Legislation and security
In Denmark, covered bond issuance is governed by the Danish Mortgage-Credit Loans and Mortgage-Credit Bonds etc. Act and the Danish Financial Business Act and a number of executive orders on, for example, ALM and property valuations, which lays down the framework for the lending and funding activities of Danish mortgage banks. The main purpose of such legislation is to ensure a high level of security for investors in relation to covered bond investments.
The legal and institutional framework has in many ways been the recipe for efficiency and success within Danish mortgage banking and is probably the foremost reason for the long and unblemished history of specialised lending in Denmark dating back to 1850.
Danish legislation was last amended in the summer of 2007, in part to ensure the continuous eligibility of Danish mortgage bonds as covered bonds under the stricter CRD definition.
The Danish mortgage banks and commercial banks are subject to supervision of the Danish Financial Supervisory Authority (DFSA).
The Danish mortgage finance system is generally considered to be very safe when it comes to the ability of issuers to meet their obligations against bondholders, and no Danish mortgage bank has ever been declared bankrupt.
Nykredit and Totalkredit's bonds are characterised by a high degree of security as a result of both the Danish mortgage finance legislation and Nykredit's credit policies. The ratings assigned by Standard & Poor's directly reflect the security of the bonds. The Danish market is generally characterised as an AAA mortgage bond market and all newly issued bonds in Nykredit and Totalkredit are AAA-rated.
The security behind Danish covered bonds rests on the following:
- Bonds are primarily issued against mortgages on real property within specified LTV limits.
- The DFSA supervises bond issuers' compliance with the regulatory framework.
- Continuous compliance with LTV limits. If property prices fall, issuers must provide additional collateral. This is a tightening compared with the previous rules, according to which compliance with LTV limits was only required at the time of loan disbursement.
- Specific requirements for regular independent valuation of the properties included in the cover pool.
- In case of the insolvency of an issuer, legislation provides for protection of investors' security in a capital centre or cover register. In principle, investors are therefore unaffected by the insolvency of an issuer, provided that the cover pool contains sufficient assets.
- Mandatory overcollateralisation (only applicable to mortgage banks).
- Strict requirements for asset/liability management (balance principle). The balance principle ensures that issuers can assume only very limited market risk in the form of interest rate risk, foreign exchange risk, option risk and liquidity risk.
Danish covered bonds are issued as either ROs, SDOs or SDROs. RO denotes mortgage bonds issued under the preceding legislation. The main difference between SDROs and SDOs is that only mortgage banks may issue SDROs. Furthermore, the eligibility criteria for SDO cover assets are slightly more comprehensive.
Investors in covered bonds have a preferential claim against all cover assets in case of the insolvency of the issuer. Bondholders rank pari passu with derivatives counterparties provided the derivatives contracts are concluded for the purpose of hedging market risk. Cash flows to derivatives counterparties and bondholders must remain unaffected by the insolvency of the issuer. Accordingly, derivatives counterparties are not entitled to demand termination of the contracts in case of insolvency, just as payments cannot be accelerated.
One of the main principles is the balance principle, which implies that all lending is funded through the issuance of bonds and that the repayments on the loans and the payments to the bondholders must always be balanced. This balance between funding and lending eliminates the interest rate, liquidity and currency risks relating to the mortgage bank balance sheets.