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Why Interest-Only Loans Could Still
Destabilize Denmark's Mortgage
Market
Primary Credit Analyst:
Casper R Andersen, London (44) 20-7176-6757; [email protected]
Secondary Contact:
Roberto Paciotti, Milan (39) 02-72111-261; [email protected]
Table Of Contents
The Downside To Interest-Only Loans
Several Hurdles Remain
Still Too Soon To Sound The Alarm
Related Criteria And Research
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Why Interest-Only Loans Could Still Destabilize
Denmark's Mortgage Market
The popularity of interest-only (IO) mortgage loans in Denmark remains significant, due in part to preferential tax
treatment of interest costs. These loans comprised more than 50% of Denmark's total mortgage volume in 2013.
Introduced in 2003, IO loans typically have 10-year terms, which will start to run out this year. Further, the majority of
them (81%), taken out in 2008-2012, are set to expire in 2018-2022. A much-discussed topic within the Danish covered
bond market is how such a spike in IO expiries will affect borrowers' payment performance and house prices in an
already depressed housing market.
Standard & Poor's Ratings Services believes that IO loans could strain the recent fragile recovery of the Danish
mortgage market. Borrowers with high loan balances remain sensitive to changes in their personal circumstances and
risk being saddled with unaffordable properties that have lost value or are difficult to sell. This could eventually lead to
an increase in arrears and potential foreclosures in the coming years.
Overview
• In our view, the popularity of interest-only (IO) loans in Denmark, combined with falling house prices, has led
to an increase in loan-to-value (LTV) ratios.
• Breaches of the legal LTV limit on mortgages of 80% could push up the number of borrowers needing to
amortize mortgages in 2018-2022, when many IO loans expire, threatening the market's stability.
• However, we understand that mortgage borrowers may extend IO terms to the mortgage loan amount up to
the 80% regulatory LTV limit, which we believe could help reduce the risk.
In our view, several factors could reduce, if not neutralize, risks to the market. The most important of these is that
since our previous report on this topic in March, there has been clarification that IO loan periods may be extended for
the portion of mortgage loans equivalent to an LTV ratio lower than 80% (see "Interest-Only Loans Could Stabilize
Denmark's Mortgage Market," published on March 22, 2013, on RatingsDirect). This would require borrowers to pay
down only the amount above the 80% LTV, which remains manageable in our view. In addition, currently subdued
house prices could increase, and households generally have large pension assets that, if released, could help borrowers
reduce debt. We believe that there is currently little incentive for borrowers to amortize their mortgages.
The Downside To Interest-Only Loans
IO loans typically account for the full or partial balance of mortgage loans for residential property in Denmark.
Mortgage loans normally have terms of up to 30 years, including a maximum IO period of 10 years, and they usually
require borrowers to amortize the loan over 20 years following the 10-year IO period.
Compared with more traditional mortgage repayment types, we generally consider IO loans to be a riskier borrowing
method. Because such loans don't amortize, LTV ratios remain higher than for other loan types, which we believe
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Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market
increases the risk of default (see chart 1).
Chart 1
House prices in Denmark have fallen in recent years, so if a property needs to be sold before the end of the IO period,
the proceeds may be insufficient to fully repay the mortgage loan. This may lead to a loss for the lender if a forced sale
is required, or bind the borrower to an unwanted property. Therefore, low house prices and generally higher LTV
ratios than when many mortgage loans were granted will require borrowers to amortize the debt to achieve an LTV
ratio that allows them to remortgage. We believe borrowers facing such a situation would likely be less willing to make
future mortgage payments, potentially resulting in increased arrears and foreclosures.
Mortgage loans in Denmark generally have long maturities, which we believe may minimize the risk of a payment
shock because borrowers don't need to fully repay the loan when the IO period expires. We generally believe that
longer loan periods provide borrowers with sufficient time to manage the change in payments.
Several Hurdles Remain
Given the significant popularity of IO loans since 2007, a substantial number of them are due to expire in 2018-2022
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Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market
(see chart 2), which we believe poses risks for the general mortgage market. We base this conclusion on a sample of
loans from four of the largest Danish covered-bond issuers as of the second quarter of 2013 (for details see the box
titled "S&P's Survey Of Interest-Only Loan Characteristics In Denmark").
Chart 2
Standard & Poor's main concerns relate to the LTV ratios. The loan amounts and average LTV ratios are higher for IO
borrowers in all the covered-bond capital centers in the sample. Moreover, we note that due to continuously declining
Danish house prices, the gap between average LTV ratios based on original valuations and those based on more recent
valuations has widened since our last report. The divergence remains most prominent for loans maturing between
2017 and 2022. There is a clear link between the highest LTV ratios--based on current valuations--and IO loans
needing to be refinanced between 2017 and 2020 (see chart 3).
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Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market
Chart 3
Moreover, the data as of June 30, 2013, indicate that the LTV ratios of loans maturing in 2014-2016 are trending
upward, although overall numbers of loans with LTVs higher than 80% remain low relative to the total market size.
Loans that need refinancing in 2013 generally still appear to benefit from the increase in house prices before the
market slumped, and we don't expect those borrowers to struggle to obtain other financing in the short term. Because
average LTV ratios do not allow a separate evaluation of loans with very high LTV ratios, we have extracted data on
loans in our sample with LTV ratios greater than 80% that mature between 2013 and 2022.
We note an increasing number of loans that, based on current valuations, will breach the 80% LTV ratio limit set out in
Danish law (see chart 4). A breach would require the borrower to repay the amount that exceeds the 80% as soon as
the IO loan period expires. The majority of such loans mature in 2020-2022, suggesting that both borrowers and
lenders of IO loans granted in 2010-2012, in particular, need to consider amortizing well in advance to address the
potential increase in mortgage payments.
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Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market
Chart 4
Breaches of LTV ratios are likely to cause a considerable increase in the number of borrowers needing to amortize
their mortgages to be able to sell the property or obtain other types of financing. This in turn could put a strain on
demand for properties and keep house prices subdued. Furthermore, the percentage of borrowers with loans that have
LTV ratios higher than 80% will likely continue to accumulate in the coming years (see charts 5 and 6).
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Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market
Chart 5
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Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market
Chart 6
That said, our analysis also indicates that the number of loans at risk will likely be relatively low at about 4% of total
outstanding loans in 2017, but this shows an increase from our previous forecast of 2.7%. We also note that these
numbers reflect only loans with an LTV ratio higher than 80%, regardless of the severity of the breach, and that LTV
ratios are based on current house prices. From our calculations, overall, each borrower currently in breach would need
to amortize approximately--Danish krone (DKK) 230,000 on average--of outstanding debt in order to reach an average
LTV of 80%.
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Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market
S&P's Survey Of Interest-Only Loan Characteristics In Denmark
To estimate the number of borrowers that could be affected when IO loans expire, we have analyzed loans from
four of the largest Danish covered-bond issuers as of June 30, 2013. The sample covers the six largest capital
centers and consists of 1,060,115 residential loans totaling DKK1,170 billion (about €156.8 billion), of which
564,456 (DKK711 billion) are reported as IO loans (see table).
We have focused on residential mortgage loans because we expect the challenges of high LTVs to be greater for
private borrowers than for commercial borrowers. This is because we generally share the market's perception
that commercial borrowers are more familiar with the IO loan product, have better access to alternative funding,
and are better prepared to adjust to a change in payments. We reflect this in our covered bond rating analysis,
where we treat the risk profiles of residential and commercial loans differently (see "Methodology And
Assumptions For Analyzing Mortgage Collateral In Danish Covered Bonds," published on May 2, 2012).
Of the mortgage loans in our sample, 60.78% have IO features, which is above the market average of 53% and
slightly lower than the 61.87% we determined for the previous report. This is mainly due to the inclusion of
Nykredit Realkredit's Capital Centre H and Realkredit Danmark's Capital Centre T in the sample, which have a
proportionally high share of IO loans compared with the market average. We included these two capital centers
to allow for as many IO loans as possible in our analysis, enabling a more thorough review of IO loan
characteristics. We have not included legacy capital centers that are not actively issuing covered bonds because
they have comparably low levels of IO loans. Had we done so, the percentage of IO loans in our sample would be
closer to the market average of 53.75%.
We base our conclusions on the assumption that most IO loans have 10-year terms because we observe that
30-year mortgage loans in Denmark typically comprise an IO period of up to 10 years. However, we understand
that some IO loans are for less than 10 years. Also, following general market practice, an IO loan is granted only
if the borrower can afford to amortize the debt at a fixed rate of interest prevailing at the time the loan is agreed.
Danish Mortgage Loans--Sample Breakdown
Percentage of total
sample (%)
Percentage of interest-only
sample (%)
Percentage of total
sample (%)
Percentage of interest-only
sample (%)
Nykredit H
26.40
31.52
24.54
28.37
Nykredit E
19.48
16.82
22.67
19.06
Realkredit
Danmark S
12.86
9.63
16.52
14.94
Nordea Kredit 2
18.02
17.37
16.41
16.85
Realkredit
Danmark T
17.11
18.55
13.87
15.14
6.12
6.11
5.99
5.64
Capital center
BRF Kredit E
Still Too Soon To Sound The Alarm
In our view, the current debate surrounding the effects of IO loan expiry periods not only reflects Denmark's long
tradition of active market discussion, but suggests there may be timely solutions for the IO dilemma. For instance,
since our last report in March this year, market participants have implemented several possible solutions to make IO
loans less attractive to home buyers, such as higher pricing and LTV limitations. This should reduce the number of
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Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market
loans expiring in any one year. In addition, it has been clarified that extending IO periods for portions of loans
corresponding to an LTV lower than 80% will be possible for the majority of mortgages.
Nevertheless, in our opinion, such measures often fall short of addressing the underlying problem of high LTV ratios
and a less liquid property market. Also, should house prices continue to decrease and we see LTV ratios increasing
further, we would consider revising our credit assumptions, which could increase our target overcollateralization levels
for the cover pools of Danish covered bond issuers.
In August 2013, the government-appointed "Rangvid" committee, to investigate the causes and consequences of the
financial crisis in Denmark, put some of the blame on banks' lax origination standards for IO mortgages. Additionally,
the Danish Financial Supervisory Authority has been commissioned to develop new review standards specifically for
mortgage lending, and will likely introduce caps IO mortgages, among other measures.
Several borrowers in our sample are technically insolvent and may experience arrears and defaults due to changes in
their personal circumstances; however, although the magnitude of the current LTV-ratio breaches has increased since
our last review, it remains manageable, in our opinion. We estimate that IO loans breaching the 80% LTV ratio,
according to current valuations, do so by an average of 17.6% (lowest center: 14%, highest center: 18.99%), up from an
average of 11.4%. However, compared with the overall amount of outstanding loans, the total is only about 4%. In
addition, while house prices remain depressed, the market is showing signs that they may yet increase in the future.
Overall real wage growth could also mitigate the risk of IO periods expiring between 2017 and 2022.
Finally, Danish borrowers generally have large holdings of pension savings assets, which, if made accessible, could
help borrowers pay down excess debt. Still, politicians as well as mortgage lenders should be aware that given
currently low interest rates, tax incentives, Denmark's weak economy, and weakening house prices, the solution to the
rising LTV ratios we have observed isn't likely to come from borrowers because incentives to amortize debt remain
limited. In addition, despite recent initiatives to dampen IO loan growth, our analysis shows that the overall risk
picture has deteriorated somewhat, because the number of IO loans breaching the 80% LTV limit, as well as the
magnitude of that breach, has increased since the second quarter of 2012.
Related Criteria And Research
• Interest-Only Loans Could Stabilize Denmark's Mortgage Market, March 22, 2013
• Covered Bond Ratings Framework: Methodology And Assumptions, June 26, 2012
• Methodology And Assumptions For Analyzing Mortgage Collateral In Danish Covered Bonds, May 2, 2012
Additional Contact:
Covered Bonds Surveillance; [email protected]
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