware of the terms and conditions of individual programs and covered bond issuances.

Pending finalization of the law and legal review, we do not expect our rating analysis to be affected by the updated law.

We believe the proposal supports our view of adequate liquidity coverage in the insolvency of a Danish covered bond issuer, and it supports our view of a very strong legal covered bond framework in Denmark.

Related Criteria

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Casper R Andersen, Frankfurt + 49 69 33 999 208;
casper.andersen@spglobal.com
Secondary Contact:Barbara Florian, Milan + 390272111265;
barbara.florian@spglobal.com

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