Global Credit Research: Danish Covered Bonds – A Primer pptx

Sector Report A u g ust 6, 2008 Covered Bonds Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 1 See last pages for disclaimer. Danish Covered Bonds – A Primer ● In the first part of this Sector Report, we provide an overview of the Danish economy including the housing market. Furthermore, we focus on the Danish covered bond market where various regulation changes have taken place. In addition, we highlight the inherent security mechanisms, bond types and give a short investment example. In the second part, we introduce the five largest issuers in the Danish covered bond market. ● The creation of the Danish covered bond market dates back more than 200 years as it was established after the great fire in Copenhagen in 1795 to finance the large reconstruction costs. In the long tradition of Danish covered bonds a default or loss has never occurred. At year- end 2007, the outstanding volume of Danish covered bonds amounted to EUR 345 bn. The Danish market is the second largest market after the German covered bond market, as well as the second eldest. The reason for the gap between Germany and Denmark is the non- existence of public sector covered bonds in Denmark, which make up the largest part in the German market. In terms of mortgage covered bonds, the Danish market is by far the largest, ahead of the Spanish and the German market. ● Currently, the Danish economy shows signs of weakness, which could be further intensified by subprime effects after years of high GDP growth rates, strongly increasing house prices and a low unemployment rate. Since 2007, house prices have declined significantly and led, in combination with the overall weakening economy, to negative GDP growth rates in Q4 2007 and Q1 2008. ● Roskilde Bank, a Danish regional bank, became the second casualty in Denmark after Bank Trelleborg, which was affected by large-scale write-downs. In order to safeguard the reliability of the Danish banking market, the Danish National Bank provided a liquidity guarantee of DKK 750 mn to Roskilde Bank. Furthermore, Roskilde might also be sold in the near future (as happened to Bank Trelleborg). This action affirmed the systemic support within the Danish banking system. ● As a consequence of the amended covered bond regulation, which now also allows commercial banks to issue covered bonds, large issuers have established new covered bond programs, e.g. Danske Bank. The similarity of Danish covered bonds to the European standard should provide a solid investment basis also for non-Danish accounts. Besides these new Jumbo-style covered bonds, there is also a large number of traditional Danish covered bonds. Moreover, compared to other covered bond jurisdictions, the Danish law stipulates different regulations, e.g. "Junior covered bonds" or the specific calculation of overcollateralization for mortgage bank issuer. ● With respect to Basel II, the newly launched covered bond types are UCITS and CRD compliant, which qualifies them for a preferential treatment with respect to regulatory capital and investment limits. Contents Kingdom of Denmark______________________ 2 Danish housing market __________________ 5 Structure of the banking market ____________ 6 Regulatory environment__________________ 7 The Danish Covered Bond Market ___________ 8 Overview _____________________________ 8 Amended Danish covered bond legislation ___ 9 Security mechanisms of Danish covered bonds13 Overview of the Danish covered bond market 16 Types of Danish covered bonds___________ 17 Fixed rate callable Danish covered bonds ___ 19 Investment in a Danish Jumbo-style covered bond________________________________ 20 Outlook on the Danish covered bond market __ 21 Covered Bond Issuer Profiles ______________ 22 Nykredit Realkredit A/S ___________________ 22 Realkredit Danmark A/S __________________ 31 Danske Bank A/S _______________________ 35 Nordea Kredit Realkreditaktieselskab A/S_____ 44 BRFkredit A/S __________________________ 54 Appendix: Eligibility criteria for cover pool assets 61 Authors Christian Meidinger (HVB) +49 89 378-12004 christian.meidinger@unicreditgroup.de Ivanka Stefanova (HVB) +49 89 378-14247 ivanka.stefanova@unicreditgroup.de Bloomberg UCCR Internet www.globalresearch.unicreditmib.eu Sector Report A u g ust 6, 2008 Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 2 Kingdom of Denmark Among EU members, Denmark has the highest employment quota Kongeriget Danmark or Kingdom of Denmark is a parliamentary representative democratic monarchy and is located between the Scandinavian peninsula and Central Europe; it has a size of 43,094 sqm. One-third of its land area is comprised of 443 islands. The capital Copenhagen is both the economic center and the biggest Danish city with more than 500,000 inhabitants. Greater Copenhagen comprises 1.4 mn inhabitants, accounting for 25% of the approximately 5.5 mn citizens of Denmark. Since 1973, the country has been member of the European Union (EU) respectively the European Economic Community (EEC), however, it is not yet a member of the European economic and monetary union. This means that the currency is still the Danish krone. Denmark's employment quota is the highest within the EU, but compared to Germany, the share of public employees is twice as high. This results in an extremely high social contribution ratio and taxes, e.g. 25% VAT. All in all, the country has one of the highest standards of living and a sound competitive ability. Strong fiscal discipline in the last few years In Denmark, fiscal discipline is strong and also a major commitment of policymakers. The budgetary surplus is expected to be above 2% of GDP p.a. in the medium term. However, in the long term, we expect a negative impact on the budgetary performance. Reasons are the recently announced tax cuts and initiatives to improve the quality of public services, which goes hand in hand with a stabilizing trend of public revenues. GDP GROWTH RATE -2 -1 0 1 2 3 4 5 Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 GDP growth rate % GDP growth rate y-o-y GDP growth rate q-o-q Source: Eurostat, UniCredit Global Research Challenging economic environment for Denmark Until 2007, macroeconomic figures in Denmark looked sound. In 2007, income per capita was USD 57,300 and significantly above the average for all AAA-rated countries by S&P (USD 45,600). The income level reflects the competitiveness of the Danish economy, the superio r productivity levels of the workforce, and high labor participation by European standards. In 2007, the real GDP growth rate was 1.8%, a significant decline compared to 3.5% and 3.1% in 2006 and 2005, respectively. This downward trend was further intensified in the last fe w months. As of Q2 2008, Denmark's economy had contracted for two consecutive quarters. The economy decline 0.6% after contracting a revised 0.2% in Q4 2007, according to Statistics Denmark. Growth is slowing worldwide as the credit crunch sends borrowing costs higher and curbs investment, while record oil prices and soaring food costs erode consume r spending power. Danish consumer prices are rising at the fastest pace in 18 years while property values fall, undermining household spending which accounts for half the USD 340 bn economy. Sector Report A u g ust 6, 2008 Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 3 Unemployment rate at a 35-yea r low Unemployment is at a 35-year low. In fact, the current level of unemployment is below the long-term structural level, indicating that there is no possibility to increase employment furthe r without changes in the legislative framework of the labor market. Hence, unemployment is expected to increase slightly in 2009. But scarcity of skilled labor will continue to dampen economic growth, even as unemployment increases. KINGDOM OF DENMARK - ECONOMIC DATA 2010f 2009f 2008f 2007 2006 2005 2004 Nominal GDP (bn USD) 330.8 330.7 330.1 333.5 276.1 258.8 243.6 GDP per capita (tsd. USD) 60.0 60.3 60.5 58.3 50.8 47.8 45.4 Real GDP (% change) 1.7 1.7 2.0 1.8 3.5 3.1 2.1 Real GDP per capita (% change) 1.2 1.3 1.7 1.4 3.3 2.7 1.8 Real domestic demand (% change) 1.5 1.8 1.8 2.3 5.4 3.3 3.6 Real investment (% change) 2.4 3.1 3.5 3.8 12.9 9.0 4.5 Gross domestic investment (% of GDP) 24.4 24.3 24 23.7e 23.2 20.8 19.9 Gross domestic savings (% of GDP) 25.7 25.5 25.9 25.7e 25.6 24.6 22.3 Real exports (% change) 3.0 4.0 4.9 5.2e 10.1 7.2 2.2 Unemployment rate (%) 3.2 3.0 2.8 3.1 3.9 4.8 5.5 f=forecast; e=expected Source: S&P, UniCredit Global Research Low inflation rate Since the beginning of 2008, the inflation rate has increased significantly to 3.8% in June 2008 due to continuing high commodity prices, e.g. the oil price skyrocketed to an all-time high in June. In contrast, until year-end 2007, the low inflation rate of Denmark was a result of the far-sighted fiscal policy. In 2007, the inflation rate was 1.7% and slightly belo w the prior year (1.9%). Denmark's already stable currency, which is pegged to the euro, also benefited from this policy. Long- and short-term interest-rate differentials with the eurozone have all but disappeared. Denmark's external performance is relatively strong and current account surpluses are accompanied by a small net external liability position. CPI Denmark (2000=100) EUR-DKK exchange rate 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% J a n-01 J u l- 01 Jan-02 Jul-02 Jan- 03 Jul- 0 3 J a n-04 J u l- 04 Jan-05 Jul-05 Jan- 06 Jul- 0 6 J a n-07 J u l- 07 Jan-08 Jul-08 CPI % 7 7.2 7.4 7.6 7.8 8 Jul- 02 Jan- 03 Jul- 03 Jan- 04 Jul- 04 Jan- 05 Jul- 05 Jan- 06 Jul- 06 Jan- 07 Jul- 07 Jan- 08 Jul- 08 DKK/EUR Source: Bloomberg, Statistics Denmark, UniCredit Global Research EUR-DKK exchange rate is stable One reason for the relatively low share of foreign investors in the Danish covered bond market is the denomination in Danish krone. However, the EUR-DKK exchange rate showed a sustainable development in the last few years, which we also expect to be the case in the next few years. This is a result of pegging the DKK to the EUR at DKK 7.46 with a fluctuation band of +/- 2.25%. Therefore, the currency risk is low and easy to manage. Significantly reduced debt levels In 1993, the central government debt peaked at 80% of GDP. As a result of the consolidation efforts, policy makers were able to reduce debt levels to approximately 25% of GDP as o f year-end 2007. Furthermore, the sustained decline in the public debt burden, coupled with a Sector Report A u g ust 6, 2008 Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 4 robust pension system and efforts to boost labor-market participation, is expected to provide sufficient fiscal flexibility to meet the challenge of an aging population. Limited fiscal flexibility Denmark has a very limited fiscal flexibility, as can be seen by the share of government revenues in GDP and high general government expenditure. Therefore, S&P expects a furthe r declining general government balance in % of GDP to 2.5% in 2010 compared to 4.7% in 2006. The reason for this is Denmark's generous welfare system. Despite high tax rates, Denmark has very low revenue flexibility among European countries. KINGDOM OF DENMARK - FISCAL INDICATORS (% of GDP) 2010f 2009f 2008f 2007e 2006 2005 2004 General government revenues 53.5 53.8 54.5 55.0 56.2 57.8 57.3 Of which central government 34.2 34.5 35.2 35.7 37.1 37.6 36.6 General government expenditures 51.0 51.0 51.2 51.1 51.6 53.2 55.4 Of which central government 31.4 31.4 31.6 31.5 32.0 32.6 34.7 General government balance 2.5 2.8 3.3 3.9 4.7 4.6 1.9 Of which central government 2.8 3.1 3.6 4.2 5.2 4.9 2.0 Of which local authorities -0.3 -0.3 -0.3 -0.3 -0.6 -0.3 -0.1 General government balance (% of revenues) 4.7 5.2 6.1 7.1 8.2 8.0 3.3 General government interest payments (% of revenues) 1.8 2.2 2.7 3.3 3.9 4.5 5.4 Central government interest payments (% of revenues) 2.0 2.7 3.5 4.5 5.5 6.5 8.1 General government debt 13.6 16.7 20.3 24.7 30.1 36.3 44.0 f=forecast; e=expected Source: S&P, UniCredit Global Research Less vulnerable to subprime- related squeeze With respect to the subprime crisis, Danish mortgage banks have been less vulnerable compared to global mortgage lenders. Danish mortgage credit institutions have a balanced funding mix. They fund large amounts with covered bonds, which are backed by high-quality collateral. In addition, the issuers benefit from a strong domestic bid. Domestic investors dominate the market The institutions that are invested in the Danish covered bond market are largely domestic insurance companies, pension funds and other financial institutions. Their investments account for more than 70% of the outstanding covered bonds. Foreign investors only hold a small but increasing proportion of Danish covered bonds (ca. 13%) as they prefer non-callable and euro-denominated covered bonds. We expect the amended law lead to an increase in issuance volume of euro-denominated bullet bonds. Particularly euro-denominated bonds in Jumbo size, which are supported by the new law, should increase the proportion of foreign investors in mid-term. Triple-A rated From a ratings perspective, the Kingdom of Denmark received a long-term triple-A rating as well as an excellent short-term rating by all three major rating agencies. RATING OF THE KINGDOM OF DENMARK Long-term issuer rating Outlook Short-term issuer rating Moody's Aaa stable P-1 S&P AAA stable A-1+ Fitch AAA stable F1+ Source: Rating agencies, UniCredit Global Research Sector Report A u g ust 6, 2008 Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 5 Danish housing market House price boom 1993-2006 After years of boom the Danish housing market has experienced a slowdown starting from 2007. In the period between 1993-2006, the national average house price skyrocketed by nearly 300%. Winners were owners of apartments in Copenhagen, which had a four-time higher value at the end of the cycle. This boom was mainly fostered by growth in disposable income, decreasing interest rates, and financial innovation, i.e. an increasing variety o f different loan types. Moreover, the expanding and innovative product range of loan types available to borrowers supported the market. New types were a) adjustable rate mortgages (ARMs), b) interest-only loans, and c) capped floating rate loans. Regarding the finance structure of the housing market and the mortgage loan market, there is a higher similarity to the German market than to the US market. The process of credit evaluation is more thorough and uniform. Moreover, it is important to note that securitization, i.e. repackaging and selling of mortgages via RMBS is not common in the Danish market. The usual way for mortgage lenders is to grant a loan, put it on their own books and eventually issue covered bonds to finance themselves. ECONOMIC DATA Mortgage-credit bonds (Annuity loans), 30Y Announcement of forced sales of real property 0 2 4 6 8 10 12 Apr-90 Apr-92 Apr-94 Apr-96 Apr-98 Apr-00 Apr-02 Apr-04 Apr-06 Apr-08 interest rate % 0 200 400 600 800 1000 1200 1400 1600 Jun-93 Jun-96 Jun-99 Jun-02 Jun-05 Jun-08 Announcm. of forced sales . Source: Statistics Denmark, UniCredit Global Research Change in sentiment in 2006 In spring 2006, sentiment in the Danish housing market changed. House prices were negatively affected by a decreasing number of interested buyers accompanied by a rapidly increasing number of properties for sale. In September 2007, there were 63k homes for sale, nearly twice as much as in the previous year. In addition, the average time fo r sale of a property increased to 138 days from 112 days in the previous year. Further pressure on house prices emerged from a slowdown in private consumption growth and increased interest rates. Borrowers with adjustable interest rate loans suffered the most due to the increasing interest rates. Nevertheless, the number of foreclosures is at a historically low level, which, however, is not expected to be the case on a medium to long-term horizon. This low level is the consequence of the sharply increasing home equity stake of Danish property owners. Residential property prices more or less stagnated or even declined at year-end 2007 The trend of house prices in Denmark is depicted in the charts below. Whereas residential property prices in the country as a whole have more or less stagnated, prices of owner- occupied apartments have declined by about 10.4%, while in the Copenhagen area much stronger declines of around 14% were registered in 2007. In addition, house prices fell by Sector Report A u g ust 6, 2008 Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 6 12% in Copenhagen. Prices for business properties, however, have not followed the trend o f residential properties and have still shown growth rates above 10% in the last few quarters. HOUSE PRICE DEVELOPMENT IN DENMARK Price index for sale of property (2006=100) House price growth (2006=100) 0 20 40 60 80 100 120 140 1992 Q4 1995 Q4 1998 Q4 2001 Q4 2004 Q4 2007 Q 4 One-family houses Business properties Owner-occupied flats -20% -10% 0% 10% 20% 30% 40% Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 One-family houses Business properties Owner-occupied flats Source: Statistics Denmark, UniCredit Global Research Outlook Danish house prices are expected to decline until year-end as well as doing next year. There are two major reasons for the current house price downturn: The oversupply of real estate as well as increasing interest rates (mortgage rates rose to 5.9% in April 2008 from 3.7% in January 2005). Despite these constraining factors and the problems that two smaller Danish banks (Roskilde Bank and Bank Trelleborg) are experiencing, the Danish economy and housing market (favorable homeowner equity stake) is stronger compared to that of many other countries. Consequently, a soft landing scenario is likely. Land register and land registration A requirement for an effective mortgage lending business is the protection of the lenders' rights on the borrowers' real estate. For this purpose, rights and claims relating to real estate in Denmark are registered with the Danish Land Registration System (Tinglysningssystemet). Any plot of land in Denmark is mapped in the Cadastral System (Matrikelsystemet) and labeled with a title number. The title number is used in the Land Registration System, where the rights and claims on a title number are ordered by rank. The ranking order of the mortgages on a given real estate must be set out in the Land Register in which registration is made subject to a judicial examination. The ranking is based on the principle of "first in, first right", and in the event of the property owner's default, the ranking in the register determines the order of payment. Structure of the banking market Market dominated by few bank groups The Danish banking market is dominated by a few large banks, i.e. Danske Bank Group, which accounts for 35% of retail lending, and Nordea Group, which accounts for 15%. Furthermore, both banks have large shares in the Danish life insurance market. Jyske Bank and Sydbank rank number 3 and 4, respectively in the Danish retail banking market, which comprises 162 banks. Among these, six banks are mortgage lenders only, while two are specialized lenders, e.g. the Danish Ship Finance and KommuneKredit (agency sector). Sector Report A u g ust 6, 2008 Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 7 DANISH BANKING MARKET Major Danish banks by total asset size Asset volume Danish banking market vs. No. of banks Others 39% Jyske Bank 6% Danske Bank Group 35% Nordea Group 15% Sydbank 5% 0 500 1000 1500 2000 2500 3000 3500 4000 2000 2001 2002 2003 2004 2005 2006 DKK bn 0 20 40 60 80 100 120 140 160 180 200 No. banks Total assets (DKK bn) Danish Banks Source: Statistics Denmark, UniCredit Global Research Strong regulatory environment The Danish banking sector is stable due to its strong regulatory environment. There is a high degree of integrity paired with a stable economy and an advanced legal system. In addition, asset quality is high and was supported by a stable GDP growth rate in the last two decades. However, if smaller banks are affected by increasing costs or any decline in asset quality, a new wave of consolidation might occur among the smaller Danish banks. With respect to consolidation in the Danish banking market, we expect no major takeovers in the short-term. However, forced takeovers of smaller banks due to large-scale write-downs are possible. Regulatory environment Established corporate governance structure In general, corporate governance for the major market players is good. In fact, most banks conform to recommendations of the Copenhagen Stock Exchange Committee regarding corporate governance. Finanstilsynet, the Danish Supervisory Authority The institution responsible for supervising the banking sector in Denmark is the Danish Supervisory Authority (Finanstilsynet), while the Danish Central Bank as well as Finanstilsynet are responsible for financial stability. Since 2005, there is also a memorandum of understanding in place, which additionally involves the Ministry of Finance and the Ministry of Economic and Business Affairs. The Danish FSA is an integrated supervisor, i.e. it covers three areas: regulation, supervision, and information on financial institutions and securities markets. The Danish FSA is an agency under the Ministry of Economics and Business Affairs, but is overseen by independent Councils. Sector Report A u g ust 6, 2008 Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 8 The Danish Covered Bond Market Overview Established in the 1790s The Danish covered bond market dates back more than 200 years and was established afte r the great fire of 1795 in Copenhagen to finance the large reconstruction costs. As a direct consequence, the first mortgage bank was established in 1797. This was just 25 years afte r the first German Pfandbrief was issued on August 1, 1782. In the long tradition of Danish covered bonds a default or loss has never occurred. This emphasizes the high security inherent in the legal system under which Danish covered bond issuers operate. Furthermore, in terms of outstanding covered bonds the Danish market ranks second after the German market, but with a significant gap. The reason for the gap between Germany and Denmark is the non-existence of public sector covered bonds in Denmark, which make up the largest part in the German market. In terms of mortgage covered bonds, the Danish market is by far the largest, ahead of the Spanish and the German market. EUROPEAN AND DANISH COVERED BOND MARKET European covered bond market by outstanding volume – 2007 Danish covered bond market by issuer 0 200 400 600 800 1000 Ireland UK Sweden France Spain Denmark Germany EUR bn Mortgage Public sector Mixed assets Ships Nykredit Group 42.3% Danske Bank Group 30.2% Nordea Kredit 11.8% BRF Kredit 9.6% Others (e.g. DLR Kredit, LRF Kredit) 6.0% Source ECBC, Bloomberg, UniCredit Global Research New Danish covered bond law since July 1, 2007 On July 1, 2007, a new regulatory framework for Danish covered bonds came into force. One of the previous core principles, the (old) balance principle that regulated a strict matching of granted loans and issued bonds, was amended. In addition, the specialized banking principle was also amended. In 2007, five new covered bond programs were introduced Following the introduction of the "new" legal framework in Denmark, a few covered bond programs were introduced in 2007. Issuers were Danske Bank (EUR 15 bn global covered bond program), Nordea Kredit Realkredit (SDRO program, capital center 2), Nykredit Realkredit (SDO program, capital center E) and BRFKredit (SDO program, capital center E). Particularly the two big commercial banks, i.e. Danske and Nordea, are candidates fo r regularly issuing euro Jumbo bonds. Since January 2008, Danske has already issued two covered bonds using the Jumbo format. In terms of market share, Nykredit Group is the leading issuer in Denmark with a share of 42%, followed by Danske Bank Group (incl. Realkredit Danmark) with 30%, Nordea Kredit with 12%, and BRFkredit with 10%. In the next few years, we expect that the issuing volume in Denmark to shift from mortgage banks to commercial banks due to the amended specialized bank principle. This is particularly the case if specialized mortgage banks belong to a bank group, e.g. Realkredit Danmark to Danske and Nordea Kredit to Nordea. Sector Report A u g ust 6, 2008 Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 9 Amended Danish covered bond legislation New Danish law since July 1, 2007 Since July 1, 2007, the new Danish covered bond law is in force. The amendment of the regulatory framework was necessary to safeguard a level playing field for Danish banks as compared to European peers (i.e. preferred regulatory treatment). The prerequisite was that Danish mortgage bonds fulfill the criteria for the EU Capital Requirements Directive (CRD), which defines the basis for preferential treatment with respect to regulatory capital since the beginning of 2008. Furthermore, the new framework brings the Danish law more in line with other European covered bond legislations and should underpin the issuance of euro-denominated covered bonds in Denmark. In addition, the group o f issuers that are allowed to issue covered bonds was also enlarged to include commercial banks. The new regulatory framework features two main changes. 1. The specialized bank principle was amended. 2. The obligatory balance principle was changed to a new balance principle with two options. ● General balance principle ● Specific balance principle In general UCITS and CRD compliant Risk weightings assigned to covered bonds were previously regulated by the EU directive 2000/12, which refers to the UCITS directive (EU directive 85/611). This directive stipulates a 10% risk-weighting for covered bonds if they fulfill the criteria o f UCITS 22(4). With respect to UCITS 22 (4), bonds issued under the old law and unde r the new law qualify as covered bonds. However, on January 1, 2008, the new Capital Requirements Directive (CRD) came into force. With respect to covered bonds, the CRD directive refers to the criteria in UCITS 22(4) but has also established explicit eligibility criteria for collateral assets. Significant legislative tightening measures are the stricter requirement for the valuation of cover assets and the continuous LTV compliance. To ensure that Danish covered bonds can also be issued as covered bonds under the ne w regulation and hence benefit from the preferred risk-weighting, Basel II, the Danish policymakers decided to amend the law. Strict balance principle softened Specialized bank principle abolished Prior to July 2007, the Danish law that regulated the issuance of mortgage bonds only allowed special mortgage banks to issue Realkreditobligationer. Since July 1, 2007, the Danish government has eased the strict balance principle. Furthermore, the Danish Financial Supervisory Authority (FSA) since then also allows commercial banks to issue covered bonds. The only restriction for commercial banks is that they are only allowed to issue Særligt Dækkede Obligationer (SDO), a special type of covered bond (cf. Executive Order no 718 o f June 21, 2007, Part 1.1). DANISH BOND LEGISLATION ON ISSUING MORTGAGE BOND'S Commercial banks Mortgage banks Prior to July 1, 2007 (old law) Not allowed to issue any kind of covered bonds - Mortgage bonds (RO=Realkreditobligationer) After July 1, 2007 (new law) Covered bonds (SDO = Særligt Dækkede Obligationer) - Mortgage bonds (RO=Realkreditobligationer) - Covered bonds (SDO= Særligt Dækkede Obligationer) - Covered mortgage bonds (SDRO = Særligt Dækkede Realkredit Obligationer) Source: UniCredit Global Research Sector Report A u g ust 6, 2008 Global Credit Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 10 New balance principle with two options The change of the previous balance principle improved the business of covered bond issuers dramatically. Under the old law, it was a strict matching of disbursed mortgage loans and issued bonds, i.e. a pass-through system with lots of taps. The new legislation regarding the balance principle allows the issuers to choose between a general or a specific balance principle (cf. Executive Order no 718 of June 21, 2007, Part 1.2). The later is still closer to the old strict balance principle. However, the issuer must choose between one of the two principles for each cover register/capital center. The balance principles stipulate rules fo r calculating financial risk inherent in each cover register/capital center. BALANCE PRINCIPLES* General balance principle Specific balance principle Stress Limit: mortgage banks Limit: commercial banks Stress Limit: mortgage banks Currency risk +/-10% of exchange rates in EU/EEA/Switzerland 10% of capital adequacy requirements plus 10% of voluntary OC Max. 10% of voluntary OC VaR 0.1% of capital base 50% other currencies 1% of capital adequacy requirements plus 1% of voluntary OC (10 days, 99% confidence interval) Interest rate risk Parallel shift by +/- 1% 1% of capital adequacy requirements plus 2% of voluntary OC Max. 10% of voluntary OC Parallel shift by +/- 1% 1% of capital base Parallel shift and twist in the curve by +/- 2.5% 5% of capital adequacy requirements plus 10% of voluntary OC Max. 100% of voluntary OC Parallel shift by +/- 1% over 3 months; Parallel shift by +/- 1% over 10 years and Continuous proport. shift in the yield structure in the intervals: 3 months to 10 years 5% of capital adequacy requirements plus 10% of voluntary OC Max. 100% of voluntary OC Liquidity risk Interest received must exceed interest paid within 12 consecutive months (calc. day-to-day, discounted basis) Interest received must exceed interest paid within 12 consecutive months (calc. day-to-day, discounted basis). Furthermore, the PV of future payments into the register must exceed the PV of future payments out of the register. Must be below: 25% (1Y-3Y) 50% (4Y-10Y) 100% (>10Y) Option risk Option price changes due to 1% change in the volatility of underlying asset 0.5% of capital adequacy requirements plus 1% of voluntary OC Max. 5% of voluntary OC Max. 4 years and structural limits on call options and index-linking *OC=overcollateralization, PV=present value, VaR=Value-at-risk Source: Association of Danish Mortgage banks, UniCredit Global Research Eligibility criteria In Denmark, the covered bond legislation specifies the following eligibility criteria for the cove r assets. In general, cover pools which comprise public sector loans and mortgage loans are allowed. The only prerequisite is a license from the DFSA. In terms of geographic origin, there is no limitation for residential and commercial mortgage loans in place. However, the limitation comes from the issuers' business model. OVERVIEW OF ELIGIBLE COVER ASSETS Mortgage loans Public loans Ship loans Substitute collateral RO X X SDRO X X X SDO (com. bank) X X X X SDO (mort. bank) X X X Source: UniCredit Global Research [...]... which also owns Totalkredit Subsidiary of Danske bank Volume of outstanding covered bonds EUR 22.1 bn EUR 6.7 bn (EUR 15 bn global covered bond program established at year-end 2007) EUR 32.8 bn EUR 74.6 bn EUR 72.9 bn Issuer A2 s/ / Aa1s/AA-s/AA-s / / Aa3/ / / / Covered bonds Aa1/ / Aaas/AAAs/AAAs Aaas/AAAs/ Aaa/ / Aaas/AAAs/ Ratings: *Compare table below: "BOND TYPES IN THE DANISH MARKET" Bayerische... Source: BankScope, UniCredit Global Research Bayerische Hypo- und Vereinsbank AG ● UniCredit CAIB Group page 30 August 6, 2008 Global Credit Research Sector Report Realkredit Danmark A/ S Bank Profile Realkredit Danmark A/ S (RDKRE; NR) is the second largest specialized mortgage lender in the Danish market and is wholly-owned by Danske Bank A/ S (Aa1s/AA-s/AA-s) Realkredit Danmark was established 1851, and... credit strength of Danske Group REALKREDIT DANMARK'S COVERED BOND RATINGS General capital center, ROs Capital center S, SDROs Moody's Aaas Aaas S&P AAAs AAAs Fitch -Source: Rating agencies, UniCredit Global Research RATING AGENCIES' COMMENTS ON THE NEWLY ESTABLISHED COVERED BONDS ISSUED OUT OF CAPITAL CENTER S Agency Comment Moody's Summary Rating Action: Moody's assigned a long-term rating of Aaa... needs in case of call for additional cover Real estate evaluation Danish law stipulates real estate evaluation Danish law stipulates real estate evaluation focused on a practical market value approach In general, the pledged property must be valued subject to an inspection of the property by a valuation officer of the mortgage bank Inspection and valuation may only be carried out by professionals who... Mortgage bonds, fixed rates (DKK) DLR Kredit A/ S Nordea Bank Danmark A/ S Mortgage bonds (EUR) 350 300 FIH Realkredit A/ S 200 Jyske Bank A/ S LR Realkredit A/ S 250 EUR bn PLAYERS IN THE DANISH MARKET Sydbank A/ S Nordea Kredit Realkreditaktieselskab Nykredit Bank A/ S A/ S 150 Nykredit Realkredit A/ S Ringkjobing Landobank A/ S Totalkredit 50 FIH ErhvervsbankA/S Realkredit Danmark A/ S 100 Roskilde Bank A/ S... perfect match between lending and funding, and it has no interest rate risk or pre-payment risk Its mortgage bonds in Capital Centre D are rated Aaa and its mortgage bonds in Capital Centre C and the General Capital Centre are rated Aa1 Most recently the covered bonds in Capital Centre E have been rated Aaa (refer to the rating action on Nykredit Realkredit, Capital Centre E from 4 December 2007) The ratings... issuer Overcollateralization and substitute assets Overcollateralization as additional safety cushion Bayerische Hypo- und Vereinsbank AG In terms of overcollateralization, there is a difference between mortgage banks and commercial banks Commercial banks can provide overcollateralization on a voluntary basis, while it is mandatory for mortgage banks Mortgage banks must meet an overcollateralization level... European Central Bank EUR-DENOMINATED CRD-CONFORM DANISH COVERED BONDS Issuer ISIN Moody's/ Issue date Maturity Cpn Maturity type Amt outstanding EUR bn S&P Danske Bank A/ S XS0369059216 Aaa/AAA 06/11/2008 06/11/2013 4.875 BULLET AT MATURITY Danske Bank A/ S XS0357775559 Aaa/AAA 04/14/2008 04/14/2010 4.375 BULLET AT MATURITY 1.25 1.25 NORDEA KREDIT DK0002018712 Aaa/AAA 11/30/2007 01/01/2009 4.0 BULLET AT... CAIB Group page 28 Global Credit Research August 6, 2008 Sector Report Rating Profile NYKREDIT REALKREDIT'S COVERED BOND RATINGS Capital center C, Capital center D, Capital center E, General capital center, ROs ROs SDOs ROs Aa1 Aaa Aaa Aa1 S&P AA Fitch Moody's Source: Rating agencies, UniCredit Global Research NYKREDIT REALKREDIT'S: RATING PROFILE Long-term Short-term Outlook Financial... mortgage bank have a preferential claim in any case, i.e a preferential claim against the assets of other capital centers before ordinary investors In contrast, if investors are not satisfied out of the capital center of a commercial bank, they rank pari passu with the claims of unsecured creditors against the bank Mortgage banks: preferential claim against both demands In case of mortgage banks, set-off . or SDRO. Real estate evaluation Danish law stipulates real estate evaluation Danish law stipulates real estate evaluation focused on a practical market value approach. In general, the pledged. 15 bn global covered bond program established at year-end 2007) EUR 32.8 bn EUR 74.6 bn EUR 72.9 bn Ratings: Issuer Covered bonds A2 s/ / Aa1/ / Aa1s/AA-s/AA-s Aaas/AAAs/AAAs . / / Aaas/AAAs/ Aa3/ / Aaa/ / / / Aaas/AAAs/ *Compare table below: "BOND TYPES IN THE DANISH MARKET" Source: Bloomberg, Rating agencies, UniCredit Global Research