STRUCTURED FINANCE RESEARCH Interest-Only Loans Could Destabilize Denmark's Mortgage Market Primary Credit Analyst: Casper R Andersen, London (44) 20-7176-6757; casper_andersen@standardandpoors.com Table Of Contents What's Wrong With Interest-Only Loans? What's Next For Interest-Only Loans? No Reason To Panic Yet Related Criteria WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 1
Interest-Only Loans Could Destabilize Denmark's Mortgage Market In 2003, Denmark's mortgage market introduced interest-only (IO) loans, which became increasingly popular up to the beginning of the financial crisis in 2007. Since then, their popularity has further increased, due in part to preferential tax treatment of interest costs, such that IO loans comprised 54% of Denmark's total mortgage volume in 2012. As increasing numbers of IO loan periods will expire, a much-discussed topic within the Danish covered bond market is the potential effects that this will have on the already stressed housing market. In Standard & Poor's Ratings Services' opinion, this challenge could destabilize the Danish mortgage market as borrowers face potential dramatic increases in their mortgage payments when their initial 10-year IO periods expire. This could in turn lead to a sharp increase in arrears and potential foreclosures. Overview Since their introduction in 2003, IO loans have become increasingly popular in Denmark, with the majority due to expire between 2017 to 2020. To examine this risk, we analyzed a sample of loans from four of the largest Danish covered bond issuers, covering the six largest capital centers. The results of our analysis clearly show that the popularity of IO loans combined with falling house prices has led to increased LTV ratios for these loans. Breaches of these LTV ratios are likely to cause a considerable increase in the number of borrowers needing to amortize their mortgages. Although the magnitude of the LTV ratio breaches remains manageable for now, current low interest rates, tax incentives, and Denmark's weak economy mean that any incentives for borrowers to amortize remain limited. What's Wrong With Interest-Only Loans? IO loans for residential borrowers in Denmark may be originated at full or part balance of a borrower's mortgage loan. The loans normally have a maturity period of up to 30 years, and with a maximum IO period of 10 years, they normally require a borrower to amortize a loan over 20 years following a 10-year pre-amortization period. Compared with more traditional mortgage repayment types, we generally consider IO loans to be a riskier borrowing method. Due to the lack of amortization, LTV ratios remain higher than for other loan types, which we believe poses a higher risk (see chart 1). If a borrower requires a new loan at the end of the IO period, the Danish legislation's loan-to-value (LTV) limits one of the key risk factors that lenders assess when qualifying borrowers for a mortgage only allow covered bond-backed refinancing with LTV ratios of up to 75%/80%. Therefore, this may limit the borrower's access to a new IO loan. Furthermore, Denmark's falling house prices and overall higher LTV ratios currently require many borrowers to amortize loans due to the breach of LTV limits before being eligible for a further IO period. Consequently, borrowers' future mortgage payments may rise substantially, resulting in potential arrears and foreclosures. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 2
IO loans in Denmark generally have long maturities, which we believe partially mitigates the risk of a payment shock because borrowers don't need to fully repay the loan when the IO period expires. We generally believe that longer maturity periods provide borrowers with sufficient time to manage a change in payments. Chart 1 What's Next For Interest-Only Loans? To provide an overview of IO loan characteristics in Denmark and the number of borrowers potentially affected when the IO loan periods expire, we have analyzed a sample of loans from four of the largest Danish covered bond issuers, covering the six largest capital centers (as of Q2 2012). Our total sample consists of 954,784 (DKK1,075,356,565,429) residential loans from four different issuers, of which 521,369 (DKK665,281,204,140) loans are reported as IO loans (see table 1). We have chosen to focus on residential mortgage loans as we expect the effect of an expiring IO period to be greater on private borrowers than commercial borrowers. This is because we generally share the market's perception that commercial borrowers are more familiar with the IO loan product, and hence are better prepared to adjust to a change in payments. We reflect this in our ratings analysis, where we treat the risk profiles of residential and commercial loans differently (see "Methodology And WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 3
Assumptions For Analyzing Mortgage Collateral In Danish Covered Bonds," published on May 2, 2012). Table 1 Sample Breakdown Capital center Percentage of total sample (%) Percentage of interest-only sample (%) Nykredit H 24.54 28.37 Nykredit E 22.67 19.06 Realkredit Danmark S 16.52 14.94 Nordea Kredit 2 16.41 16.85 Realkredit Danmark T 13.87 15.14 BRF B 5.99 5.64 Of the volume of loans in our sample, 61.87% have IO features, which is above the total market share of 54%. This is mainly due to the inclusion of Nykredit Realkredit's capital centre H and Realkredit Danmark's capital centre T, which have a proportionally high share of IO loans. We included these two capital centers to include as many IO loans as possible in our analysis and to demonstrate IO loan characteristics after their introduction in 2003. If we had included further older capital centers, the average percentage of IO loans would move toward the market level of 54%. Our sample also clearly shows that in all capital centers, the loan amounts and average LTV ratios are higher for IO borrowers, which in our view makes these loans increasingly risky. As described, the IO feature normally observed in Denmark comprises a maximum 10-year IO period within a 30-year loan. Although not all reported IO loans have been originated with a full 10-year IO maturity, we understand that most IO loans have, and we have based our analysis on this assumption. Also, general market practice dictates that IO loan origination can only occur if the borrower can afford amortization and a fixed-rate of interest (at the then current level). When and where? Our analysis of the sample shows that IO lending became more popular up to the onset of the financial crisis, but perhaps more interestingly; borrowing increased substantially during the crisis years (2007 to 2010) and after the introduction of the new Danish covered bond law in 2007. Chart 2 demonstrates that most IO loans were originated between 2007 to 2010 and will mature between 2017 and 2020. The IO loan product has been hugely popular in Denmark, particularly in Copenhagen, but has evolved largely in line with market distribution (see chart 3). Although our sample doesn't show any significant geographical distribution shift of the different loan vintages, some capital centers are more or less exposed to certain regions (in accordance with the lender's traditional customer base). WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 4
Chart 2 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 5
Chart 3 Reasons for concern? It's clear from our sample that due to declining Danish house prices, average LTV ratios based on original valuations and those based on current updated valuations diverge, with the divergence being most prominent for loans maturing between 2017 and 2020. There is a clear link between the highest LTV ratios based on current valuations observed and the IO loans needing to be refinanced in between 2017 to 2020 (see chart 4). Loans that need refinancing in 2013 and 2014 generally still benefit from increased house prices over the IO period, and based on this observation, we don't expect borrowers to struggle to obtain IO loans in the short term. As our observations on average LTV ratios may not tell the full story in terms of the highest LTV ratios, we have examined the number of loans in our sample that have a LTV ratio greater than 80% maturing between 2013 to 2022. Chart 5 shows the increasing number of loans that will potentially breach the 80% LTV ratio borrowing limit set out in the Danish legislation, which would require a borrower to amortize as soon as the IO loan period expires. This clearly indicates that the majority of loans potentially breaching the 80% LTV bracket mature in 2020, suggesting that in particular, the 2010 vintage may require lenders, as well as borrowers to prepare well in advance for the potential increase in mortgage payments. The results of our analysis clearly show that the popularity of IO loans combined with falling house prices has led WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 6
to increased LTV ratios for these loans. Breaches of these LTV ratios are likely to cause a considerable increase in the number of borrowers needing to amortize their mortgages. In our view, the percentage of borrowers with loans that have LTV ratios of more than 80%, as a percentage of all borrowers, is likely to substantially increase and could potentially threaten overall mortgage market stability (see chart 6). However, our sample also indicates that the loans at risk will only comprise 2.7% of the total number of loans in 2017. We note that these numbers include all loans with an LTV ratio of above 80%, regardless of the severity of the breach, and LTV ratios are based on current house prices. Chart 4 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 7
Chart 5 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 8
Chart 6 No Reason To Panic Yet In our view, the current debate surrounding the effects of IO loan expiry periods reflects Denmark's long tradition of active market discussion to find timely solutions for challenges facing the mortgage market. Market participants have suggested a number of possible solutions to help borrowers facing potentially higher mortgage payments. In November 2011, the Association of Danish Mortgage Banks suggested a solution that would allow borrowers to treat their property debt as two separate loans. The solution allows borrowers to roll over debt within an 80% LTV threshold into a new IO loan, whereas any debt exceeding this limit must be amortized by a 30-year maturity second tier mortgage loan. In this scenario, our credit risk assumption would reflect the total LTV ratios of both loans, which would normally lead to a higher probability of default assumption. In our opinion, this solution is likely to increase LTV ratios for all Danish capital centers, and could therefore increase our credit risk and target overcollateralization levels for the cover pools. Although the number of loans in our sample that may experience arrears and defaults due to higher required mortgage payments may seem alarming, the magnitude of the LTV ratio breaches remains manageable, in our opinion. The loans breaching the 80% LTV ratio, according to current valuations, do so by an average of 11.4% (lowest center: 8%, WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 9
highest center: 15.25%). In addition, house prices are currently back to 2005 levels and may yet increase. Overall inflation could also help to mitigate the risk of IO periods expiring between 2017 to 2022. Finally, Danish borrowers generally have large holdings of pension savings assets, which, if made accessible, could help borrowers to pay down excess debt. However, politicians as well as mortgage lenders should be aware that given current low interest rates, tax incentives, and Denmark's weak economy, the solution to the high LTV ratios observed isn't likely to come from borrowers as incentives to amortize remain limited. Related Criteria Covered Bond Ratings Framework: Methodology And Assumptions, June 26, 2012 Methodology And Assumptions For Analyzing Mortgage Collateral In Danish Covered Bonds, May 2, 2012 Additional Contact: Covered Bonds Surveillance; CoveredBondSurveillance@standardandpoors.com WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 22, 2013 10
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