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Entries in covered bonds (2)


Wanted: International Buyers of Danish Mortgage Bonds

Not too long ago, I compared the Japanese economy to a bumblebee because of the economy's ability to keep on chucking along even as the government debt/GDP ratio stormed above the 200% mark. I am starting to think that the same comparison might be warranted too in the case of my home country. 

One striking aspect of the Danish economy that any economist following the discourse on Denmark must be pondering is that despite the widespread idea that Denmark has a serious productivity problem relative to its peers, it has not yet shown up in the data. Denmark is still running a sizeable trade as well as income surplus which together adds up to a tasty current account surplus.

So what gives and can this situation be maintained? 

The reason that I have been forced to think about this was today's report by Bloomie that the Danish bank and mortgate originator Nykredit announced that it would actively seek to widen its international investor base for covered bonds backed by mortgages of which the bank is Europe's largest holder and which contributes to making the Danish market for mortgages one of the world's biggest. 

Basically, the problem for Danish financial institutions is that under the new Basel rules, covered bonds backed by mortgages will be treated as less liquid than government bonds (and thus less liquid than is currently the case) and thus Nykredit et al will be left holding way too many of these securities. The problem in a nutshell is this; 

Denmark is leading efforts to persuade the European Union to ease liquidity rules set by the Basel Committee on Banking Supervision that the Nordic country says penalize the world’s third-largest mortgage-bond market. While the EU has signaled it may accommodate some of the demands, standards scheduled to take effect by 2015 are still likely to treat covered bonds as less liquid assets than government debt, Engberg Jensen said.

“I don’t think we can totally avoid a haircut” on how banks treat covered bonds in their liquid assets, he said. “I don’t think that we’ll end up with rules where covered bonds and government bonds are equal.” This means “we need to find a broader investor base. We want to be stronger in Europe and we have also started in the Middle East and the Far East. We’ve had investors for many years in the U.S. and Europe.”

Under the new rules, banks must abide to a limit of 40% in terms of how much of the securities portfolio that can be made up by (mortgage) covered bonds which leads to the obvious result that ... 

“If we get the new rules, most Danish banks will have to restructure to sell mortgage bonds and buy government bonds,” Engberg Jensen said. While Danish banks have relied on the country’s covered bonds to generate liquid assets, lenders in Germany and Asia have room to purchase the securities without breaching Basel’s 40 percent limit, Nykredit estimates. The company wants to sell its bonds to banks in those regions to make up for the selloff it expects to see in Denmark, Nykredit Group Managing Director Karsten Knudsen said in the same interview.

Denmark has a problem here, a big one in my opinion and the only chart you need to look at is the following. 

(click on picture for better viewing)

Despite the crisis, Denmark has not delevered substantially and mortgage debt remains a sizeable portion of GDP; 134% by my calculations in 2010. And this is mortgage debt alone and thus leaves out a large private debt burden, all corporate debt as well as a growing government debt. 

It is important to understand where Denmark is here. Denmark is like Spain, Ireland and Australia with large a large private debt burden which will only really make itself felt once the government has to assume the final bill (think Ireland here). Now, at this point my compatriots would know doubt file this post under the "one flew over the (...)'s nest" folder as comparing Denmark with the countries made above seem more than outrageous. But try to get the main point here. Denmark's main debt problem is in the private sector and given the Irish experience, once the sovereign has to plug a hole in the domestic financial system, it is the total debt that matters and not merely the government debt. 

Recently, the EU commission issued a report with a stark warning to Danish policy makers that both the size and structure of the housing market with the majority of loans made up by variable interest rate and no-amortisation/down payment (often both in the same loan!) represented a current and future source of instability. The Danish central bank has even suggested to phase out these loans entirely even if it seems that such a proposal has not got political backing in the Danish parliament regardless of the result of this year's election. 

According to Bloomberg, Nykredit and others have noted that they will try to separate the way they funds their adjustable rate mortgage portfolio from their fixed rate portfolio. This is almost hilarious in its uselessness in my opinion since the main problem here is not a flow issue but a stock issue as evidenced by the chart above. 

When all is said, I think you should take away the following point from this.

Essentially, if Danish mortgage originators start selling bonds to foreign investors for the obvious rational reason that they need to abide to new capital requirement rules it will mean a defacto deterioration of the current account (not necessarily a problem, just a fact when you sell securities abroad). So, the question is; how willing will foreigners be to finance one of the most overlevered housing markets in the world and at what yields?

When I run the scenario in my head, I end up in a situation where it might be quite difficult to push Danish covered bonds to foreigners at acceptable prices, liquidity will dry up and re-financing will get more difficult. In addition, if yields go up prices (i.e. house prices) will fall and exacerbate the difficulty in pushing the securities since the prices on the underlying collateral (i.e. property will go down). 

Now, far be it from me to attempt to put Denmark in a club to which it does not belong but think about it for a minute. The road map for how a Danish government might be forced to issue government bonds and swap them for unsellable covered bonds in order to allow its financial institutions to abide to the Basel rules is an almost sinister way in which the Danish sovereign ultimately may end up being on the hook for the total stock of debt in the society, just as we have seen elsewhere. 

Am I seeing ghosts? Perhaps, but consider yourself warned. 


Quantitative Easing à l`ECB? 

One cannot fault the good journalists for trying, one really can't. Yet, as hard as they tried they could not get President Trichet to concede that the ECB has now entered some form or state of quantitative easing as well as they could not wring an answer as to whether the 1% interest stance would constitute an intermediate floor for the ECB policy rate. Before, however, we get ahead of ourselves let us begin with the beginning.

The almost trivial outcome of today's council meeting in Frankfurt was actually the decision to push the main nominal interest rates down 25 basis points to 1%. If anything, risks to this decision seemed to come from the upside in the sense that all the talk of impending green shoots and second derivatives would make the ECB pause. What was always going to be much more interesting at this meeting would be whether the ECB would announce a series of those famous unconventional monetary measures, and if so; what they would be. In their comment leading up to today's decision, Danske Bank economist Frank Øland pointed out that he expected some form or measure of buying paper or assets. For my own part, I mused a bit on what the heck the ECB was saying in the first place conceding that talks about unconventional measures were indeed popping up in the statements of council members.

Consequently, the ECB brought three things to the table today in the form of longer term refinancing operations, the decision to let the European Investment Bank become eligible counterparty to the Eurosystem's monetary policy operations and most importantly a decision to, in principle, start buying covered bonds of which 60 billion euros was mentioned as the headline figure.

Now, all this about principles of course is open to a wide range of interpretations and Trichet certainly had to dodge a lot bullets at the press conference regarding whether this constituted quantitative easing or not. In the dying minutes of the conference Trichet himself used the words credit easing, and I will let be up to my readers to decide what this means. The president also snubbed FT reporter Ralph Atkins in his question of whether he was allowed to write that the ECB is printing money or, as it were, sterilizing the purchases. The more interesting bit here of course is why exactly the ECB would be buying covered bonds, of all assets. In order to understand this, you basically need to go to Spain and recount the story about cedulas hipotecarias, what they mean for the Spanish financial system and the stress her banks are currently suffering. Start with this one by Edward and then this, this, and this. And if that is not enough, you can go chew on the role of the German Phandbrief. Basically, I think there is a sound economic rational behind the ECB's decision to begins its asset purchase program on this front and whether we call it quantitative easing or not is of little matter I think. It will be most interesting next meeting to see what exactly the ECB is planning in the detail.

With respect to the economic outlook and the level of interest rates and its future change, we were served the regular bout of newspeak from the council which essentially is a reflection of the fact that the journalists were trying to get Trichet to pre-commit to an interest rate floor. Their endeavors were unsuccessful and in stead we got a rather conflicting message in the sense that while Trichet pointed out how 1% constituted no such thing as a floor, he also highlighted the idea that the current stance was appropriate and had also taken into account future weaker signals on the economy. In this light, we can only guess as to how forward looking the council believes the 1% nominal interest rate really is. Personally, I think that the extent to which the green shoots/second derivative punt continues the ECB will stand pat at its next meeting.


Economic Outlook

(click on graphs for better viewing)

Turning to the specifics of the economic situation the ECB rightfully recognised the severity of the situation in the introductory statement and pointed out that risks are still skewed to the downside even amidst green shoots.  It is rather obvious that the downturn is in full force and the recession is now also biting, as it were, on the real economy. This is most obvious from the quick deterioration on the labour market as well as the general slowdown in the real sector.

In terms of inflation, the message was a bit unclear in so far as I think the fundamental discourse is counter intuitive. There is a natural reason as to why this is though in the sense that the ECB would like to be worried about deflation at the same time as it wants to be adamant about anchoring inflation expectations and ever so pointing out that whatever unconventional measures taking are temporary.

There can be no doubt that the Eurozone is teetering on the brink of deflation but since this is also primarily a base effect from a very sharp reduction in commodity prices, the ECB is happy to stick with the standard argument that although inflation should turn negative in mid year it will rebound in subsequent quarters. The fact that headline inflation is adding negatively to the overall HICP can be seen from the negative sign of the graph plotting the spread between core and the main HICP index. it is interesting to observe how the ECB is now confident that energy prices won't lead to an entrenchment towards deflation when we all remember how the bank was terrified of second round effects from higher energy prices a year ago. Perhaps this asymmetry in the famed argument of nominal rigidities and how this may prevent the Eurozone from deflation is what disturbs me the most. Add to this of course that Trichet still maintains that the council is represent 329 million European citizens which apparently means that he does not see, or wants to mention, the fact that places such as Ireland and Spain are already well and truly bogged down in deflation. On the other hand of course, and given recent signs  that commodity prices are beginning to sneak back up, we should expect the ghost of second round effects to emerge once more.

Finally, it is interesting to look briefly at financing and credit conditions where it was noted by Trichet how lending to households and non-financial corporations are still falling. Also, if we look at the annual rate of growth in the much allured M3 measure it has also fallen back steadily. Now, just as I don't care much about the M3 when it running at 10+% I am not sure I care much now since the creation of money/deleveraging may have a life of its own beyond the M3.  Of course, as Danske Bank points out basing their analysis on the lending survey there may also be a second derivative here too, but this would only echo the general sentiment expressed by Trichet in the sense that whatever stabilization we are observing it is situated at very low if not negative levels.

Turning to the evolution of credit the picture is similar. The figure which is actually underestimating the trend because of the one year moving average clearly shows though how the flow as derived by the total stock is on a clear downtrend. In both Q4-08 and Q1-09, the evolution of the stock of household loans was negative. Moreover, Danske Bank's fine analysis of the lending survey suggests that a lot credit tightening is still clogged up in the pipeline even if the trough may have been reached. The interesing thing here will the extent to which the second quarter will see some improvement over a Q4-08 and Q1-09 which were clearly utterly abysmal. Note also that the chart to the right is an average which is of course ripe with generalizations. Basically, some economies such as Spain and Ireland are experiencing a much faster rate of contraction in credit than can be derived from this chart. Also and given the fact that this is after all a unique crisis, we really don't know much the overall stock needs to be capped before we are "done".

In summary, today was a quite significant meeting if there ever was one and the thing to watch is how the ECB will conduct itself in the covered bond market. As noted above, I am thinking cedulas and Spanish cajas as the main key words.