Danish Mortgage Lenders

Transcription

1 Banking System Outlook December 2006 Contact Phone London Janne Thomsen Lynn Valkenaar Adel Satel Danish Mortgage Lenders Proposed amendments to the legislative framework may challenge this strong system, in which all mortgage lenders display a low risk profile and stable, albeit low, earnings and stable ratings RATED MORTGAGE INSTITUTIONS IN DENMARK Mortgage Institutions Fundamental Rating Secured Debt Issued by Secured Rating Outlook Nykredit Realkredit A/S Aa3 General Capital Centre Aa1 Stable Capital Centre C Aa1 Capital Centre D Aaa Totalkredit A/S A1* Capital Centre C Aaa Stable Realkredit Danmark A/S n/a General Capital Centre Aaa Stable Danske Credit Capital Aaa DLR Kredit A/S A1 Aa1 Stable Nordea Kredit Realkreditaktieselskab n/a Aaa Stable BRFKredit A2 General Capital Centre Aa2 Stable Capital Centre B Aa1 *Subordinated debt rating Summary Opinion Moody s rates five of Denmark s seven specialised entities that are licensed to finance housing loans via the issuance of covered bonds (Realkreditobligationer) 1. These mortgage institutions currently account for the bulk (about two-thirds) of total lending in Denmark. The covered bonds issued to finance these loans represent over 60% of the Danish bond market thus making this one of the largest markets for covered bonds in Europe. The outlook of all ratings is stable. 1. Totalkredit continues to have a stand alone rating for its covered bonds as well as for its subordinated debt issue. Danske Kredit is part of Realkredit Denmark. However its bonds are still outstanding. The unrated LRF accounts for approximately 0.4% of outstanding mortgage bonds in the market.

2 Mortgage banks business activities and bond issuances are supported by an extremely strong and restrictive legal framework, dating back to 1850 and which remains founded on the key principle of ensuring low risk for bond investors. The rated entities benefit from strong franchises and solid fundamentals, but operate in a well-penetrated and low-margin market, with product innovation and distribution capabilities being the common way to compete. Competition among the mortgage banks is strong, but their low margins and high efficiency represent effective barriers to entry for new players. The global balance principle ensures the closest possible match between mortgage loan payments and issued bonds, thus keeping market risks to a minimum for the specialised lenders. It is also important to note that the mortgage lenders do not carry the risk of pre-payments, as prepayment can only take place when the debtor presents actual bonds or pays all costs involved in redeeming the outstanding bonds. WILL THERE BE CHANGES TO THE STRICT LEGAL FRAMEWORK FOR DANISH MORTGAGE BANKS? In December 2006 The Danish Ministry of Economic and Business Affairs has sent a new draft bill on revised covered bond legislation into public consultation. A working group under the Danish Financial Supervisory Authority is currently working on implementing EU regulation for covered bonds in Denmark and the draft of a revised legislation allows covered bonds to be issued by all credit institutions going forward. However central parts in the revised legislation concerning balance principle and joint funding regulation are not yet addressed. As the legal framework is not in place at this time, then it is difficult to see the implications for the mortgage banks, however it may lead to a two tier covered bond system in Denmark i.e. the existing one and one with less strict balance principle open for both mortgage banks as well as banks. Intuitively a revised less strict system may benefit the larger Danish banks (and mortgage banks) as they will be able to issue larger liquid issues and also have the benefit of large number of transactions. Due to the low margins it is difficult to see that a new law would benefit smaller regional or local players unless they co-operate as has been seen in the past when the regional and local banks established Totalkredit. However when the regional and local banks sold Totalkredit to Nykredit some of the agreements entered into at that time, may limit the upside the banks currently have in relation to Totalkredit. Investors may also demand higher yields should there be a two tier covered bond system and that may again lead to higher costs for the customers, however it all remains to be seen when the new legal framework is revealed. STRENGTHS A very detailed and restrictive legal framework Strong domestic franchises in most mortgage lending segments High cost efficiency Diversified distribution network Solid asset quality Global balance principle Good capitalisation CHALLENGES Limited growth potential in a well-penetrated market Highly commoditised nature of mortgage loans with low margins Possibility that product innovation may over time limit the sizes of pools of similar assets and thus the size of mortgage bond series may put pressure on funding costs Focus on cost reduction and efficiency due to low margins and limited growth opportunities Effect on funding costs in relation to a new covered bond law 2 Moody s Banking System Outlook

3 Key Features of the Danish Mortgage System A WELL-ESTABLISHED SYSTEM According to Danish law, mortgage credit institutions are the only entities that are allowed to finance loans against mortgages on real estate by issuing covered bonds. The first Danish covered bond institutions (and their bonds) were established in 1797, and the first law governing the institutions and the bonds was enacted in Although the legal framework has been updated since then, the main objective of offering a low-risk system to investors and affordable housing finance for retail customers and real estate finance for corporate clients has remained unchanged. The credit institutions cannot take deposits and are regulated by the financial supervisory authority. A specialised lender may enter into other activities, but only if they are considered supplementary to the mortgage activities. The supervisory authority has ruled that these activities have to take place at subsidiary level, such as a bank, insurance company or real estate agent chain. SPECIALISED LENDERS ACCOUNT FOR MAJORITY OF TOTAL LENDING IN DENMARK Lending by mortgage credit institutions accounts for approximately two-thirds of total lending in Denmark and the bonds issued by the institutions represent over 60% of total Danish bonds. The Danish covered bond market is the second largest in Europe with a total size of DKK1.776 billion (238 billion) as at 30 June MOST MORTGAGE LENDERS CO-OPERATE CLOSELY WITH COMMERCIAL BANKS Most mortgage institutions in Denmark benefit from co-operation with commercial banks, although this may take different forms: Realkredit Danmark and Nordea Kredit benefit from ownership by the two largest Danish banks: Danske Bank and Nordea Bank Danmark, respectively. DLRKredit (DLR) a specialised commercial and agriculture lender and Nykredit Realkredit have each formed co-operations with regional and local banks. DLR is owned by more than 100 regional and local banks, whereas Nykredit Realkredit has, via its acquisition of Totalkredit, established a solid co-operation with the previous owners regional and local banks. BRFKredit (BRF) is the only mortgage institution that operates on a standalone basis from the Danish banking system. BRFKredit and Nykredit Realkredit are majority-owned by a foundation and an association, respectively. As a result, if they were to be taken over, the proceeds would have to be used for the benefit of Danish society. A CONSOLIDATED MARKET The Danish mortgage bond market has overall been stable over recent years, the main increases in net volume being due to increases in property value. In 2005 and the first half of 2006, the gross volume of new bond issuances recorded significant growth compared to previous years, thanks largely to a high level of refinancing of existing series. However, it is difficult to identify major pockets of growth in the various segments. Banks were first allowed to establish mortgage institutions in Since then we have seen some alignment between the owner bank s market share in other banking products and that of the owned mortgage institution. We expect this to continue going forward, such that, for example, Nordea Kredit will gain market share until it approaches that of its owner, Nordea Bank Danmark. We also expect that Realkredit Danmark s total market share may dip to a level closer to that of Danske Bank in lending. However, this process has been considerably slower than expected, reflecting the non-bank owned mortgage institutions capacity to retain their existing customers. STRONG COMPETITION BETWEEN BANKS AND MORTGAGE INSTITUTIONS In view of the low margins that characterise the Danish mortgage system, banks have not been in competition with mortgage lenders. However, as part of a shift among banking/mortgage groups towards low-margin mortgage loans, we note that product innovation combining banking and mortgage products has been a key trend since This enables banking/mortgage groups to retain customers and also to obtain higher margins than is possible with mortgage loans (although their margins are not as high as those possible in pure bank lending). Many of the new type of bank/mortgage products use a general security over the property, a so-called ejerpantebrev. The mortgage institutions are not permitted to take this type of security and are thus by law restricted in their ability to compete with the commercial banks. Moody s Banking System Outlook 3

4 In the end of 2005 mortgage lenders recorded loan growth of 12% whilst commercial banks grew almost twice as fast with main explanation the sophisticated products they were allowed to use comparing to mortgage banks. However, the trend has smoothed again until October Growth in Lending 30% 25% 20% 15% 10% 5% 0% Oct Bank Lending Mortgage Lending Total lending CONVERSIONS ARE DECREASING Over the past years, the Danish mortgage institutions have enjoyed very high activity levels due to high rates of conversion. However, due to the interest rate levels, these activities have decreased in It is important to note that none of the specialised mortgage lenders has any risk in relation to prepayments of mortgage loans. Irrespective of the interest rate type, a customer can prepay a mortgage loan at any time by purchasing the bonds in the market, or by paying the par value in cash if a callable bond has been used to finance the mortgage loan. The mortgage credit institution will receive a prepayment fee to cover administrative costs in relation to the prepayment. The sale of a property will not necessarily trigger prepayments as the new owner can take over the outstanding mortgage loan. For the past 200 years, almost all property in Denmark has been financed through mortgage loans issued by mortgage credit institutions. Due to the property owner s option to prepay the mortgage at any time, conversions (i.e. remortgaging) play a major role when interest rates are either falling or rising. MULTI-DISTRIBUTION CHANNELS ARE IMPORTANT All of Denmark s mortgage credit institutions offer their products through as many distribution channels as possible, including telephone banking, Internet banking and government-authorised real estate agents. The bank-owned mortgage credit institutions also use the branch network of their parent bank. Realkredit Danmark and Nykredit Realkredit use their own branch networks as distribution channels. In addition to this, Nykredit Realkredit also has access to the regional and local banks branches that distribute Totalkredit s services and in some cases also Nykredit s. BRF has distribution agreements with several regional banks for residential mortgages (mainly foreign banks and those banks that did not own Totalkredit) and uses its own distribution system for corporate lending. BRFKredit s main distribution channels for residential lending are the real estate agents in Denmark s largest real estate agent chain, EDC. All the other mortgage institutions also use real estate agents to distribute the loans. Financial Fundamentals PROFIT IS SATISFACTORY AND STABLE, ALBEIT LOW All of the Danish covered bond credit institutions display satisfactory financial fundamentals, although profits are low due to the low fees involved in the high-volume business. The mortgage banks profit is considerably lower than the 4 Moody s Banking System Outlook

5 commercial banks and international players due to lower risk for the Danish mortgage banks due to the balance principle and because is no margin or prepayment risk Preprovision Income / Risk Weighted Assets % BRF DLR Eurohypo AG Hypothekenbank in Essen Nordea Hypotek Nordea Kredit Nykredit Realkredit A/S Realkredit A/S Stadshypotek Swedbank Mortgage AB LOW EARNINGS REFLECT LOW RISK The net interest income consists of administrative fees and the yield of the investment portfolio. It is important to note in this context that any interest rate change on outstanding bonds poses a risk not to the mortgage credit institution but directly to the debtor. Due to the balance principle, Danish mortgage credit institutions are not affected by the changing interest rate environment, and fees are agreed on a fixed basis at the start of a mortgage and continue throughout its life. The mortgage credit institutions could increase these administrative fees if necessary, and this occurred in the 1990s, when some of them faced asset quality problems. Due to strong competition and transparency of fees, the fee differences among mortgage credit institutions are minimal fees are currently at around 50 basis points, among the lowest in Europe Net Interest Margin % BRF DLR Eurohypo AG Hypothekenbank in Essen Nordea Hypotek Nordea Kredit Nykredit Realkredit A/S Realkredit A/S Stadshypotek Swedbank Mortgage AB Moody s Banking System Outlook 5

6 The credit institutions are restricted to investing a minimum of 60% of their regulatory capital in listed bonds. Although this opens up the possibility of investments in equity, which may be more volatile than the bond investments, this risk is mitigated by the legal limits of allowed risk levels for mortgage credit institutions. The institutions risk weighted recurring earnings power, defined as pre-provision income in relation to riskweighted assets, improved slightly at the end of 2005 to a range from 0.66% to 1.27%. On a post provision recurring earning power results continued to improve in 2006, mainly due to market valuations and the continued write-back of provisions. After several years of investments in technology, most institutions have managed to improve their cost efficiency, and expenses as a percentage of average assets ranged from 0.08% to 0.46% in H In the cases of Nordea Kredit, Realkredit Danmark and for comparison the Swedish mortgage bank Swedbank Mortgage AB, the cost bases are especially low, as all origination and other administrative tasks are performed by the parent. Operating Expenses % Average Assets BRF DLR Eurohypo AG Hypothekenbank in Essen Nordea Hypotek Nordea Kredit Nykredit Realkredit A/S Realkredit A/S Stadshypotek Swedbank Mortgage AB GOOD CAPITAL LEVELS The institutions have not only general reserves but also additional reserves that are specially targeted at the individual mortgage bond series. These funds are built up from the institution s income. All the institutions have good capital levels and only a limited issuance of hybrid capital. By law, the capital of an institution has to amount to at least 8% of its risk-weighted assets and off-balance sheet items. Capital levels are controlled several times a year by the supervisory authority. Institutions Tier 1 capital ratios currently (as at H1 2006) range between 7.1% (for DLR) and 10.80% (for BRFKredit). Due to their foundation status, Nykredit and BRF are expected to have higher capital levels than those of limited companies (which are owned by a strong bank) that are able to increase capital levels if need be. When the mortgage banks implement Basel II, Moody s expect under pillar one the entities will be able to reduce capital levels considerable, due to the high level of residential mortgage. However, due to the entities, so far, prudent capital management, Moody s expect capital levels to remain satisfactory. 6 Moody s Banking System Outlook

7 Tier 1 ratio % BRF DLR Eurohypo AG Hypothekenbank in Essen Nordea Hypotek Nordea Kredit Nykredit Realkredit A/S Realkredit A/S Stadshypotek Swedbank Mortgage AB Risk Management is Prudent LOANS ARE FINANCED BY COVERED BONDS As noted, the loans provided by the mortgage institutions are financed via covered bonds issued in the domestic market. The terms of the covered bonds generally mirror those of the underlying loans as regards the nominal amount, coupon and other terms. The covered bonds are issued in series, each of which relates to a so-called capital centre and is based on a group of mortgage deeds. Regulations for asset-liability management and capital have to be met on a capital-centre basis as well as for the whole mortgage credit institution. We note that there has only ever been one late payment on a mortgage bond in the system s more than 200-year history: this occurred in 1933 and involved a specialised mortgage lender to agriculture in a specific region in Denmark. Investors did ultimately receive full payment. Bonds issued by the Danish mortgage banks are mainly held by banks, other mortgage banks, insurance companies, pension funds and households either directly or via investment funds. THE BALANCE PRINCIPLE Until 1989, the covered bond credit institutions had to follow a strict balance principle i.e. there had to be a perfect match between the issued bonds and the mortgage loans with respect to maturity and interest rates. For practical reasons, the strict balance principle was changed to the new global balance principle, which allows a deviation of up to 1% of the mortgage credit institution s capital base. Interest rate risk due to cash flow differences, this may amount to a maximum of 1% of the capital base. Interest rate risk has to be calculated as the worst-case scenario of six calculations, as specified in the executive order issued by the supervisory authority. These regulations are among the most detailed and restrictive Moody s has seen so far, and therefore provide significant support for the Danish mortgage system. Currency risk is calculated on the basis of total on- and off-balance sheet items and may not exceed 0.1% of the capital base. Liquidity management Net present value of incoming and outgoing payments connected with issued bonds, future payments, other securities and financial instruments must be calculated on a daily accumulated and discounted basis for different periods into the future. Future liquidity deficits should not exceed 25% of the mortgage credit institution s capital base from the first to the third year. From the fourth to the tenth year, the limit is 50% of the mortgage credit institution s capital base and 100% from year 11. Moody s Banking System Outlook 7

8 Callable loans must be funded by callable bonds with matching cash flows i.e. full transfer of call risk to investor and absence of derivatives hedging required. EXCELLENT ASSET QUALITY A credit institution can provide loans backed by any type of property, but there are different loan-to-value (LTV) criteria in place depending on property type. A limit of 80% LTV is in place for residential mortgages, subsidised housing and private rentals. The limit is lower at 70% for agriculture and 60% for weekend homes, offices and industrial premises, and LTV on land is 40%. The supervisory authority has issued detailed regulations for the assessment of the market cash value of properties. Non-performing loans are currently at a historic low, hovering between 0.01% and 0.07% of total loans in H Non Performing Loans / Gross Loans % 0.3 BRF 0.25 DLR 0.2 Nordea Hypotek 0.15 Nordea Kredit 0.1 Nykredit Realkredit A/S Realkredit A/S Swedbank Mortgage AB Due to the benign economic climate, these levels have steadily improved over recent years. The mortgage credit institutions now also benefit from much tighter credit assessment procedures compared with the 1980s, when nonperforming loans were at relatively high levels. All specialised lenders have well-diversified loan portfolios. In addition, many mortgage lenders have asset quality guarantees from originating parent banks (e.g. Realkredit Danmark from Danske Bank, Nordea Realkredit from Nordea Bank), or, as in the case of Totalkredit, from the co-operating banks that originate Totalkredit mortgages. Under these guarantees, the originating bank will typically cover losses incurred on the loan part exceeding the LTV limit set in the legislation on residential mortgages. For DLR, these figures are typically higher for commercial mortgages. BULLET LOANS HAVE SO FAR NOT RESULTED IN INCREASED RISK Since October 2003, it has been possible for the credit institutions to provide residential loans with bullet features for example, a 30-year amortising loan may have interest-only payments for up to 10 years. The loan will still be repaid at the end of the 30 years; therefore the amortisation will be quicker during the last 20 years and a sudden increase in the monthly instalment will occur at the end of the interest-only period. These loans have become very popular recently and, as at H1 2006, accounted for almost 35% of the total loans. However, all credit institutions have enhanced their credit assessment criteria for granting bullet loans and thus far there has been no visible deterioration in asset quality. Moody s continues to monitor the situation to assess whether the increase in volume in interest-only loans will significantly affect the LTV levels and other aspects of the Danish mortgage institutions so far comfortable risk profiles. 8 Moody s Banking System Outlook

9 RISING PROPERTY PRICES ARE MONITORED CLOSELY Since the beginning of 2006, property prices have increased on average by 11% countrywide, and about 8% in Greater Copenhagen to 9% in smaller Danish villages (defined as populations of less than 5,000). Moody s is paying close attention to the continued price increase as Denmark is now one of the countries with highest average growth in property prices. Most of the average increases in property prices can be explained by the low interest rate level, economic growth, general inflation level and demographic changes. However, there are pockets of price increases, especially in the Greater Copenhagen area, that cannot be explained by these factors, although it has to be noted that non-danish residents are limited to purchasing newly built or renovated properties, which has also led to some price pressure. Significantly, the buy-to-let market such as we have seen in many other countries barely exists in Denmark, given that owners are obliged to live in their properties. We will continue to monitor the price development and the regional differences closely. On average, homeowners mortgage-credit interest expenses will increase this year by 1.2% of gross income for every 1-percentage-point increase in the short-term interest rate, compared to 1% of gross income in In general we see the increase in disposable income to be larger than the increase in the short term interest rates. Affordability of Disposable Income % Debt Burden Interest Burden LARGE CUSHIONS IN THE FORM OF LOAN-LOSS RESERVES Although loan loss reserves have been decreasing as a result of the implementation of IFRS and the change in the Danish regulations for provisioning to a neutrality principle from a cautious principle, they are still at solid levels. As at H1 2006, the loan-loss reserves of the rated mortgage lenders were between 0.05% and 0.43% of gross lending and reflecting the Danish provisioning regulations. 2. Source: Central Bank of Denmark Moody s Banking System Outlook 9

10 Related Research Analyses: Denmark, July 2006 (98115) BRFKredit, August 2006 (98815) DLR Kredit A/S, August 2006 (98816) Nykredit Realkredit A/S, December 2005 (95841) Banking System Outlook: Denmark, December 2005 (95903) Banking Statistical Supplement: Denmark, August 2006 (98587) Special Comment: Moody's Rating Approach to European Covered Bonds, June 2005(93038) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 10 Moody s Banking System Outlook

11 Appendix Moody's Rating Approach to European Covered Bonds Moody's released the revised rating methodology for European Covered Bonds in June 2005 and this methodology is currently being rolled out for all rated covered bond markets. The Danish mortgage bond market will be reviewed in the course of The current ratings on the bonds issued by the various capital centres are not expected to be adversely affected by this review. Please see the summary of the new methodology below. Summary "Covered Bonds" are defined as debt instruments that have recourse to either the issuing entity (the "Issuer") or the group to which it belongs, or both, and, upon Issuer Default to a pool of collateral (the "Cover Pool"). Moody's rating methodology for European Covered Bonds focuses on the expected loss to investors. The rating model employed is thus referred to as the "Moody's Expected Loss Covered Bond Rating Model" (or "Moody's EL Model"). The Moody's EL Model employs a so-called 'joint default' approach which takes into account both the credit strength of the Issuer and the value of the Cover Pool. While the Issuer is performing, there will be no loss under the Moody's EL Model. In the event of an Issuer Default, the final loss will be determined by the value of the Cover Pool, which will be impacted by various factors, notably the credit quality of the Cover Pool, and refinancing and market risks. These in turn will be impacted by the strength of the legal framework and any contractual commitments, as applicable. Moody's is now employing this method for all new Covered Bond issuances and programmes, and intends to migrate ratings on existing Covered Bonds to the new method over the coming year. This process will include a further review of all primary legislations and a more detailed analysis of collateral in the Cover Pools and hedging arrangements. We anticipate that during this review some aspects of this methodology are likely to be further updated, in particular when making country-by-country adjustments for specific market or legislative features. Moody's Rating Approach For Covered Bonds Moody's EL Model looks at each Covered Bond issued on a month-by-month basis from its date of issue through to its legal final maturity. For each month, Moody's calculates the probability of an Issuer Default (defined below) based on its senior unsecured rating and the loss (if any) to the Covered Bonds following such default. The probability of Issuer Default in each month is then multiplied by the relevant loss (if any) for that month to give the expected loss to Covered Bond investors for each affected month. These amounts are then discounted, and the discounted numbers summed for each month from the time of issue of the Covered Bond to its legal final maturity. The resulting number gives the expected loss to the Covered Bond on which Moody's rating is based. In Moody's approach, "Issuer Default" is assumed to have the effect of creating a standalone Cover Pool that may need to be administered by a newly appointed party. It should be noted that Issuer Default does not necessarily mean there has been a default on the Covered Bonds. Moody's expects that an administrator (or a party delegated by the administrator) would run the Cover Pool following an Issuer Default. The loss following Issuer Default will depend on (i) the value of the Cover Pool in relation to the outstanding Covered Bonds and (ii) any outstanding claim against the Issuer. The analysis of the value of the Cover Pool will be considered in the context of the Issuer Default and thus assumes a stressed environment. In assessing the value of the Cover Pool, Moody's considers (i) the credit quality of the Cover Pool, (ii) the refinancing risk if funds need to be raised against the Cover Pool, and (iii) any interest and currency rate risk to which the Cover Pool is exposed. Analysis of (i) to (iii) will include consideration of any impact of legislative provisions and contractual commitments, which includes the role of the administrator (appointed following Issuer Default) in administering and servicing the Cover Pool as well as any incremental cost of such process. Moody s Banking System Outlook 11

12 Moody's rating approach thus comprises four key categories prior to and following Issuer default, as follows: Prior to Issuer Default 1.Issuer Following Issuer Default 2.Credit quality of the Cover Pool. 3.Refinancing the Cover Pool. 4Market risks. Issuer The minimum rating that a Covered Bond should achieve is equivalent to the senior unsecured rating of the Issuer. During the life of the Covered Bond, Moody's EL Model calculates the probability of Issuer Default based on the Issuer's senior unsecured rating. Moody's EL Model assumes that when the Issuer performs these obligations throughout the life of the Covered Bond, there will be no loss to investors. However, in the event of Issuer Default, the analysis switches to the Cover Pool and, if applicable, any unsecured claim against the Issuer. When rating Covered Bonds, the Moody's EL Model takes into account various Issuer and Issuer group-related benefits in addition to the senior unsecured rating of the Issuer. Credit Quality of the Cover Pool The credit quality of the Cover Pool will determine the amount of loss caused by credit deterioration on the assets in the Cover Pool that Moody's EL Model assumes will impact the Cover Pool after Issuer Default. The credit quality of the Cover Pool is measured by the Collateral Score. Moody's aims to publish Collateral Scores, where sufficient information on the Cover Pool is provided, and with the Issuer's approval. Within the Moody's EL Model, the Collateral Score plays a key role in determining the cash flow that is assumed will be received by the Covered Bonds following Issuer Default. Refinancing the Cover Pool Following an Issuer Default, the timely repayment of principal may rely on funds being raised against the Cover Pool because the duration of the assets in the Cover Pool will generally be longer than that of the Covered Bonds. In other words, the "natural" amortisation of the Cover Pool assets may not be sufficient to repay principal under the Covered Bonds. Where the "natural" amortisation of Cover Pool assets alone cannot be relied on to repay principal, Moody's EL Model assumes that funds must be raised against the Cover Pool, most likely at a discount to the notional value of the Cover Pool. Little pricing data is available for this type of fundraising and, accordingly, Moody's will calculate refinancing margins based on the price history seen for similar asset pools in the securitisation and other markets. Under Moody's EL Model, the following three key considerations are taken into account in determining the refinancing risk for any Cover Pool: - The refinancing margin that is required to refinance the Cover Pool remaining after adjustment for any write-off following Issuer Default. Refinancing margins are also impacted by the Collateral Score. - The size of the Cover Pool that is required to redeem in full all Covered Bonds prior to their legal final maturity. - The average life of the Cover Pool that is expected at the time of refinance. Market Risks Following Issuer Default, investors in Covered Bonds may be exposed to interest and currency rate risk, which may arise from the different payment promises and durations made on the Cover Pool and the Covered Bonds. Under Moody's EL Model, the following two key considerations are taken into account in determining the interest and currency rate risks for Covered Bonds: - The level and length of exposure to these market risks. The level and length of exposure depends on the specific characteristics of the Covered Bonds and the Cover Pool backing the Covered Bonds, and in addition, the hedging arrangements in place. - The stress imposed by the Moody's EL Model on any exposure to these market risks. 12 Moody s Banking System Outlook

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