Abstract
This 2013 Article IV Consultation examines the performance of Sweden’s fiscal policies to counter effects of global financial crisis. Economic growth in Sweden has been moderate since global financial crisis of 2008–2009. The IMF report posits that with potential growth moderately weaker and the natural rate of unemployment to remain elevated, policies should focus on growth-enhancing reforms, especially in the labor market. It suggests that good policies that secure the soundness of Swedish international banking groups are expected to benefit borrowers not only in Sweden but across the region.
III. Covered Bonds and Financial Stability1
Covered bonds have been increasingly used by Swedish banks since 2006, and the total outstanding amount currently represents more than ½ of Swedish GDP. Their use has enhanced financial stability through several channels (e.g. longer funding maturity, better incentives to bank issuers, and a broader appeal to global investors). However, their extended use could also increase liquidity risks and government contingent liabilities.
A. The Use of Covered Bonds in Sweden
1. Unlike traditional bonds, covered bonds assure holders a priority claim to specially selected collateral in the so-called cover pool. A covered bond is a claim on the issuing institution, where if the issuer is not able to meet its obligations, the holder of the bond has priority to specially-selected collateral. Covered bonds differ from traditional mortgage bonds in four main aspects: (i) they are governed by a well-defined regulatory framework that ensures that the cover pool is of high quality (e.g., in Sweden, as detailed in Table 1, this is a function of maximum Loan to Value (LVT) ratios, maximum share of riskier assets, etc.);2 (ii) the cover pool is dynamic; (iii) the holder of covered bonds has seniority on the cover pool if the issuing institution suspends payments; and (iv) credit risk remains on the balance sheet of the institution that issued the covered bond.
Mortgage Loans that can be Included in the Cover Pool
(Percent)
Mortgage Loans that can be Included in the Cover Pool
(Percent)
| Type of Collateral | Highest Loan-to- Value Ratio | Maximum Share of the Cover Pool |
|---|---|---|
| Mortgage loans for housing purposes | 75 | 100 |
| Mortgage loans in property for agricultural purposes | 70 | 100 |
| Mortgage loans in property for commercial purposes | 60 | 10 |
| Public loans to local or central government | 100 | 100 |
| Complementary collateral, such as liquid claims on central and local government | 100 | 20 |
Mortgage Loans that can be Included in the Cover Pool
(Percent)
| Type of Collateral | Highest Loan-to- Value Ratio | Maximum Share of the Cover Pool |
|---|---|---|
| Mortgage loans for housing purposes | 75 | 100 |
| Mortgage loans in property for agricultural purposes | 70 | 100 |
| Mortgage loans in property for commercial purposes | 60 | 10 |
| Public loans to local or central government | 100 | 100 |
| Complementary collateral, such as liquid claims on central and local government | 100 | 20 |
2. Swedish banks started issuing covered bonds in 2006 and they now represent more than ½ of Swedish GDP. The first Swedish covered bonds were issued in 2006 by 3 institutions, and since 2008, 7 approved banks have issued them on the Swedish market. The volume of covered bonds increased rapidly over the years, and they represent more than EUR 200 billion as of 2011 (see Figures 1 and 2). Only Denmark, where covered bonds represent about 150 percent of GDP, has a larger exposure to this type of funding.
Swedish Covered Bond
(EUR billion)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: European Covered Bond Council and Fund staff calculations.
Swedish Covered Bond
(EUR billion)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: European Covered Bond Council and Fund staff calculations.Swedish Covered Bond
(EUR billion)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: European Covered Bond Council and Fund staff calculations.
Largest Covered Bond Markets, 2011
(LHS: EUR billion; RHS: Percent of GDP)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: European Covered Bond Council and Fund staff calculations.
Largest Covered Bond Markets, 2011
(LHS: EUR billion; RHS: Percent of GDP)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: European Covered Bond Council and Fund staff calculations.Largest Covered Bond Markets, 2011
(LHS: EUR billion; RHS: Percent of GDP)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: European Covered Bond Council and Fund staff calculations.3. About one-quarter of covered bonds are issued in foreign currency. To avoid the undesirable effects of exchange rate fluctuations, banks cover the risks associated with lending in Swedish kronor through currency swaps. This avoids liquidity risks in foreign currency but opens the door to rollover risks on these swaps arrangements since they have shorter duration than mortgages.
Currency Composition of Outstanding Covered Bonds
(Percent)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: ECBC and Fund staff calculations* Covered bonds issued in DKK, SEK and NOK.
Currency Composition of Outstanding Covered Bonds
(Percent)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: ECBC and Fund staff calculations* Covered bonds issued in DKK, SEK and NOK.Currency Composition of Outstanding Covered Bonds
(Percent)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: ECBC and Fund staff calculations* Covered bonds issued in DKK, SEK and NOK.B. Implications for Financial Stability
4. The use of covered bonds could increase financial stability through a number of channels:
Longer funding duration: Covered bonds are issued at fixed longer-term periods than traditional bonds (but still below a standard mortgage in Sweden). This improves asset-liability management by adding funding certainty as compared with many other asset backed structures.
Larger appeal for bond holders: The demand of covered bonds is greater than for traditional bonds due to their secured nature and preferential weighting for banks’ liquidity requirements (e.g. Basel III allows covered bonds as “Level 2” assets, and they have only 15 percent haircut for the purposes of calculating the Liquidity Coverage Ratio).3 This higher demand usually translates into lower spread on covered bonds, reducing banks’ funding costs. More generally, in distressed markets, covered bonds can also offer a safe alternative to government bonds in conditions when investors demand more safety and there is an overall lack of safe assets.
Better incentives for originators: Issuer and investor interests are better aligned as the issuer retains the credit risk of the assets in the cover pool. Unlike mortgage-backed securities, the bank issuer retains a 100 percent interest in the asset pool of a covered bond, forcing banks to focus on credit quality. Moreover, there are also additional measures to reduce credit risks in the covered bond framework (e.g., incentive for prudent loan origination due to loan-to-value limits, credit risk assessment of the pools, and the external monitoring of loan performance).
5. At the same time, the use of covered bonds could have a negative impact on financial stability:
Crowding out of unsecured creditors: uninsured depositors and other creditors may be less willing to make unsecured loans to banks, which have pledged a large part of the assets as collateral.
Concentration risks: banks could replace third party bonds they hold with mortgage covered bonds issued by other parts of their group (e.g., they own mortgage companies). This could increase risks because banks and their mortgage operations will have increased exposures to the same clients.
Increase liquidity risks: A large portion of low-risk assets being pledged as collateral would decrease banks’ future access to liquidity. Uncollateralized assets constitute unused liquidity buffers for banks, which can be used for unexpected liquidity needs such as those from committed credit lines or margin calls related to derivatives.
C. Potential Impact of a Sharp Reduction in House Prices
6. A downward correction of house prices would trigger losses on bank lending but they could be absorbed by existing bank buffers. As discussed in the Nordic Regional Report (NRR) 2013 and Riksbank stress tests (see Sveriges Riksbank (2011)), Swedish banks’ capital buffers would likely be sufficient to deal with the direct impact of lower house prices on their credit portfolio, assuming that historic parameters remain stable. Mortgage lending in Sweden has historically exhibited both low default rates and low loss–given-default rates due to the loans being contracted mostly for primary residences amidst full recourse from lenders, generous and reliable social benefits, and stable (and up to recent years increasing) housing prices.
7. However, house price corrections could occur simultaneously with large increases in banks’ funding costs that could trigger additional losses if these increases cannot be passed through to borrowers. Four channels related to covered bonds are analyzed: (i) Non-linear increases in overcollateralization needs; (ii) higher rollover risks; (iii) increasing risks for unsecured creditors; and (iv) impact of larger contingent liabilities on government funding costs.
Non-linear increases in overcollateralization needs
8. Bank funding costs could be further accelerated by banks’ needs to increase overcollateralization when the decline in house prices substantially increase loan-to-value ratios of existing mortgages. The amount of collateral that banks have to find to replenish cover pool overcollateralization levels might increase faster, and at increasing speeds, than the decrease in house prices given the current loan-to-value distribution of mortgages (see Box 1 for more details).
Higher rollover risks
9. A decrease in house prices could affect Swedish banks’ capacity to roll over foreign-currency-denominated covered bonds and currency swaps. A sharp fall in house prices could lead investors to start questioning how the liquidity and price of covered bonds may come to be impacted. This type of rollover risk could also extend to currency swaps, which are used to hedge the risks of lending in domestic currency part of the wholesale foreign currency borrowing.
How would a drop in House Prices affect Banks’ Overcollateralization Needs?
The impact of a reduction in house prices on covered bond markets would depend primarily on the LTV ratios of the loans in the cover pool, the degree of overcollateralization in the cover pool, and the availability of liquidity or substitute collateral to the banks.
To illustrate this effect, we use data on the distribution of LTV ratios from Sweden’s Financial Supervisory Authority (FSA). According to the FSA 2013 Report on the Swedish Mortgage Market, the average LTV ratio of banks’ mortgage loan portfolio amounts to approximately 64 percent (see Figure), whereas the LTV ratio of new loans is about 70 percent.1
Sweden: Mortgage Loans by Loan to Value Ratio
(Percent, 2012)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Source: Sweden FSA.
Sweden: Mortgage Loans by Loan to Value Ratio
(Percent, 2012)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Source: Sweden FSA.Sweden: Mortgage Loans by Loan to Value Ratio
(Percent, 2012)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Source: Sweden FSA.Taking the midpoint of each LTV category in the 2012 distribution of mortgages, and using the maximum LTV ratio of 75 percent allowed in the collateral pool for household mortgages, it is possible to estimate the change in the number of mortgages fully eligible in the collateral pool. The Table below summarizes these results for price falls of 10, 20, 30, and 40 percent. For example, 38 percent of mortgage loans will not meet the 75 percent threshold for being fully included in the cover pools if house prices fall by 10 percent. Instead, this ratio would increase to 78 percent with a 20 percent house price drop (the midpoint LTV of the 51–75 LTV bucket is now above 75 percent).
Impact of House Price Declines on the Distribution of Mortgage LTV ratios
(Percent)
Impact of House Price Declines on the Distribution of Mortgage LTV ratios
(Percent)
| Loan to Value Ratio Category | Distribution | Assume LTV at Midpoint of Category Before Shock | After 10 percent decline in house prices | After 20 percent decline in house prices | After 30 percent decline in house prices | After 40 percent decline in house prices |
|---|---|---|---|---|---|---|
| 0 − 25 percent | 5 | 12.5 | 13.9 | 15.6 | 17.9 | 20.8 |
| 26 − 50 percent | 17 | 38 | 42.2 | 47.5 | 54.3 | 63.3 |
| 51 − 75 percent | 40 | 63 | 70.0 | 78.8 | 90.0 | 105.0 |
| 76 − 85 percent | 27 | 80.5 | 89.4 | 100.6 | 115.0 | 134.2 |
| > 85 percent | 11 | 92.5 | 102.8 | 115.6 | 132.1 | 154.2 |
| Percentage of Mortgage Loans not meeting 75 percent LTV threshold | 38 | 38 | 78 | 78 | 78 | |
| Total | 100 |
Impact of House Price Declines on the Distribution of Mortgage LTV ratios
(Percent)
| Loan to Value Ratio Category | Distribution | Assume LTV at Midpoint of Category Before Shock | After 10 percent decline in house prices | After 20 percent decline in house prices | After 30 percent decline in house prices | After 40 percent decline in house prices |
|---|---|---|---|---|---|---|
| 0 − 25 percent | 5 | 12.5 | 13.9 | 15.6 | 17.9 | 20.8 |
| 26 − 50 percent | 17 | 38 | 42.2 | 47.5 | 54.3 | 63.3 |
| 51 − 75 percent | 40 | 63 | 70.0 | 78.8 | 90.0 | 105.0 |
| 76 − 85 percent | 27 | 80.5 | 89.4 | 100.6 | 115.0 | 134.2 |
| > 85 percent | 11 | 92.5 | 102.8 | 115.6 | 132.1 | 154.2 |
| Percentage of Mortgage Loans not meeting 75 percent LTV threshold | 38 | 38 | 78 | 78 | 78 | |
| Total | 100 |
Since a mortgage with a LTV ratio above 75 percent can be included in the cover pool only up to the legal threshold, the reduction in eligible cover pool collateral would be a function of both the magnitude of the decline in house prices and their impact on mortgages’ LTVs. Assuming the composition of cover pools is similar to the FSA 2013 distribution of LTV ratios, the adjacent Figure shows the reduction in eligible collateral under different house price declines. The impact of a drop in house prices on the eligible cover pool is non-linear. While a 10 percent reduction in house prices reduces the eligible pool by about 5 percent, a 30 percent drop in house prices triggers a reduction in eligible collateral of about 21 percent. Since many mortgages initially have a below 75 percent LTV ratio, the larger the fall in house prices, the larger the proportion of mortgages that will exceed the maximum limit for LTV. Even though these rough calculations should be taken with caution (e.g. the midpoint of each LTV category is used due to lack of full mortgage distribution data), they highlight the potential impact of the dynamic characteristics of cover pools. If collateral does not fully satisfy the required standards, at least a fraction is removed from the cover pool and has to be replaced or, if not replaced, existing overcollateralization (if any) can be used as a buffer. In this context, if sharp falls in house prices materialize, banks’ funding costs could increase due to either the need to replenish cover pools or to the drop in overcollateralization levels—in case they are large enough—triggering rating downgrades in covered bonds (high overcollateralization is often cited by credit rating agencies when giving high ratings, see Bakke et al. (2010)).
Estimated Reduction in Eligible Cover Pool due to Drop in House Prices
(Percent)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: Sweden FSA and Fund staff calculations.
Estimated Reduction in Eligible Cover Pool due to Drop in House Prices
(Percent)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: Sweden FSA and Fund staff calculations.Estimated Reduction in Eligible Cover Pool due to Drop in House Prices
(Percent)
Citation: IMF Staff Country Reports 2013, 277; 10.5089/9781484382554.002.A003
Sources: Sweden FSA and Fund staff calculations.Increasing risks for unsecured creditors
10. The fall in house prices would shift further risks to unsecured creditors. The risks faced by unsecured creditors, including uninsured depositors, increases with lower house prices since fewer assets will be left for them in the event of a bankruptcy. This is because the dynamic collateralization feature of covered bonds effectively leads to a dynamic subordination of unsecured creditors. This increase in risks could trigger sharp increases in funding costs (or even a sudden stop in unsecured funding flows) especially if the value of implicit government support are perceived to be low.
Impact of larger contingent liabilities on Government funding costs
11. The increase in contingent government liabilities could even drive up sovereign risk premiums if the fall in house prices are very large. Unlike (or to a lower extent than) other unsecured investors, insured depositors do not price in the increased risk at default that may result from large levels of covered bonds and house price declines. The distortion created by the fact that neither depositors nor banks are sensitive to risks could open the door to large costs to the deposit insurance scheme (and the government) in the case of bank failures.4,5
D. Conclusion
12. Although covered bonds have many advantages, this form of secured funding could shift risks to unsecured creditors and tax-payers via government contingent liabilities. The level of covered bonds could reach levels where even small declines in house prices could trigger important non-linear effects. Against the background of subordination, several countries have established covered bond issuance limits as percentages of total assets/liabilities (in Canada, Australia, New Zealand, US, among others) or as a function of the capital ratio of each bank (e.g., Italy). In this context, another measure that would incentivize banks to internalize the risks of increasing volumes of covered bonds is to make deposit insurance premiums (charged to banks) a function of the size of collateral pools in bank balance sheets.
References
Bakke, Bjørn, Ketil Rakkestad, and Geir Arne Dahl, 2010, “Norwegian Covered Bonds – A Rapidly Growing Market,” Norges Bank, Economic Bulletin, 2010, Vol. 81, pages 4–19.
Juks, Reimo, 2012, “Asset Encumbrance and its Relevance for Financial Stablity,” Sveriges Riksbank Economic Review, pp. 1–23, 2012:3.
Nordic Regional Report, 2013, International Monetary Fund, August.
Sveriges Riksbank, 2011, “The Riksbank’s inquiry into the risks in the Swedish housing market.”
Finansinspektionen, 2013, “The Swedish Mortgage Market 2013” Sweden Finanical Supervisory Authority, Annual Report.
Prepared by Ruchir Agarwal (EUR) and Eugenio Cerutti (RES).
The Swedish rules also require an independent inspector to monitor and ensure that the assets in the cover pool adhere to the requirements. Each cover pool monitor—who is being appointed by the regulator and paid by the covered pool issuer—must submit a report on an annual basis and notify the regulator as soon as he/she learns about an event deemed to be significant.
Also as highlighted by Juks (2012), the Solvency II Directive requires insurance companies to hold less capital if they hold covered bonds as compared to unsecured debt. Central banks, such as the ECB, have typically lower haircuts for covered bonds than for unsecured debt. Covered bonds are usually excluded from write-downs in many resolution frameworks, while unsecured debt is not.
The level of deposits in the Swedish banks is about 100 percent of GDP.
Note that this is somewhat limited in Denmark, where large part of the issuers of covered bonds are mortgage institutions that both cannot take deposits and are separate entities without ties to banking groups.