Trends in Mortgage-Credit Financing: the Market and its Players

Lars Jul Hansen, Market Operations, and Jesper Ulriksen Thuesen, Financial Markets

INTRODUCTION AND SUMMARY

During the last 10 years, the Danish mortgage-credit market has undergone considerable development. Many additional products have been introduced, but without any changes in the fundamental structure of the Danish mortgage-credit system, including the balance principle. The wider product range is an advantage to borrowers, who now have better opportunities for individual home-financing solutions. Financial consulting has become important to many borrowers.

Intensive product competition in a market with many, complex options for borrowers entails that sales and marketing activities, including efficient sales channels, have become more important. However, price competition has not intensified.

The new loan types and the related new bonds have not reduced the outstanding volume of traditional callable fixed-rate mortgage-credit bonds, since the aggregate mortgage-credit market has expanded as real property has appreciated in value.

In the most recent generation of mortgage-credit bonds, the same volume has not been built up as in the traditional mortgage-credit bonds, be they fixed-rate or adjustable-rate. In addition, the market for the latest bond types is to a lesser extent a uniform market where bonds from the various issuers are seen as perfect substitutes. There is presumably less liquidity in these bonds than in the more traditional Danish mortgage-credit bonds. Both investors and borrowers should take varying characteristics, including liquidity risk, into consideration when using the new products.

THE DEVELOPMENT IN MORTGAGE CREDIT IN DENMARK

In the last decade, new home-financing products have been introduced at a steadily increasing rate. Adjustable-rate mortgage-credit loans were reintroduced in 1996 and have achieved a large volume, particularly within the last five years. In 2003, they were followed by deferred-amortisation loans. Towards the end of 2004, adjustable-rate mortgage-credit loans with capped interest rates for up to 30 years were introduced. Moreover, the banks began to offer a new type of competing mortgage loan against real property as collateral.^[1]

Today's borrowers are quick to adopt new loan types, cf. Chart 1. Traditional callable fixed-rate bonds still make up a considerable proportion of the total market, but their share has been declining in recent years. On the other hand, the proportion of variable-rate bonds, i.e. adjustable-rate and capped-rate bonds, has risen substantially. Since their introduction in 2003, deferred-amortisation bonds have also gained considerable ground.

From their introduction, the new opportunities offered to borrowers by the mortgage-credit institutes have contributed to higher remortgaging. The wider range of mortgage-credit products available today has also improved borrowers' future remortgaging opportunities. Furthermore, these opportunities have improved both in connection with changes in the level of interest rates and changes in the term structure of interest rates.^[2] Revenue from remortgaging is a substantial element of the mortgage-credit institutes' profits.

CONSEQUENCES FOR THE MORTGAGE-CREDIT INSTITUTES

The structure of the Danish mortgage-credit system, which is based on the balance principle, cf. Box 1, has not impeded the rapid development of a broader range of products for borrowers and an equivalent increase in the number of different Danish mortgage-credit bonds. On the other hand, the development of new products has not changed the fundamental structure of the Danish mortgage-credit system, i.e. the way in which real property is used as collateral, the way in which loans are financed via the issuance of bonds, the close relationship between the borrower's interest and redemption profiles and the characteristics of the equivalent bond series, and the fact that private borrowers can normally finance the purchase of owner-occupied homes at the interest rates prevailing in the capital markets, i.e. that are not determined by the creditworthiness of the borrowers.

Credit and market risks
There has been no change in the procedure for pledging collateral, or in who incurs credit risk. Mortgage-credit borrowing is only possible up to a limit of 80 per cent of the property value (permanent residence), and in some cases the interval of 60-80 per cent of the property value is
covered by bank guarantees, which further reduces the mortgage-credit institutes' credit risk. However, some new loan types may entail certain shifts in credit risk; for instance, credit risk is higher for deferred-amortisation loans since repayments are postponed.

The mortgage-credit institutes' market risk has not changed significantly in recent years either.^[3] The main challenge to the mortgage-credit institutes in terms of hedging changing market risks thus relates to their wish and need to hold working portfolios of the new bond series themselves. Consequently, market risk in relation to Danish mortgage-credit products is still predominantly traded in the market, i.e. between borrowers and investors.

Risks relating to increasing competition
Competition in the mortgage-credit area has not led to increasing price competition, i.e. competition in relation to the costs payable by borrowers to the mortgage-credit institutes. In some cases, the mortgage-credit institutes have even raised contribution rates in connection with the introduction of a new product. Likewise, the fact that the interest payable on the banks' new type of mortgage loans against real property as collateral is sometimes slightly higher has not prevented the widespread use of loans of this type. Table 1 shows that the costs of raising loans are remarkably identical across mortgage-credit institutes.^[4] At the same time, contribution rates have not been falling.

For the mortgage-credit institutes there is, however, a profit risk as a result of the increased product competition. Due to the first-mover effect when new products, including variations of existing products, are introduced, a mortgage-credit institute can win – or lose – market shares in connection with its own or its competitors' introductions of new products. This can contribute to the ongoing development of new products.

Sales and marketing have to a larger extent than previously become a key competitive parameter in Danish mortgage credit. To be able to expand the customer base and business volume, it is essential to have a sales network that can be in close contact with borrowers. The banks' branch networks are important in this respect. Advisory services offered by estate agents also play a role, even though most private customers will probably always consult their own advisors in connection with major mortgage-credit transactions.

The significance of advisory services is likely to increase as the range of mortgage-credit products becomes ever more complex and thereby increasingly difficult for individual borrowers to grasp. Banks with affiliated mortgage-credit institutes have a competitive edge in that they can offer customers complete financial solutions, full-customer concepts, of which home financing is only one – albeit significant – element, and where direct price comparisons between various financial products become more difficult for the individual borrower.

As a result of the more intensive marketing, combined with the development in interest rates and the introduction of new loan types, the average borrower today remortgages more frequently than just a few years ago. The development in remortgaging activity, cf. Chart 2, indicates increased activity immediately after the introduction of new loan types.

CONSEQUENCES FOR THE MARKET

Broadly speaking, Danish mortgage-credit bonds can be grouped into three categories: traditional callable mortgage-credit bonds, traditional adjustable-rate mortgage-credit bonds, and capped-rate bonds. Within each category there are a number of variations, e.g. deferred-amortisation bonds and different types of capped-rate bonds. Consequently, the range of bond types is considerably larger than it was 10 years ago. Against this background it is interesting to see whether the larger number of bond series has had or may potentially have consequences for liquidity in the key bond series and in the market as such.

Firstly, liquidity may change as the total issuance is spread across more series. So far the impact of the increased number of bond series has, however, to a large extent been set off by the growth in the total volume of outstanding mortgage-credit bonds resulting from higher housing prices and new construction. Secondly, liquidity may change due to changes in the perception of the Danish mortgage-credit market as a uniform market and to any related consequences for market making in mortgage-credit bonds.

Danish mortgage-credit bonds are still predominantly traded in a telephone-based market.^[5] Data is therefore not available for analysis of liquidity indicators such as current bid-ask spreads, market depth at the various spreads and order coverage. However, data is available for one of the key liquidity indicators, i.e. the volume in the various bond series. Table 2 shows the outstanding volume in a number of the largest mortgage-credit bonds.

As can be seen, the outstanding volume in most bonds is considerable. For comparison, Chart 3 illustrates the historical development in the outstanding volumes in the largest callable and uncallable bonds. Although part of the recent decrease is probably attributable to the introduction of new products, the outstanding volume in the largest callable bond at present, 5 per cent 2035, is at the same level as in previous periods. For adjustable-rate bonds, the pattern is even clearer. The current outstanding volume in the largest adjustable-rate bond series was higher in 2005 than in the preceding nine years. Viewed in isolation, the relatively large outstanding volumes in callable fixed-rate bonds and adjustable-rate bonds indicate that so far the development in the mortgage-credit market in recent years does not give rise to concern about reduced liquidity in these bonds.

It is characteristic that these bonds are still traded in a uniform market, i.e. mortgage-credit bonds with a given coupon and maturity are regarded as almost perfect substitutes across issuers, and therefore also in the market maker arrangement that exists for these bonds. The market maker
arrangement, whereby a number of securities dealers have committed to quoting current two-way prices within fixed bid-ask spreads for given amounts, greatly supports liquidity in the bonds comprised by the system.

The latest bond types in the Danish mortgage-credit market are not traded in a uniform market in the same way, since these bonds do not have identical characteristics to the same extent as traditional bonds. The outstanding volumes in a number of capped-rate and deferred-amortisation bonds are, moreover, substantially lower than for more traditional bonds, cf. Table 2. However, recently market-making activities have been established in some of the capped-rate and deferred-amortisation bonds, which ensures a certain degree of liquidity in these bond series. Overall, liquidity in the new bond types must be deemed to be lower than in the more traditional bond types.

Liquidity may possibly play a special role when the first deferred-amortisation loans expire if a large proportion of these loans are to be converted into new deferred-amortisation loans. In that case it may potentially be difficult for borrowers to buy the bonds in the market, especially if by that time interest rates have risen.

Differences in liquidity will also be taken into account in investors' assessments of the individual bond series. The borrowers' improved possibilities of remortgaging to other loan types, and their increased inclination to remortgage, even if the gain is small, means that significant changes in the outstanding volume of a given mortgage-credit bond can take place at a faster rate than previously. This applies in connection with fluctuations in interest-rate levels, but also in connection with changes in expectations of future interest rates. Ongoing product development also means that investors should increasingly be aware of event risks, i.e. the introduction of new products leads to increasing remortgaging activity in existing bond series.

At the end of the 3rd quarter of 2005, non-residents owned by and large the same proportion of the 30-year capped-rate products as of total Danish mortgage-credit issues, viz. approximately 14 per cent. So far there are thus no signs of diminished interest on the part of foreign investors. It is assumed that the group of foreign investors in Danish mortgage-credit bonds will continue to mainly comprise sophisticated investors such as large institutional investors and hedge funds. Such investors are normally interested in series with large volumes, e.g. because they generally operate with large transaction amounts.

The Danish mortgage-credit sector must consider whether further product development will eventually result in bond series that are so small that this will jeopardise the hitherto favourable interest-rate terms for Danish mortgage-credit bonds. Should that be the case, the borrowers' costs will increase. Falling liquidity may also be to the detriment of investors, although they receive a certain degree of compensation via higher yields.

CONSEQUENCES FOR BORROWERS

Borrowers, i.e. households and the corporate sector, have more opportunities, but are also faced with greater challenges, as a result of the development in the Danish mortgage-credit market.

In principle, the wider range of loans, including loans with different risk profiles, is an advantage since it give borrowers more freedom of choice and better opportunities to structure portfolios with individual financial risk profiles.

The option to remortgage from fixed-rate to adjustable-rate or deferred-amortisation loans with lower monthly payments can also help to mitigate the financial consequences of social events such as un­employment or a divorce. However, such remortgaging is only possible once.

The increasing complexity of the loan market also presents a number of challenges to borrowers. When purchasing real property and when contemplating whether and when to remortgage or raise a supplementary loan, the borrower must make a number of complex decisions on the basis of an assessment of the general market development: fixed or variable interest rate, capped variable rate, deferred-amortisation periods, mortgage loan, the potential impact of future product innovation on the market, etc. Financial consulting has therefore become important to many borrowers.