The Risk Outlook

The risk outlook is dominated by the financial crisis and the global recession. Considerable uncertainty prevails as to future developments, and factors such as the depth of the international recession are difficult to assess.

The estimated failure rates of Danish companies are increasing and the value of collateral pledged for bank loans is being eroded as a result of falling housing and land prices. The banks' credit risk is thus rising, and how it evolves is the key factor in terms of the development in bank earnings and solvency.

The mortgage-credit sector is still assessed to be robust. However, the sector is facing substantial credit risk, which may be exacerbated by households' choice of loan types and by housing price developments. Moreover, SDO legislation has exposed the sector to a new risk factor, as it must restore the collateral behind the SDOs issued when property prices fall.

Overview of significant risks to financial stability

This chapter describes significant risks to financial stability, i.e. risks associated with financial market developments, macroeconomic risks of both international and Danish origin, and vulnerabilities in the Danish financial sector, cf. Table 2.

In the next chapter, risks to financial stability are translated into two hypothetical stress scenarios which form the basis for stress tests of the Danish financial sector.

Risks associated with global macroeconomic and financial developments

What started as a purely financial crisis has evolved into a global economic recession, leading to rising credit losses for the banks. Loss trends will determine the development in bank earnings and solvency. The situation of the banks affects – and is affected by – future economic developments in a potentially self-reinforcing interaction process.

Recent months have seen signs of a slowdown in the recession, but it is still too early to call off the risk of further deterioration. A protracted decline in global trade, further drops in housing prices in many countries, including the USA, and significant consumer restraint could all make the downturn deeper and longer than expected. Macroeconomic conditions have deteriorated particularly sharply in several Eastern European countries, posing a risk to banks with large exposures in these countries.

Developments in the financial sector may also lead to further deterioration in the macroeconomic outlook. The banking sector is deleveraging, which could be an extensive process if the risk profile is to be brought back to the historical average. In other words, there is a risk that the banks will actively seek to reduce their lending portfolios, with further negative implications for private consumption and investment. In a worst-case scenario, this could send the global economy into a deep and prolonged recession, causing a significant increase in credit losses.

Many countries have adopted extensive fiscal-policy stimulus packages in an attempt to stem the tide of the recession. Quite a few countries, not least the USA, are thus rapidly increasing their public debts. This is leading to a greater supply of government bonds, which could have a substantial impact on future interest-rate developments. Other things being equal, an increase in market interest rates will dampen demand for goods and services and thus poses a risk to macroeconomic developments. The increase in the supply of government bonds and government-guaranteed bonds could also affect financial stability by partly "crowding out" private-sector bond issues, thereby reducing private-sector financing opportunities.

Though rescue packages have helped to stabilise global financial conditions, the situation is still far from normal. Due to the significant uncertainty and nervousness, even incidents that would, in normal circumstances, have a limited impact could have systemic consequences.

Risks to the Danish economy

The outlook for the Danish economy is more uncertain than usual. Danmarks Nationalbank expects unemployment to peak, at just over 190,000, in the 1st half of 2011. This figure is subject to considerable uncertainty, however, and higher unemployment figures cannot be ruled out, especially if the international economic outlook turns out to be more dire than expected.

As Chart 26 shows, growth in bank lending and cyclical developments have been very subdued in recent quarters. In Denmark, as in the international economy, the financial sector and the real economy may interact in a self-reinforcing process. Limited banking buffers and declining values of borrower collateral may translate into a significant drop in lending, fuelling a downward spiral by affecting the real economy and prices of financial and real assets.

Danish GDP and bank lending in Denmark	chart 26
Source: Statistics Denmark and Danmarks Nationalbank.

Another risk is associated with housing-price developments. The downward pressure on housing prices is reflected in the continued high number of homes on the market. Against this backdrop, cash prices are expected to decline further in 2009 and then gradually approach normal price development. However, there is a risk of stronger price drops, especially if the banks cut back significantly on lending, unemployment exceeds expectations, or interest rates rise to a considerably higher level. In this scenario, the financial position of Danish households will deteriorate.

At the same time, the value of the banks' collateral will be reduced. The combination of households' inability to meet their payment obligations and declining collateral values will affect the banks.

A continued decline in housing prices will also render a large number of construction projects unprofitable, meaning that banks exposed to non-residential lending and developers may incur losses.

The price per hectare of agricultural land has been surging in Denmark in recent decades, cf. Box 11. The price per hectare sextupled during the period from the 1st quarter of 1995 to the 2nd quarter of 2008. The 3rd quarter of 2008 saw a reversal of this trend, with prices of agricultural land tumbling by 12 per cent relative to the preceding quarter. The steep rise in land prices is not immediately attributable to changes in fundamental economic conditions within the agricultural sector, so there is a risk that land prices will plunge over the coming years. As the bank debt of farms rose in tandem with land prices, developments in agricultural land prices pose a risk to the banks.

Credit risk on lending to Danish agriculture	Box 11
Credit risk on lending to Danish agriculture depends, in part, on the agricultural sector's ability to generate a profit large enough to service the debt and, in part, on value developments for the collateral pledged as security for the debt. This Box analyses the risk that land prices, and thus the value of the collateral, will fall. Over the last 20 years, the price per hectare of agricultural land has been surging in most EU member states. This trend has been particularly pronounced in Denmark where land prices began to take off at the end of 2003, cf. the Chart below. Overall, land prices sextupled during the period from the 1st quarter of 1995 to the 2nd quarter of 2008. In comparison, housing prices tripled during the same period. Subsequently, the trend has been reversed, with land prices tumbling by 12 per cent from the 2nd to the 3rd quarter of 2008.
prices of agricultural land and housing
Note: Land prices are measured in terms of the selling prices for agricultural properties of 60-100 hectares. Housing prices are measured in terms of the prices of single-family and terraced houses. Source: Statistics Denmark and the Association of Danish Mortgage Banks.
The steep rise in land prices does not seem to reflect a similar increase in the output value of the agricultural sector. Measured in terms of gross value added, Danish agriculture was the only sector to experience a decrease from 1995 to 2008 (at constant prices), gross value added declining by about 12.5 per cent over the period. In comparison, overall Danish gross value added rose by 24.5 per cent1 cent during the same period. The agricultural sector in the EU is highly regulated and subsidised, entailing that regulatory changes could affect land prices. However, EU subsidies to agricultural producers fell by 0.8 per cent p.a. in real terms2 during the period 1996-2006. On the other hand, the total area required by public authorities as separation distances for application of semi-liquid manure increased by 17.2 per cent3 during the same period. Other things being equal, this increased demand, and thereby the price of agricultural land. However, this increase took place mainly in the period 1995-2002 – and thus before land prices took off. During the period of rising land prices, there has been an increase in the debt of the agricultural sector, cf. the Chart below. When land prices took off around 2003, short-term debt began to soar. The rise in mortgage debt has been more moderate and even. Overall, the agricultural sector's debt has not risen nearly as much as land prices.
development in agricultural debt
Source: Statistics Denmark.
The steep rise in land prices is not immediately attributable to changes in fundamental economic conditions within the agricultural sector. Therefore, there is a risk that land prices will plunge in the coming years. As the banks' exposure to the agricultural sector has increased substantially, there is a risk that the banks will suffer increased write-downs on agricultural exposures. It is important to the banks that agriculture can generate earnings that are sufficient to service its debt.
1 Gross value added is defined as the value of output less the value of intermediate consumption. 2 EU subsidies are deflated by the GDP deflator. Source: Own calculations, based on Statistics Denmark and various versions of the Executive Order on Animal Farming, Livestock Manure, Silage, etc. (available in Danish only), the Danish Ministry of the Environment.

Danmarks Nationalbank's task in relation to assessment of financial stability is to analyse risks. However, Danmarks Nationalbank's expectations may turn out to be over-pessimistic. Thus global fiscal relaxation could lead to stabilisation of the international economy and the various bank rescue packages in Denmark and abroad could prevent negative interaction between financial and macroeconomic developments.

Credit risk for Danish banks continues to rise

According to Danmarks Nationalbank's failure-rate model, KIM, the probability that Danish companies will fail over the coming years increased in 2008, cf. Chart 27.¹ In 2008, the estimated failure rate of the weakest 10 per cent of the companies exceeded 14 per cent, double the rate in 2005.

estimated failure rates for danish companies	chart 27
Note:2008 is a preliminary estimate based on a limited number of financial statements. Source: Own calculations based on data from Experian A/S.

The steep increase in 2008 relative to 2007, for both the weakest companies and the median company, is primarily attributable to negative cyclical expectations. In 2008, the indebtedness of Danish companies increased and several companies posted negative earnings. Tradition ally, these factors all imply a higher probability that a company will fail.

Among the various sectors, construction and trade, etc., experienced the greatest increases in estimated failure rates from 2007 to 2008, cf. Chart 28. Accordingly, banks that are exposed to these sectors are faced with the prospect of increased losses and provisions. Agriculture is not included in KIM, but the agricultural sector must also be considered to be one of the exposed sectors, cf. Box 11.

estimated failure rates of weakest companies, broken down by sector, 90th percentile	chart 28
Source: Own calculations based on data from Experian A/S.

Another factor that may affect the banks' credit risk is exposure to companies owned by private equity funds. These companies tend to be thinly capitalised and are thus particularly sensitive to recessions.

Therefore, the banks may be faced with the choice of acquiring the company or writing down its loans.

Danmarks Nationalbank uses KIM and assumptions of expected losses on exposures to households and agriculture to calculate a credit-risk measure for each bank.² The credit-risk measure expresses the individual bank's expected loss ratio on its entire lending portfolio. According to the credit-risk measure, the banks' overall credit risk on exposures to households and the corporate sector, including agriculture, increased from 2007 to 2008, cf. Chart 29. All institutions are above the line indicating unchanged credit risk. The increase is primarily attributable to higher credit risk on exposures to the non-agricultural sector, but the credit risk on exposures to agriculture and households has also shown a rising trend. Furthermore, the banks have increased the proportion of exposures to the non-agricultural sector, cf. Chart 31. Moreover, there was a clear tendency for the banks with the highest credit-risk measures to experience the highest increase in the credit-risk measure from 2007 to 2008.

credit-risk measures for the banks' lending portfolios	chart 29
Note: The analysis includes only institutions having at least 30 companies as customers. The sum of loans and guarantees is used as weights in the weighted averages. Source: Danish Financial Supervisory Authority, financial statements and own calculations.

The banks have reduced their large exposures
The banks have significantly reduced large exposures over the last year, thereby – other things being equal – lowering the risk of large losses on individual exposures. However, some banks still have significant exposures.

The Danish Financial Supervisory Authority's key ratio for large exposures³, a measure of large exposures as a percentage of the base capital, was reduced from 125 per cent in 2007 to 89 per cent in 2008 for the banks in group 1, while the ratio for the banks in group 2 was reduced from 155 per cent to 113 per cent. This trend continued in the 1st quarter of 2009. Measured in kroner, 13 of the 14 banks reduced the total amount of large exposures from 2007 to 2008.

Chart 30 shows large exposures as a ratio of the excess capital adequacy (measured as the difference between the base capital and the minimum capital requirement of 8 per cent). This provides an indicator of the concentration of the lending portfolio relative to the banks' buffers. Measured as a ratio of the excess capital adequacy, the weighted average of large exposures for the banks in group 1 fell from 397 per cent in 2007 to 201 per cent in 2008, while the weighted average for the banks in group 2 was reduced from 505 per cent in 2007 to 390 per cent in 2008. The reduction for the banks in group 1 is, to some extent, attributable to the transition to Basel II, which has resulted in a fall in risk-weighted assets, thereby increasing the excess capital adequacy. In 2008, two institutions among the banks in group 2 stood out by having a significantly higher risk concentration than the other banks.

large exposures, per cent of excess capital adequacy	chart 30
Note: Calculated on the basis of the Danish Financial Supervisory Authority's key ratio for large exposures. Source: Financial statements.

Medium-sized banks increased their exposure to the corporate sector
The banks in group 2 increased their ratio of loans and guarantees to the corporate sector from 58 per cent at the end of 2003 to 72 per cent at the end of 2008. During the same period, the banks in group 1 reduced the ratio of lending to the corporate sector from 78 to 74 per cent, cf. Chart 31. The opposite trend applies to lending to the private sector. The ratio of loans and guarantees to the public sector was unchanged for both groups from 2003 to 2008.

breakdown of loans and guarantees on selected sectors	chart 31
Note: Exposure to the property market is calculated as the proportion of loans and guarantees to the sectors property administration, etc., as well as building and construction. Nordea Bank Danmark is not included in Chart due to lack of data. Source: Financial statements.

The largest corporate lending sectors are shown in Chart 31. Both large and medium-sized banks have increased their ratio of loans and guarantees to the property market in recent years. With a lending ratio of 23 per cent, the banks in group 2 continue to be more exposed to this sector than the banks in group 1 (15 per cent). The banks in group 2 became significantly more exposed to credit, financing and insurance business from 2007 to 2008, the ratio of loans and guarantees increasing from 14 to 22 per cent.

Compared with the banks in group 1, the banks in group 2 are more exposed to the sectors agriculture, property market, other corporate sectors and private individuals.

Uneven picture of the banks' interest-rate risk

Interest-rate risk is the risk of losses as a consequence of changes in interest rates in the financial markets and constitutes a major part of the banking institutions' market risk. The last year has seen extremely volatile financial markets. Other things being equal, this, in combination with difficult financing conditions and rising risk premiums, has rendered it more difficult for the banks to manage their interest-rate risk.

Eight of 14 of the banks in groups 1 and 2 experienced increasing interest-rate risk in 2008 – expressed as the part of the core capital after deductions that is lost on an increase in interest rates by 1 percentage point. For the banks in groups 1 and 2 as a whole, the interest-rate risk is unchanged and declining, respectively, cf. Chart 32.

interest-rate risk of danish banks	chart 32
Note: Calculated on the basis of the Danish Financial Supervisory Authority's key ratio, "interest-rate risk". The ratio is an expression of the part of the core capital after deductions that is lost on a parallel shift of the yield curve by 1 percentage point. Sourcee: Financial statements.

As more banks have become more exposed to increases in interest rates, the banks have also become vulnerable to falling interest rates due to "floor risk". Floor risk reflects the fact that the deposit rate cannot be negative. In a situation where the market rate is so low that, if it declines further, the deposit rate cannot be lowered correspondingly, the banks' interest-rate margin, and thus their core earnings, may come under pressure.

Liquidity maintained after government guarantee

The financial crisis has put the liquidity and capital contingency planning of Danish banks under strong pressure. The government guarantee for most non-subordinate claims has been crucial in ensuring that a number of banking institutions have been able to maintain their liquidity. Moreover, Danmarks Nationalbank expanded the credit facilities available to banks and mortgage-credit institutes at Danmarks Nationalbank in the course of 2008 to facilitate access to liquidity. These facilities, which are temporary and run until 30 September 2010, are included in the calculations of liquidity by the institutions.

The Danish Financial Supervisory Authority's key ratio for liquidity provides an indication of the banking institutions' excess liquidity cover. The ratio shows excess liquidity in relation to the statutory minimum requirement under which liquidity must constitute at least 10 per cent of the total debt and guarantee commitments less subordinated capital, which can be included in the capital base.

In 2008, the banks' excess liquidity cover was reduced slightly relative to 2007, cf. Chart 33. The Chart also shows that the spread in the banking institutions' excess liquidity cover has been reduced in recent years. Thus the institutions with the smallest buffers have built up liquidity reserves, while the institutions with the largest buffers have reduced theirs. In 2008, the lowest excess cover increased to 38 per cent from 18 per cent in 2007, while the highest excess cover in 2008 declined to 155 per cent from 161 per cent in 2007. In 2008, five banks – all of them from group 2 – had excess liquidity cover of more than 100 per cent.

excess liquidity cover in danish banks	chart 33
Note: The Chart is based on the Danish Financial Supervisory Authority's key ratio, "cover relative to statutory liquidity requirement", which shows excess liquidity after compliance with the 10-per-cent requirement, cf. section 152 of the Danish Financial Business Act. Liquidity must amount to at least 10 per cent of the total debt and guarantee commitments less subordinated capital investments, which can be included in the calculation of the base capital. Source: Financial statements.

The government guarantee on bank debt is temporary and the banks should therefore prepare strategies for obtaining funding when the schemes are discontinued.

Summary of risks facing the banks

Credit risk is currently the key factor in terms of the development in bank earnings and solvency. The estimated failure rates of Danish companies are increasing and the value of collateral pledged for bank loans is being eroded by falling housing and land prices.

At the same time, the banks are vulnerable to falling interest rates due to "floor risk", as the banks' interest-rate margin, and thus their core earnings, may come under pressure in a situation where the market rate is so low that, if it declines further, the deposit rate cannot be lowered correspondingly.

The government guarantee on bank debt has been crucial in ensuring that banks have had access to liquidity, thereby contributing to reducing the banks' liquidity risks.

Risks to the danish mortgage-credit sector

The Danish mortgage-credit system is, and always has been, exposed to credit risk. This risk depends, in part, on the households' ability to service their debt and, in part, on price developments for the homes mortgaged. As the banks often assume some of the credit risk associated with the mortgage-credit loans they arrange, this also poses a risk to the banks. For many adjustable-rate loans, there is a significant mismatch between maturity and financing. Thus the system is dependent on continued access to the capital markets, cf. the section on "Refinancing risks". Covered bonds (known as SDOs in Denmark) have introduced a new risk element, as the credit institutions must restore the collateral underlying the SDOs issued when house prices fall.

The rating agencies are currently reviewing their rating methodologies in light of the financial crisis. The impact of the review on the assessment of covered bonds remains to be seen. Preliminary announcements indicate e.g. enhanced focus on liquidity risk. Moreover, increased emphasis will probably be placed on the credit rating of the issuer in the assessment of individual issues.

Credit risk
Rising unemployment and falling housing prices reduce both the households' ability to service their debt and the collateral value, thereby increasing the credit risk faced by the mortgage-credit sector.

Below, the interest-rate exposure of Danish homeowners, the link between homeowners' choice of loans and the mortgaging ratio of the homes, and the homeowners' mortgage debt as a ratio of gross income are analysed. The analysis is based on a cross-section of the mortgage-credit loans of Danish households.

Homeowners with a high mortgaging ratio have more interest-rate sensitive loans
Today, homeowners have a choice between a number of different mortgage-credit loans ranging from fixed-rate loans with amortisation to uncapped adjustable-rate loans without amortisation. As illustrated by Chart 34, there is a strong tendency for homes with a high mortgaging ratio, on average, to be financed via interest-rate-sensitive loans, often with deferred amortisation. 38 per cent of the outstanding bond debt is invested in homes with a mortgaging ratio of between 40 and 60 per cent.⁴ 61 per cent of the outstanding debt on these homes is with amortisation. In contrast, for the 7 per cent of the bond debt invested in homes with a mortgaging ratio of more than 80 per cent, only 26 per cent of the outstanding debt is with amortisation.

correlation between loan types and mortgaging ratios	chart 34
Note: The outstanding bond debt is stated at fair value on 28 November 2008 and property values are estimated on 30 November 2008. Adjustable-rate loans are refinanced via new bonds at a refinancing auction, while interest on floating-rate loans is determined on the basis of a reference rate, i.e. without issue of new bonds. Source: Own calculations.

Part of the explanation for the substantial difference in loan types for the various mortgaging ratios is that, previously, homeowners had access only to traditional loan types. Thus the households with the new loan types tend to be fairly new homeowners with a high mortgaging ratio. Nevertheless, these homeowners are more vulnerable to rising interest rates or loss of income.

Homeowners with deferred-amortisation loans have the highest debt burden
There are wide regional differences in the homeowners' debt as a ratio of income, cf. Chart 35. The highest debt burden is found in the Copenhagen area, in Northern and Eastern Zealand and in Eastern Jutland. These areas saw the largest price increases for single-family and terraced houses and owner-occupied flats in the period 2004-06, and some of these areas have taken the brunt of the recent price falls, translating into higher credit risk.

Mortgage debt as a ratio of income – loans with and without amortisation, broken down by areas	chart 35
Note: Mortgage debt is outstanding debt in cash. Income is gross income. Source: Own calculations.

Across Denmark, there is a clear tendency for homeowners with deferred-amortisation loans to have a higher debt burden than those who have loans with amortisation. The debt burden of the median household with at least one deferred-amortisation loan is between 28 and 36 per cent higher than that of the median household with amortisation on all loans. As previously stated, one explanation could be that deferred amortisation was not an option when some of the households with a relatively low current debt burden took out their loans. Another explanation could be that some households have utilised deferred amortisation to increase their debt burden. The latter could have contributed to the rise in housing prices.

In the current situation of falling housing prices, homeowners with deferred-amortisation loans are the most vulnerable. Firstly, they tend to have a higher rate of indebtedness than other homeowners. Secondly, they have already utilised the buffer that deferred amortisation could provide to other homeowners.

Homeowners with uncapped adjustable-rate loans
Homeowners with uncapped adjustable-rate loans are another potentially exposed group in the housing market. Table 3 shows the change in the interest burden if the short-term interest rate goes up by 1 percentage point. In this context, the short-term interest rate is defined as the rate of interest on an adjustable-rate loan, irrespective of the fixed-interest period.

The interest-rate exposure varies considerably – both within and between various parts of the country, reflecting both differences in the debt burden and the fact that, for some households, the adjustable-rate option applies only to part of their debt. If interest rates go up by 1 percentage point, the 10 per cent most interest-rate sensitive households in Copenhagen will e.g. see a rise in their interest expenses equivalent to at least 4.2 per cent of their gross income, while the corresponding figure for Western Jutland is 3 per cent. The pattern from Chart 35 is also seen in Table 3, i.e. that the most vulnerable households are the ones located in the areas that experienced the largest price increases for single-family and terraced houses and owner-occupied flats in the period 2004-06. Thus some of the households whose housing values have declined the most are also the households most sensitive to interest-rate rises.

Refinancing risks
For adjustable-rate loans financed via short-term fixed-rate bonds, a mismatch exists between the maturity of the loan and the underlying bonds. The proportion of this loan type was increasing until 2005, at which time it accounted for about 40 per cent of the bonds issued by the mortgage-credit institutes, cf. Chart 36. Over the last three years, floating-rate bonds have won market shares from fixed-rate bonds for financing of variable-rate loans. However, the latter type still accounts for more than 30 per cent of the bonds outstanding.

outstanding volume of mortgage-credit bonds, broken down by loan type	chart 36
Note: Nominal value, average for the year. Before 2006, capped floating-rate bonds are included under uncapped floating-rate bonds. Source: Danmarks Nationalbank.

Short-term fixed-rate bonds underlying variable-rate loans are predominately refinanced in December. The financial turmoil last autumn demonstrated that considerable risk is incurred by both borrower and issuer when the entire refinancing process takes places within a relatively short time span. There were periods of considerable uncertainty as to the level of interest rates and the opportunity, in general, to sell the bonds. Therefore, it is positive that one institution has already spread the refinancing process across the year, while other institutions are preparing to do so.

Another way to eliminate the refinancing risk is by issuing floating-rate bonds with the same maturity as the loan. However, the use of floating-rate bonds is hampered by the fact that interest-rate fixing typically follows the CIBOR rate – a reference rate for uncollateralised interbank loans. Dur ing the financial crisis, CIBOR has been highly volatile and relatively high.

Top-up collateral for covered bond loans (SDOs)
New legislation on covered bonds (SDOs) and covered mortgage-credit bonds (SDROs) took effect on 1 July 2007. Below, SDOs and SDROs are referred to collectively as SDOs. As a result of this legislation, mortgage-credit institutes have almost exclusively been issuing SDOs since 1 January 2008. The capital requirement for acquiring SDOs is lower than for acquisition of traditional mortgage-credit bonds (ROs) issued after 1 January 2008. Consequently, SDOs are a more attractive investment than ROs for credit institutions subject to capital requirements. SDOs account for an increasing share of the total outstanding volume of bonds issued by mortgage-credit institutes, reaching approximately 37 per cent in March 2009, cf. Chart 37.

outstanding volume of mortgage-credit bonds, broken down by ROs and SDOs/SDROs	chart 37
Note: Nominal value, end of month. Source:Danmarks Nationalbank.

Statutory requirements for top-up collateral
Under SDO legislation, LTV (loan-to-value) limits must be observed on an ongoing basis for each individual loan.⁵ For a housing loan, the LTV limit is 80 per cent, which means that the credit institution must immediately pledge top-up collateral if the market value of the home declines, or the market value of the SDOs increases to the point that the LTV limit is breached. Top-up collateral is placed in a cover pool⁶, pledged as collateral for the series under which the bonds are issued. Assets that can be included as top-up collateral must be comprised of secure assets, such as government bonds. Moreover, receivables and guarantees issued by credit institutions can be used for up to 15 per cent of the nominal value of the SDOs issued. The credit institution may choose either to transfer existing assets from its reserves⁷ or to borrow to finance new assets as top-up collateral. If the credit institution chooses to borrow to finance the top-up collateral, it may do so by raising loans against collateral in the cover pool after the SDOs issued. The Danish Financial Supervisory Authority has requested institutions authorised to issue SDOs/SDROs to state their total SDO/SDRO issues, the volume of top-up collateral pledged by the institution, and the volume of top-up collateral the institution is able to pledge without having to issue new debt against the cover pool as collateral, calculated at the end of February 2009 or the closest possible date. The institutions stated that SDOs totalling kr. 965 billion had been issued. Top-up collateral amounting to a total of kr. 29 billion, equivalent to 3 per cent of the SDOs issued, had been pledged. The top-up collateral was financed by kr. 20 billion from the institutions' reserves, kr. 5 billion from guarantees issued by credit institutions and kr. 3 billion from loans against collateral in cover pools. The institutions stated that at the time of calculation, they were able to pledge top-up collateral of a further kr. 55 billion, equivalent to 6 per cent of the SDOs issued, without issuing new debt.

Top-up collateral requirements
Following recent price developments in the housing market, credit institutions may be required to provide top-up collateral. As previously stated, the LTV limit must be observed for each individual loan. In order to calculate a credit institution's top-up collateral requirements, information is thus required on the market value of each property and each loan.

Below, a data selection, cf. Box 12, is used to calculate top-up collateral requirements for single-family and terraced houses, owner-occupied flats and summer cottages. For these types of property, the LTV limit is 80, 80 and 60 per cent, respectively. If all housing prices drop by the same percentage, the top-up collateral requirement increases more than proportionally, cf. the convex curve in Chart 38. The reason is that an increasing number of loans require top-up collateral.

Top-up collateral requirements, general fall in house prices	chart 38
Note: The point of departure is outstanding bond debt stated at fair value on 28 November 2008 and property values estimated on 30 November 2008. Source: Own calculations.

Due to the convexity of Chart 38, the requirement for mortgage-credit institutes to pledge top-up collateral is higher if the prices of some properties fall sharply, while others see only a limited price fall, than when the fall is evenly distributed. This is illustrated by Chart 39 in three experiments. In all three cases, prices drop by an average of 20 per cent, but the pattern differs. Each of the three experiments consists of 20,000 outcomes under which the price of each property could, with the same probability, have one of two outcomes, as prices fall by 15 or 25 per cent, 10 or 30 per cent, or 5 or 35 per cent, respectively.⁸In Chart 39, the intersection between the first and the second axes indicates the requirement for top-up collateral on a general property-price drop of 20 per cent. The experiment illustrates that very uneven falls in housing prices increase the requirement in terms of top-up collateral. Moreover, the spread, in itself, means that the actual top-up collateral required becomes more uncertain.

When house prices fall, the decline in the prices of various properties usually varies considerably. Thus, it is very likely that the actual requirement on an average fall in prices of 20 per cent is to be found somewhere along the first axis in Chart 39 rather than in the intersection with the second axis.

Top-up collateral requirements, spread in fall in house prices	chart 39
Note: The Chart is based on three experiments in which the fall in prices may result in one of two possible outcomes. Source: Own calculations.

It is obviously difficult to predict the probability distribution for future developments in housing prices. However, recently the largest declines in prices have tended to be in areas that saw the strongest increases within a relatively short time span. It is not given that this will always be the case, as property prices may be affected by various structural changes that could permanently change the relative prices in various geographical areas. Despite this reservation, it could be a useful test of the potential top-up collateral requirement to allow housing prices to fall back to the level seen a number of years earlier.

Chart 40 calculates the top-up collateral requirement if the Association of Danish Mortgage Banks' real-property price statistics were reversed from the 3rd quarter of 2008. (Thus, the price of an owner-occupied flat in Copenhagen in the 3rd quarter of 2005 is calculated as the current price multiplied by the price ratio between owner-occupied flats in Copenhagen in the 3rd quarter of 2008 and 2005, respectively.) As prices of owner-occupied flats in Copenhagen, in particular, have already dropped sharply, a resulting fall in all property types in all parts of Denmark will not be seen until the 2nd quarter of 2005.

Top-up collateral requirements, price fall to historical levels	chart 40
Note: The point of departure in the 3rd quarter of 2008 is outstanding bond debt stated at fair value on 28 November 2008 and property values estimated on 30 November 2008. Prices of owner-occupied flats on Bornholm and summer cottages in Copenhagen city and environs are kept constant due to a lack of data for price developments for these areas. Source: Association of Danish Mortgage Banks and own calculations.

A comparison between Charts 38 and 40 shows that a price adjustment using prices from the 3rd quarter of 2003 requires the same top-up collateral as a general drop in prices of 35 per cent.

Financing of top-up collateral
As already stated, the credit institutions, in addition to using existing reserves and guarantees, may finance top-up collateral by raising debt against cover pools as collateral. Bank Rescue Package II also enabled the institutions to issue this type of debt against a government guarantee that may run until the end of 2013. Great uncertainty obviously prevails as to the rate of interest on debt issued against cover pools as collateral if the housing market weakens further, causing the issuance requirement to increase. Viewed in isolation, the government-guarantee option can be expected to improve issuance opportunities. However, as evidenced by the financial crisis, when the need for capital is greatest, access to capital may be limited.

Opportunities for reducing risks
There are various ways to reduce the three risks identified above for the Danish mortgage-credit system. However, it is difficult to do anything about the credit risks already on the books. Developments have shown that, over the longer term, the sector should take special care that households do not use deferred-amortisation loans and adjustable-rate loans as an entry ticket to a property market in which prices are soaring. This could exert further upward pressure on the market, thereby increasing the risk of future price falls.

Overall, there are two ways to reduce refinancing risks. Firstly, the sector can work towards ensuring that a smaller part of the lending portfolio consists of adjustable-rate loans financed via fixed-rate bonds. This does not necessarily limit the opportunity for variable-rate loans, as these can also be financed via floating-rate bonds. Secondly, the sector may spread out refinancing over the year, thereby reducing systemic risk.

The financial crisis has shown that there may be significant correlation between developments in the property markets and risk aversion in international markets. This could cause uncertainty as to the opportunities for credit institutions to pledge top-up collateral and thus maintain the SDO status of the bonds issued. In the short term, this problem has been partly alleviated by the possibility of obtaining a government guarantee. Looking for ward, it is important, however, that a more permanent solution be found.

Again, there are two solutions, which may be combined. The credit institutions may be required to contribute a significant buffer to the cover pool at the time the loan is offered. Alternatively, the lending limit for SDO loans at the time of issue may be lowered relative to the LTV limit. In that case, the institutions may finance the "last-ranking" part of the loan against ROs, the LTV limit of which must be observed only at the time of issue.

The implications of the SDO legislation are being evaluated. At present, it is clear that the requirement for constant observation of the LTV limit has introduced a new risk, which also contains a clearly procyclical element. Danmarks Nationalbank will attach importance to ensuring that the evaluation carefully considers how this risk could be reduced. In its consultation response on SDO legislation in 2007, Danmarks Nationalbank expressed that it would prefer a robust and simple SDO model and that the lending limit at the time of lending was to be set at 70 per cent for residential properties. Danmarks Nationalbank still finds that lowering the lending limit will translate into a significant reduction of the risks facing the Danish mortgage-credit system.

Obviously, it should be ensured that a statutory amendment does not exacerbate the problems of an already pressured housing market. One possibility is to introduce a gradual reduction of the lending limit at the time of issue in a few years when the housing market has stabilised.

¹ Danmarks Nationalbank's failure-rate model, KIM, has been used to estimate the probability that a company will fail. See Financial stability 2007 for further details of KIM.

² The credit-risk measure is calculated as PD_i^corporate ∙ U_i^corporate + PD^households ∙ U_i^households + PD^agriculture ∙ U_i^agriculture . PD_i^corporate is the debt-weighted estimated failure rate in Danmarks Nationalbank's failure-rate model, KIM, for companies using bank i. The year's average loss ratio for each of the two groups is applied as an approximation of the estimated failure rate for households (PD^households) and agriculture (PD^agriculture). U_i is the proportion of bank i's lending to the corporate sector, the households and agriculture, respectively. The credit-risk measure is specified in the glossary in Financial stability 2007.

³ An exposure is defined as large if it amounts to 10 per cent or more of the institution's base capital.

⁴ The area of the Chart that is in the 40-60 range on the y axis.

⁵ For a more detailed description of SDO legislation, see the sections on SDOs in the chapter "Recent Economic and Monetary Trends" in Danmarks Nationalbank, Monetary Review, 1st Quarter 2007 and the chapter "Framework Conditions for the Financial System" in Financial stability 2007.

⁶ For a mortgage-credit institute, a cover pool is a capital centre in the form of a series or a group of series with an associated series reserve fund.

⁷ It appears from the Danish Mortgage-Credit Loans and Mortgage-Credit Bonds Act that loans financed via SDOs or SDROs must be issued in separate series with a series reserve fund. The assets of a series reserve fund must be sufficient for the series to comply with the solvency requirement. Assets allocated to a series reserve fund by the mortgage-credit institute are included in its base capital. On 3 October 2007, the Danish Financial Supervisory Authority decided that all assets under a series invested in sufficiently secure assets may be included in the calculation of whether the LTV requirement has been met for the series in question, i.e. that the mortgage-credit institutes – to the extent that their base capital is allocated in series under which SDOs are issued and their base capital is invested in sufficiently secure assets – may include their base capital as top-up collateral without making a deduction in the base capital.

⁸ Each outcome has been adjusted, so exactly half of the properties have each of the two outcomes.