Moody’s cut the ratings of several Danish financial institutions and related covered bonds late yesterday (Wednesday), with risks resulting from the issuers’ reliance on wholesale funding cited as one of two major weaknesses.

The rating agency said that a first driver of the financial institutions’ downgrades was a combination of a difficult operating environment, weakening asset quality and low profitability, then went on to detail its concerns about their reliance on market funding. It said it sees this as a weakness because it leaves the Danish financial institutions vulnerable to potential sudden changes in investor sentiment.

“Moody’s recognises the historical stability of the Danish covered bond market, on which many domestic financial institutions rely, directly or indirectly, for large parts of their funding,” it said. “However, Moody’s is increasingly concerned by the dependence of Danish institutions on the uninterrupted functioning of that market, particularly given changes to its structure that increase refinancing risk.”

The rating agency said that there has been a shift from long term issuance that matched mortgage duration to covered bonds of shorter maturities to fund adjustable rate mortgages (ARMs).

“The maturity mismatch between long term mortgages and the covered bonds funding them raises issuers’ exposure to refinancing risk very significantly,” said Moody’s. “This is a credit negative, as refinancing risk has materialised repeatedly in global funding markets over the course of the financial crisis, even for ostensibly reliable and resilient sectors.”

This meant that Moody’s downgrades were harsher for specialised mortgage lenders than for other Danish banks, with the rating agency saying that they would struggle to access alternative funding sources in a funding stress scenario given a “near complete” reliance on covered bonds.

“Furthermore, most Danish covered bonds require additional collateral to be provided if the market value of existing collateral falls,” added Moody’s. “However, specialised issuers possess limited unpledged assets and may need recourse to unsecured markets or to support from Danmarks Nationalbank in a stress scenario.

“In addition, we recognise that covered bonds play a central role in Denmark, amounting to Dkr2.4tr, or approximately135% of GDP, at year-end 2011. They are widely issued by financial institutions who also hold them as liquid assets. Any issuer-specific problem would therefore likely spread and affect other institutions.”

The rating agency also said that uplift to reflect government support for financial institutions is lower than in other European systems given that the country’s bail-in framework.

Moody’s cut Danske Bank and Finnish subsidiary Sampo from A2 to Baa1, Nykredit Realkredit from A2 to Baa2, and DLR Kredit from Baa1 to Ba1.

Nykredit said on 13 April that it had requested Moody’s cease rating the group and its issuance.

“The cooperation has been satisfactory for several years, but due to Moody’s volatile view of the Danish mortgage industry in recent years – despite the low loan loss and arrears ratios by international standards – the significance of the ratings to Nykredit and to Nykredit’s investors has diminished significantly,” it said.

Danske subsidiary Realkredit Danmark and BRFkredit last year ceased having their covered bonds rated by Moody’s.

Covered bonds issued out of six of Nykredit’s capital centres were cut by Moody’s by between one and three notches:

• Nykredit Capital Centre H; downgraded to A1; previously Aa1 on review for downgrade
• Nykredit Capital Centre D; downgraded to Aa3; previously Aa1 on review for downgrade
• Nykredit General Capital Centre; downgraded to Aa2; previously Aa1 on review for downgrade
• Nykredit Capital Centre E; downgraded to Aa2; previously Aaa on review for downgrade
• Nykredit Capital Centre G; downgraded to A3; previously Aa3 on review for downgrade
• Totalkredit Capital Centre C; downgraded to Aa1; previously Aaa on review for downgrade

Nykredit junior covered bonds issued out of capital centres E and H were also cut, from A2 to Baa2. Covered bonds issued out of capital centre C were affirmed at Aa1.

Covered bonds backed by Danske Bank’s I and D pools were cut from Aaa to Aa1, on review for downgrade, after Danske was downgraded to Baa1.

The covered bonds have a Timely Payment Indicator (TPI) of “probable”, meaning that they can be rated up to six notches higher than the issuer rating under Moody’s methodology, and the issuer downgrade lowered the maximum achievable rating of the covered bonds, resulting in their downgrade. At Aa1, the covered bond rating incorporates the maximum uplift, meaning that they could be cut if the issuer is downgraded, all other variables being equal.

Moody’s said that the covered bonds are on review for downgrade pending actions from Danske to implement “committed” OC. It said that although OC was sufficient as of the last reporting date to offset an increase in Moody’s expected loss on the covered bonds resulting from the issuer downgrade, this is not considered “committed” and the rating agency limits the value of OC that is considered “voluntary” because it can be removed at the issuer’s discretion.

“In its continued review of the covered bonds Moody’s will assess whether there will be sufficient ‘committed’ OC available to support the covered bond ratings,” it said.

Moody’s said that an analysis showed that if “committed” OC is not provided, its expected loss analysis would indicate ratings of Aa2 for Danske’s D covered bonds and Aa3 for the I covered bonds.

DLR Kredit covered bonds issued out of capital centre B and its general capital centre were cut from Aa1 to A2, after DLR’s issuer rating was cut to Ba1. The covered bonds’ ratings are constrained by the issuer’s Ba1 rating and a TPI of “probable high”, meaning that they could be cut if the issuer is downgraded further.

Moody’s said that its new minimum OC levels consistent with the A2 covered bond ratings are 12.5% for capital centre B and 6% for the general capital centre.

“The in-place OC in both capital centres is consistent with the newly positioned ratings and Moody’s notes that DLR provides 10.5% OC in ‘committed’ form,” said the rating agency.