18 PERSPECTIVES ON BUSINESS AND ECONOMICS | VOL 41 | 2023 loans are purely funded through covered bonds sales (Finance Denmark, 2021). Key financial products Mortgage banks offer three general types of mortgages: fixed-rate mortgages (FRMs), adjustable-rate mortgages (ARMs), and floating-rate mortgages. FRMs are typically 30-year loans with a predetermined rate for their lifetime. ARMs, which also fall in the long-term category, are funded by short-term bonds that mature between one and ten years. When the underlying bullet bonds funding an ARM mature, they are replaced by newly issued bonds, with a new coupon rate. The coupon rate of the newly issued bonds determines the loan interest rate for subsequent periods until the next bullet bond issuance, occurring every three to five years. Floating-rate mortgages, despite also being funded by bullet bonds, differ from ARMs due to their more frequently changing loan rates that typically move every three or six months. The floating rate typically tracks the interest rate paid between banks for overnight loans, updated daily (Finance Denmark, 2021). For borrowers, ARMs and floating-rate mortgages generally offer lower rates than their FRM counterparts. However, this initial affordability comes with the cost of future uncertainty stemming from fluctuations in interest rates as well as changes in the money market, central banking, and macroeconomic conditions. In response to this additional risk, lending standards are tightened for those looking to acquire an ARM or an interest-only mortgage (IOM). IOMs are loans of a fixed or adjustable rate where borrowers have to pay interest only on the borrowed amount for a period up to ten years. Borrowers can exclusively qualify for an ARM or IOM if they also qualify for a 30-year FRM with a rate exceeding the current market level (Finance Denmark, 2021). Once lending arrangements have been reached, the Danish system offers borrowers attractive prepayment and refinancing schemes. Because loans are funded entirely by covered bonds, borrowers can prepay their mortgages by purchasing the outstanding bonds at par or market value. This option is particularly attractive during times of rising interest rates, where the market prices of previously issued bonds fall as new bonds enter the market with higher, more appealing rates. Borrowers with FRMs and ARMs can repurchase related covered bonds at par at any time, whereas those with floating-rate mortgages are able to repurchase their debt only during a rate restructuring and at prearranged prices, typically 100% to 105% of the bond’s price. Denmark is unique in allowing prepayment on all mortgages. In most countries, repayment is not always an option and can incur penalties as much as 10% of the principal. Borrowers can also change debt obligations by refinancing loans (Finance Denmark, 2021). Mortgage loans under the Danish covered bond system offer borrowers transparent and relatively low prices compared to other European mortgage systems. A borrower’s rate is directly dependent on the coupon rate of its underlying bond whose coupon is publicly accessible through stock exchanges. If a borrower is looking to finance their house with a 30-year FRM, they can easily determine the baseline rate for their loan by looking up the coupon rate for 30-year covered bonds. From a pricing perspective, Danish mortgages have been shown to be more attractive compared to those from other covered bond and universal bank systems around the world (Finance Denmark, 2021). Stability and security in the Danish mortgage market No MCI has ever defaulted on a covered bond, and there has not been a late payment to an investor since the 1930s (Finance Denmark, n.d.). Even in periods of turbulent markets like the 2008 global financial crisis or the COVID-19 pandemic, MCIs, without government intervention, were able to sell billions of dollars in covered bonds, support the housing market, and help borrowers with lending practices that are forgiving, such as expanded credit facilities, IOM periods, and payment holidays (Finance Denmark, 2021). Oversight from the Danish Financial Supervisory Authority has a large role in establishing the mortgage system’s stability. MCIs are required to report their market risk to the agency each quarter, a process that includes several stress tests evaluating the institution’s ability to withstand interest rate changes, exchange rate volatility, hedging, and liquidity risks. MCIs can only extend a loan that is worth no more than 80% of the assessed value of a residential property, helping to limit the severity of potential losses. This measurement is called the loan-to-value (LTV) ratio. The Danish Financial Supervisory Authority also sets strict benchmarks for the lending of IOM, capital buffers, overall lending growth, re- financing operations, and share of high LTV ratio loans (Danske Bank, 2016). These provisions, in addition to preferential rights for investors on MCI capital and one of the fastest default timelines in Europe, make Danish covered bonds incredibly safe investments, thereby earning the highest possible credit ratings from international agencies (Enoch et al., 2013).
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