Non-Callable Loans for Cooperative Housing Societies

Ib Hansen and Hans Henrik Knudsen, Market Operations

Introduction and summary

The Danish mortgage-credit model is based on flexibility and transparency. It has won worldwide acclaim for offering homeowners a simple, well-functioning financing system. In recent years, the range of products has been developed substantially and in some cases the consequences of the financing structures are not easy to understand. Therefore, the new products make increasing demands on lenders and borrowers.

Mortgage loans are largely granted with the option to repay the loan at par or at a price close to par. This protects the borrower against substantial price losses in the event of falling interest rates.

When interest rates decline, the price of a bond loan rises. Loans that cannot be redeemed at par – non-callable loans – can be highly price-sensitive to interest-rate declines. This means that it can be very burdensome to redeem long-term, non-callable loans, for instance when the homeowner sells his house. Therefore, these loans are not suitable for home financing.

Some, especially new, cooperative housing societies have taken out quite risky non-callable loans with rising interest payments. The structure of these loans makes it difficult to understand the financial consequences, such as potential price losses if interest rates decline and the impact of rising debt service payments. The reason is that the loans are typically designed as a combination of a loan and a financial agreement – an interest-rate swap. The complexity of the products therefore requires that both lenders and borrowers truly understand the risks associated with this type of loan.

Homeowners risk being locked in by non-callable loans

The mortgage-credit system in Denmark is based on issuance of bonds against real property as collateral. A pivotal point is that the mortgage-credit institute does not assume risk as a consequence of fluctuations in interest rates, or when homeowners refinance their loans.

Non-callable loans impose a significant risk on the borrower
If the borrower wishes a standard fixed-rate mortgage loan, it is taken out in the form of a callable loan. The call option implies that the borrower is protected against a sharp rise in the outstanding debt beyond par if interest rates decline. The borrower's option to redeem the loan at par is offset by the mortgage-credit institute issuing bonds which can also be redeemed at par. If the borrower redeems the loan at par, the bond will be prepaid at par. This means that the bond investor must reinvest the funds at a lower interest rate. In other words, the bond investor is subject to a prepayment risk.

The bond investor must obviously be compensated for taking this risk, and this will be in the form of a higher interest rate. Callable loans thus bear a higher interest rate than non-callable loans with the same maturity. Or put differently, callable loans are more expensive that non-callable loans, but are associated with lower risk of large price rises.

Unlike callable bonds, non-callable bonds have no embedded call option. This means that the mortgage payments on the loan are lower, but the borrower is not protected against price rises above par.

Price rises are not necessarily of major significance if the loan is held to maturity. If the home is to be sold, however, it may pose a serious problem if the price of the loan has risen markedly. Then the borrower will have to realise the price loss, which could make repaying long-term loans very burdensome.

Broad support for protection of borrowers
Due to the risk of prices rising above par, it has been a general rule that mortgages should be granted on conditions that allow the borrowers to repay their loans without being locked in by unexpectedly large remaining debt. Therefore, fixed-rate mortgages are granted as callable loans. In other words, the borrower can meet his obligations by repaying the remaining debt.

In connection with the Act on Covered Bonds (SDOs), it was generally agreed that borrowers should still be able to meet their obligations by repaying the loan at par. This is called the par rule, and it enjoys broad support.

In the report on the statutory basis for SDO loans, the parties involved in the political accord specified that they expect SDO loans to be redeemable through purchase of the underlying bonds or at a price that does not deviate significantly from par. If there are no underlying bonds, the loan is to be redeemable at par. At the 2010 annual meeting of the Danish Mortgage Banks' Federation the Minister of Economic and Business Affairs stated that this rule will be preserved.

The Association of Danish Mortgage Banks attaches great importance to the par rule, which is also reflected in the Association's consultation response regarding SDO legislation from 28 January 2010:

"It is essential to preserve the par rule – also after an evaluation in 2012. The political support behind the par rule means that borrowers should also in future be protected against significant price increases, and that they should neither need to make requests nor negotiate the price with the mortgage-credit institute regarding prepayment of the loan. Moreover, it is crucial to stability in the Danish economy that borrowers can always, at reasonable costs, refinance into the loans that are best and least expensive in view of their financial position and obtain the refinancing gains arising from time to time."

Danmarks Nationalbank has, most recently in its consultation response from 23 November 2009 to the evaluation of the legislation on covered bonds, emphasised that the bond investor and not the borrower should be exposed to the current financial risks:

"Ahead of the evaluation and at the meeting mentioned above, Danmarks Nationalbank has expressed its wish that the so-called par rule be preserved. The long-standing stability of the Danish mortgage-credit system is based on the bond investor and not the borrower being exposed to the current financial risks. The borrower obviously has to pay for this security via higher current interest payments. Historical evidence shows that if borrowers do not have the option to redeem loans at par, they could subsequently find themselves in an unfavourable situation. Danmarks Nationalbank therefore attaches importance to the par rule being preserved."

Teaser loans
In recent years, product development for home financing has resulted in a new loan type. Initially the borrower's interest payments are low, but subsequently they rise in steps until the loan matures. This type of loan has been nicknamed teaser loans, because the borrower is tempted by the initial low interest rate. Such loans are offered in the USA, where they were a contributory factor behind the subprime crisis.

Thus, many US homeowners took out loans with teaser interest rates in the years leading up to the subprime crisis. It turned out that neither homeowners nor mortgage-credit institutes were capable of assessing the homeowners' financial positions relative to this loan type. In many cases the homeowners could not pay the rising mortgage instalments.

When house prices began to fall, they could not refinance their teaser loans into new loans, and the subprime crisis erupted.

In Denmark, this type of loan is, as far as can be determined, not offered to individual homeowners. However, if more homeowners form a cooperative housing society, they can take out a teaser loan.

Compared with a fixed-rate loan, the essence of the loan is that the borrower postpones interest payment until a later date. If a teaser loan is combined with deferred amortisation, quite substantial payments are postponed.

Of course, certain business considerations can make teaser loans a suitable choice. But the consequences should be analysed and assessed very carefully.

Teaser loans are non-callable loans with a high risk
When non-callable loans are granted as teaser loans, and possibly combined with deferred amortisation for a great number of years, the price sensitivity of the loan becomes very high. This means that falling interest rates lead to substantial price rises, implying price losses for the borrower, cf. Box 1.

example: price sensitivity of teaser loans	Box 1
The following is an example of a teaser loan granted to a cooperative housing society. The total loan amount is kr. 288 million. The interest-rate sensitivity appears from the lender's material: if interest rates decline by 1 per cent, the borrower will suffer a price loss of 19 per cent of the principal, totalling almost kr. 55 million. In comparison, the interest-rate sensitivity of a 30-year 5-per-cent callable loan is much lower. If interest rates decline by 1 per cent, the resulting price loss is 2.5 per cent or just over kr. 7 million. Chart 1 shows the interest profile of the teaser loan compared with a 5-per-cent fixed-rate loan.
teaser loan compared with a fixed-rate loan	Chart 1

Teaser loans are a combination of non-callable loans, which are not suitable for home financing, and loans with rising interest rates, which may tempt the borrower to take out excessive loans. The structure of the loan makes it difficult to understand the financial consequences, such as potential price losses if interest rates decline and the effect of rising debt service payments in future.

The risk on the loan lies in the interest-rate swap
It is not possible to take out the non-callable loans described above directly. Non-callable bonds are not issued at such long maturities. Therefore, the loans are designed by combining two products: an adjustable-rate mortgage loan and an interest-rate swap, cf. Box 2. While the mortgage-credit loan is taken out with a mortgage-credit institute, the interest-rate swap is entered into with a commercial bank, typically from the same financial group.

Interest-rate swap in teaser loans	Box 2
An interest-rate swap is an agreement between two parties to exchange interest payments. In a teaser loan, the borrower has taken out an adjustable-rate mortgage loan with a mortgage-credit institute, cf. Chart 2. Subsequently, the borrower agrees with a commercial bank, typically from the same financial group, that the bank pays the borrower an adjustable rate in return for which the borrower pays the bank a fixed rate that increases in steps. The borrower will then pass on the adjustable rate to the mortgage-credit institute and has thus restructured his adjustable-rate loan into a non-callable loan.
Illustration of interest payments on teaser loans	Chart 2
The fixed rate in an interest-rate swap is determined so that the present value of the adjustable rate and the fixed interest payment are identical. When the contract is concluded, the market value is therefore zero. If market rates decline, the market value of the swap will rise, reflecting a price loss for the borrower. When interest rates fluctuate strongly, the market value of the swap agreement will change significantly.

Falling interest rates may have a strong negative effect
As mentioned above, the market value of long-term, non-callable loans may rise and fall sharply. When a loan is designed as a combination of an adjustable-rate mortgage loan and a swap, the price fluctuations will stem predominantly from the swap. The price of the mortgage loan is typically quite stable. The reason is that it is an adjustable-rate loan, and the interest rate is therefore reset at relatively frequent intervals. The market value of the interest-rate swap, however, may become very negative for the borrower when interest rates decline and very positive when interest rates rise.

The commercial bank determines the price of the interest-rate swap
Ordinary mortgage-credit loans can always be redeemed at a known market price. This increases transparency. However, if a borrower wishes to redeem a teaser loan, it is not possible to find the market value in an official price list. The redemption price of an interest-rate swap depends entirely on the commercial bank's valuation.

An interest-rate swap agreement is, like any other financial contract, redeemable against payment. The price can turn out to be quite high.

concluding remarks

Loans that cannot be redeemed at par – non-callable loans – can be highly price-sensitive to interest rate declines. For long-term, non-callable loans, this can make it very burdensome to redeem the loan, for instance when the homeowner sells his house. Therefore, long-term, non-callable loans are not suitable for home financing.

Some, especially new, cooperative housing societies have taken out quite risky non-callable loans with rising interest payments. The structure of these loans makes it difficult to understand the financial consequences, such as potential price losses if interest rates decline and the impact of rising debt service payments. The reason is that the loans are typically designed as a combination of a loan and a financial agreement – an interest-rate swap. The complexity of the products therefore requires that both lenders and borrowers truly understand the risks associated with this type of loan.

LITERATURE

Danmarks Nationalbank (2009), Evaluation of covered bonds – Analysis of consumers' home financing options and competitive conditions, consultation response to the Ministry of Economic and Business Affairs, 23 November (in Danish only)

Trade and Industry Committee of the Danish Parliament (2007), Report on proposals for the Act to Amend the Financial Business Act and various other legislation (covered bonds), Report, 22 May (in Danish only).

Association of Danish Mortgage Banks (2010), The Association of Danish Mortgage Banks comments on a report on evaluation of the Act on Covered Bonds, press release, 28 January (in Danish only).

Ministry of Economic and Business Affairs (2010), Basis for speech by Brian Mikkelsen, Minister of Economic and Business Affairs, at the annual meeting of the Danish Mortgage Banks' Federation, 24 March (in Danish only).