17 MARTINDALE CENTER FOR THE STUDY OF PRIVATE ENTERPRISE Danish mortgage debt and systemic risk from rising interest rates Ben Wainfan Denmark’s stable and efficient mortgage system, combined with over a decade of low interest rates and accommodative tax policies, has enabled Danish borrowers to accumulate Europe’s highest debt-to-income ratio. With interest rates and debt servicing costs rising, Danish borrowers, particularly the most leveraged ones, face financial challenges that may affect the economy and society for years to come. This article explores the implications of rising interest rates and offers policy solutions to protect the most vulnerable from overindebtedness. Overview of the Danish mortgage system Since its inception, the Danish mortgage system has been considered one of the most stable, transparent, sophisticated, and effective models for the financing of residential and commercial properties. The system utilizes a covered bond model where mortgage credit institutions (MCIs), specialized and heavily regulated lenders that are restricted to mortgage activities, fund mortgages through the proceeds of covered bond sales without taking deposits. All new loans are exclusively funded by the issuance of mortgage bonds of equal size, cash flow, and maturity characteristics. This differs from other European mortgage systems, which fund around 15% of loans through these bonds (Finance Denmark, 2021). The Danish covered bond market is four times the size of its government bond market and the second largest in Europe with more than $380B in bonds outstanding (Nykredit Markets, 2020). Proceeds from bond sales are subsequently passed to the borrower, and, similarly, interest and principal payments are passed directly to investors holding mortgage bonds (International Monetary Fund [IMF], 2007). For example, if a borrower takes out a 30-year loan at a fixed rate of 2%, the MCI would fund this loan by issuing bonds with a 30-year maturity and 2% coupon. The matching of bond and mortgage loan characteristics is referred to as the matching principle. This principle is applied to every mortgage, even those with shorter maturities or adjustable rates. Throughout the life of the loan, a borrower makes principal and interest payments to the MCI, which transfers these funds to the bond investors. These institutions profit by charging a margin on the loan, taking a percentage of the debt outstanding to cover administrative costs, expected future losses, return requirements on the capital that funds the loans, and capital buffer requirements. This margin is paid by the borrower throughout the loan term. If interest rates fall and payments from borrowers decrease, MCIs pass along these same low payments to bondholders (Finance Denmark, 2021). While MCI performance is directly sheltered from interest rate fluctuations, it is subject to credit risk. If a borrower is unable to make payments, the mortgage bank is still required to fulfill the remaining payments to bondholders. This helps shield bond purchasers from credit risk and incentivizes MCIs to evaluate the loans they issue. To mitigate this credit risk, MCIs assess borrowers on their net worth, income, and sensitivity to interest rate movements (Larsen, 2018). This assessment, however, is a binary one aimed at determining whether a borrower is creditworthy. Creditworthy borrowers are typically offered a standard range of rates and term options (Kjeldsen, 2004). This contrasts with a system like that of the United States where credit assessment is nonuniform and rates may differ significantly for the same term loan based on where the borrower sits on the spectrum of creditworthiness (Danish National Bank [DNB], 2021). The Danish mortgage system also differs from most other European countries, which subscribe to a universal banking system. Universal banks’ operations can include a wide variety of services, such as commercial banking, investment banking, wealth management, and insurance. European universal banks can take deposits and finance loans from a variety of sources, the vast majority coming from customer deposits and self-financing. Danish MCIs are restricted to mortgage-related activities, where
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