A proposal for conditional extension of some Danish covered bonds is a “step in the right direction” but does not fully eradicate mortgage banks’ refinancing risk, S&P said today (Wednesday), and an issuer said the rating agency’s intervention could be helpful.

The rating agency said that changes to Denmark’s mortgage covered bond legislation proposed by the country’s authorities would alleviate S&P’s “immediate” concerns about mortgage banks’ refinancing risk, but do not neutralise what S&P perceives as “substantial, albeit latent” default risk in the event of market disruption given banks’ heavy reliance on short term funding.

“If the law is enacted as drafted, we consider that it won’t fully address the fundamental issue of the annual refinancing of a large portion of the covered bond market,” said S&P. “The law, as we understand it, will not discourage the use of short term [one year] F1 mortgage loans.

“Therefore mortgage lenders’ dependence on short term liabilities will remain high, perpetuating the status quo. What’s more, the proposed extension of mortgage covered bonds’ maturity dates, in effect, passes the role of lender of last resort from the central bank to investors.”

The proposed amendment does, however, address S&P’s immediate concerns about refinancing risk, because it extends mortgage lenders’ short term liabilities if there is market stress, said the rating agency.

“Specifically, we understand it virtually eliminates Danish mortgage banks’ default risk from a failed mortgage covered bond auction,” it said. “In addition, the draft legislation provides investors with a clear framework for how the authorities will deal with failed bond refinancing, and this will be included in new bond documentation.”

A key feature of the Danish mortgage model is the balance principle, and in part because of this a large proportion of Danish mortgages are funded by adjustable-rate mortgage (ARM) bonds that mortgage banks have to refinance annually, mostly at refinancing auctions.

The system has come under increasing scrutiny in recent years, including from Denmark’s central bank, with S&P’s view that it involves Danish mortgage banks incurring considerable refinancing risk having rating implications. In July, for example, S&P revised the rating outlooks on several Danish mortgage banks downward because it considers them to have a comparatively large asset-liability mismatch.

Various initiatives have been launched to address the issue of refinancing risk, with the latest being a proposal by the Danish government to amend the country’s mortgage bond legislation to provide for the conditional forced maturity extension of ARM bonds in certain stressed scenarios.

Under the proposal, the maturity date of ARM bonds would be automatically extended by one year in the event of a failed refinancing auction or, for bonds with terms of up to three years, if the coupon rate increased by more than 5% compared with the coupon the previous year.

In early November S&P said that the proposed change would be credit neutral for covered bonds. In its comment today the rating agency said it was responding to frequently asked questions from investors about the credit implications of the Danish authorities’ plan, and also addressing other issues raised by the draft legislation.

It noted that although it does not consider that implementation of the law would result in a major shift in the composition of investors’ portfolios, “the conversion of mortgage covered bonds to soft bullet maturity may cause certain international investors to leave the market”.

This could be because of policy restrictions on investing in extendible bonds, it said, noting that the share of international investors, at about 18% of the nominal volume of outstanding bonds, is at an all-time high.

An official at a Danish mortgage bank rated by S&P today downplayed the rating agency’s comments, saying that it did not contain anything new, and said he preferred not to comment given that the government’s proposal is still under discussion.

An official at another issuer also noted that the draft legislation is a work in progress, with the timeline for the progression of the bill having been revised just this past Thursday.

He said that S&P’s comment was not surprising in terms of it not being fully satisfied by the draft legislation in its current form.

“The comments from S&P could be helpful in order to change the wording of the current bill,” he said.