By Thomas

Why Denmark has a big debt burden AND low interest rates?

As reported on Bloomberg:

Denmark’s AAA to Survive World’s Biggest Private Debt Load, Fitch, S&P Say

It is true there is a low public debt and high private debt – and the AAA rating is probably most descriptive of the loss of quality of the real estate bonds. These bonds are rapidly approaching junk status.

Real estate bonds.

Real estate in Denmark was traditionally financed with fixed interest convertible annuities up to 80% of the value of the real estate. The building society bills an administration fee which through time (150 odd years) has varied below ½% to about 2% in times of duress. This fee covered not only the administration of payments but also cost and losses due to foreclosures.

That gave a stable system with high liquidity and no default risk to the investor. The convertibility gave all the advantages to the debtor: When interest was lowered you could convert on demand into a lower interest rate but with the same debt – when rates went up the investor could always get out of low yield bonds at an affordable cost as 1 million debtors ware greedily eager to buy their own bonds when quotes dropped to refinance to a higher interest rate but lower debt.

Professional investors and banks priced the risks of interest variation into it – to the extent that sovereign bonds were uninteresting and risk wise were on par with real estate bonds.

This has now changed with the introduction of zero amortization (officially up to 10 years of grace) and flexible interest rate. Which reform was the more destructive is still a matter of debate among connoisseurs: Was it the 500 lb bomb or the ensuing conflagration that destroyed the house? Competing causes of death in medical jargon.

Today up to ¾ of all real estate bonds in Denmark have either the one or the other flaw – or both. The popularity was due to the lower interest rate caused by burdening the debtor with all the risk. Building societies had been taken over by banks and real estate was still financed without regard to creditworthiness of the debtor – because formerly it wasn’t necessary as the building society just foreclosed in the event of non-payment – and could sell the relative small amount of repossessed house at price of their security.

The access to “cheap” financing of course led to a double boom in house prices and prices in the last 10 years. To top these monumental mistakes banks started to lend the final 20% of the price with similar scant regard to the debtor’s ability to pay – that fuelled the fire – naturally.

The booming prices naturally led to a building boom as the price of new build residences was cheaper than pre-used houses – but as always the basic demand was not taken into account.

The banks that – so far – have gone into receivership have typically been banking developers.

The next round of applause will go to the building societies and their banks: Danske Bank/Realkredit Danmark, Nykredit Realkredit/Nykredit Bank, BRF/BRFBank and Nordea. Of which combination Danske Bank is the largest.

denmark debt

The real trouble is that the variable interest cum no amortization real estate bond has to carry low interest or the debtor will not be able to pay. The banks today stand without security for the outer 20% of the original price. The only option the banks have is to buy their own bonds to jerk up prices to keep interest rates low. Thus low interest rates on Danish variable rate interest real estate bonds are emphatically NOT an expression of quality, but of issuer’s desperation.

Furthermore the associated bank has to show “understanding” with the bank loans. Neither building society bonds nor banks will be able to survive a further drop in prices – and up to now – the prices have been kept at rather accurately 80% of former top level – which incidentally is the percentage the building society finances limit.

The trouble is that the banks have run out of tricks. Trade in houses have dropped –first to 2/3 in the period 2008-2010 (there is no renting shortages) – to about half in three first quarters of 2011 and rumors have that they have come down to dead slow in Q4. Credit is being denied: The banks cannot finance more of their own bonds and can’t loan.

Investors as pension funds and banks with surplus deposits have during the last year got rid of variable interest real estate bond – and they are not buying. This has of course put pressure on the interest rates of the few sovereign bonds – to the point where very short term papers carry negative interest – and deposits in the Central Bank is making the general coffers moan in the seams.

The current low interest rates on Danish sovereign bond have nothing whatsoever to do with Denmark’s international credit rating: It is simply an expression of the natural flight towards quality at any cost by investors, banks and depositors.

The Central Bank issues bonds out of proportion to the deficit needs – just to give a give depositors a safe heaven. This liquidity is used to intervene on the currency market.

With a consistent surplus on the balance of payment it is difficult to keep the exchange rate from rising – which is why the Central Bank intervenes.