In its Covered Bond Market Insights reports, S&P Global Ratings presents the local covered bond market, explains how the relevant legal framework works, provides an overview on the local mortgage market, compares key characteristics of the existing programs, and presents the results of a scenario analysis. In this report, we review the Dutch covered bond market. In our view, favorable credit conditions, stable ratings and outlooks on most issuers, and a strong sovereign will continue to support ratings stability for Dutch covered bonds in the medium term.

Overview: An Established But Dynamic Covered Bond Market

The Dutch covered bond regulatory framework was introduced 11 years ago, although Dutch covered bonds had been issued for years before that using the structured model. The covered bond market comprises 10 residential mortgage-backed programs from nine issuers, representing over €87 billion of outstanding issuance.

Although the market is expanding, with an increasing share of global issuances and some innovative structuring, it faces a number of challenges--some widely shared by the covered bond market, some more specific to the Dutch economy.

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Eurozone monetary stance will stay loose

Following the European Central Bank's announcement of its new expansionary package, we expect rates to remain low at least until 2023. The ECB resuming net asset purchases of €20 billion a month from November 2019, plus reinvesting €183 billion of maturing debt over the next nine months, should keep covered bond yields close to historical lows.

European covered bond framework under implementation

The European Parliament approved in September the final version of the directive and regulation on the harmonization of covered bonds. Following the publication of the directive and regulation in the Official Journal of the European Union, which we expect before year-end, national authorities have 18 months to transpose it into their national legislation and an additional 12 months to apply the new rules. The alignment of the Dutch legislative framework with the European Banking Authority's best practices is high (see "Harmonization Accomplished: A New European Covered Bond Framework," published April 18, 2019).

Macroprudential measures have not prevented house prices from rising further

We expect house prices in the Netherlands to grow 6.5% this year and 5.5% in 2020. This marks a deceleration from 9.1% in 2018, as worsening affordability and weaker growth weighs on the market. Macroeconomic measures including reduced loan-to-value (LTV) ratios and mortgage interest tax deductibility are expected to sooth demand for housing, which is still high on the back of a stable real economy, low unemployment rate, and favorable financing conditions (see "Europe's Housing Markets Lose Speed As The Economy Weakens," Sept. 24, 2019).

The Legal Framework: Light Regulation Leaves Space For Innovation

Legal framework

The first Dutch covered bonds were structured products entirely defined by documentation. Since 2008, a framework inscribed in the Financial Supervision Act has regulated Dutch covered bond issuance. The framework was further amended in 2014, when it received the status of law, and in 2015.

Bondholders have a dual recourse to receive payments on their debt: they have unlimited recourse to the issuing bank but also recourse to the cover pool assets if the issuer becomes insolvent. The framework stipulates a clear segregation of the cover pool assets for the bondholders' benefit, who have a senior claim to them. This is achieved by a transfer of the assets from the issuing bank to a bankruptcy-remote covered bond company (CBC).

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Set-off risk

The Dutch mortgage market contains a number of products that raise specific set-off issues upon issuer insolvency. These products, known as savings mortgages ("Spaarhypotheek"), insurance mortgages ("Verzekeringshypotheek"), and investment mortgages ("Beleggingshypotheek"), are designed to take advantage of a tax asymmetry that allows the borrower to obtain a cheaper effective rate of interest on his or her mortgage loan. In effect, the borrower, instead of repaying principal to the lender (the bank), invests in a savings product provided by an insurance company (the insurer). The return on this investment is tax free (as are interest payments) and is used to repay the mortgage loan.

Therefore, following the insolvency of the issuer, there is a potential set-off risk pertaining to deposits maintained by borrowers with the issuer (whose loan has been included in the cover pool). This risk can be mitigated by the coverage tests or additional overcollateralization.

Conditional pass-through covered bonds as an innovative structure

Conditional pass-through covered bonds have been particularly popular in the Netherlands given the very high proportion of interest-only loans in Dutch pools: these increase any potential refinancing costs dramatically in case of a liquidity gap. As conditional pass-through covered bonds structurally eliminate refinancing risk--the risk that the pool administrator is forced to liquidate the assets to repay a maturing bond--we delink the rating on a covered bond from the rating on the issuing bank when the covered bond's overcollateralization is legally or contractually committed. This allows lower-rated issuers to access a 'AAA'-dominated market.

Despite the prevalence of conditional pass-through covered bond programs in the Dutch covered bond market, other maturity structures, such as hard and soft bullet structures, are also present.

As our analysis of covered bond programs starts with the assumption of the issuer's default on day one, we typically model in our cash flows a switch to the pass-through mode and the extension of the bonds to their legal final maturity date. Our rating therefore addresses the timely payment of interest and of principal on the legal final maturity date, and not on the scheduled maturity.

Coverage tests

Issuers typically commit to a minimum level of overcollateralization via contractual asset coverage tests (including the amortization test).

These tests are designed to not only ensure a minimum ratio of cover pool assets for covered bonds, but they also serve to enhance the credit quality of the assets in the portfolio. This is because the tests exclude certain mortgage loans from the amount eligible and therefore create an incentive for issuers to remove them from the cover pool. Non-eligible loans can include mortgages subject to set-off risk or impaired assets, among others.

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Mortgage Market Overview: Slower Price Gains Expected

A thriving economy

Over the past several years, the Dutch economy has expanded at a faster pace, and the unemployment rate has trended lower than the eurozone average. We expect to see this trend continue in the medium term as well. Key risks to the country's economy stem from the external environment including the U.K.'s exit from the EU (Brexit), the slowdown in global growth, and escalating trade tensions.

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Economic Indicators
Year	Real GDP growth (%)	Unemployment rate (%)	HPI change (%)
2018	2.5	3.8	9.1
2019f	1.7	3.4	6.5
2020f	1.3	3.4	5.5
2021f	1.5	3.5	4.6
2022f	1.5	3.4	4.0
Source: S&P Global Ratings. HPI--House price index.

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Price rises slow on worsening affordability and weaker growth

Solid economic growth, a buoyant labor market, negative real interest rates, and sluggish supply mean house prices have continued to rise strongly. Therefore, housing has become increasingly hard to afford with a price-to-rent ratio at 24% and price-to-income ratio at 28% above their long-term averages, respectively. We expect that stretched affordability together with macroprudential measures will cool the housing market. A deceleration in transactions since mid-2017 underpins this assumption.

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Dutch cover pool

Even though the Dutch covered bond legislation contemplates public loans, commercial mortgages, and shipping loans, currently all existing programs comprise residential mortgage-backed covered bonds.

The Dutch mortgage market is characterized by high LTV ratios and a large proportion of interest-only loans. This has resulted in the Netherlands having one of the highest household debt ratios compared to other European economies: 239% of the net disposable income as of 2018, based on Organisation for Economic Co-operation and Development data.

Since 2013, newly originated mortgages need to amortize to benefit from tax deductibility, and banks are encouraging households to amortize interest-only mortgages contracted previously. As a result, the share of various amortizing structures (linear mortgage loans, annuity mortgages) are gaining popularity in the market.

Also, the maximum LTV ratio has been reduced in incremental steps to 100% by 2018 from 120% in the early 2000s. The majority of the outstanding mortgages pay a fixed interest rate for a period ranging from five to 15 years. At the end of the fixed-rate period, the interest rate typically resets to a new fixed rate.

The homeownership rate in the Netherlands (68%) is comparable with other Western European countries (66% on average) and is lower than in most Eastern and Southern European economies (81% on average). We expect the Netherlands' residential mortgage market to stay stable at around its current level in the medium term despite macroprudential measures that discourage investment into real estate.

High social benefit support

The Dutch social security system is one of the most comprehensive in Europe, encompassing sick leave, unemployment benefits, disability benefits, maternity leave, child support, and pensions. As such, it provides a safety cushion for borrowers if personal circumstances change or if the economy takes a downturn. In particular, employees are entitled to unemployment benefits in the Netherlands if they partially or completely lose their jobs, resulting in more stable collateral performance for residential pools throughout economic cycles.

Tax incentive for mortgages

The structure of the long-standing generous tax-relief system for residential mortgages has largely influenced the profile of the Dutch mortgage market (mortgage interest payments have long been fully tax-deductible for up to 30 years). This explains the long maturities and still-dominant share of interest-only loans because there was no incentive to repay principal. Since 2013 and for newly originated mortgages, only amortizing loans are eligible for the interest-rate tax deductibility, leading to a new origination profile comprising mostly annuity loans. Further, the interest deductibility on mortgages is being gradually reduced to 37% by 2023 from the current 49%.

NHG guarantee

Owner-occupier borrowers can apply, subject to strict conditions and limitations, to a Nationale Hypotheek Garantie (NHG) from the Homeownership Guarantee Fund (Waarborgfonds Eigen Woningen; WEW), which is an independent institution that has fallback agreements with the Dutch government and municipalities. The guarantee covers the major part of the losses remaining to a lender at the end of the foreclosure process on a defaulted mortgage loan. It will be effective only if certain conditions are met so that the WEW will not necessarily cover NHG-guaranteed loans if the borrower defaults.

We equate the creditworthiness of the WEW to that of the Dutch sovereign and give credit to the NHG guarantee in our loss-given default calculation on a case-by-case basis, depending on the historical payout rate from the NHG that the bank can show. The presence of a large proportion of NHG-guaranteed loans in some of our rated programs has by and large led to a below-average weighted-average loss severity (WALS; our measure of loss-given default) for our rated Dutch pools compared to other countries (see "Global Covered Bond Characteristics And Rating Summary Q3 2019" published Sept. 10, 2019).

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Ratings Outlook: Covered Bonds Are Well Insulated From Risk Of Bank Downgrades

On top of a buoyant economy, Dutch covered bonds benefit from highly rated issuers, which are the first recourse for bondholders. Moreover, programs with a highly rated issuer and which are not conditional pass-through can benefit from unused notches of uplift, offering some protection against downgrades of the issuing bank.

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Table 5  |  View Expanded Table

Chart 9 shows the breakdown of the average target credit enhancement levels compared to available credit enhancement across countries. We define the target credit enhancement as the overcollateralization commensurate with the maximum collateral-based uplift.

Dutch programs on average have both lower credit and market risk compared to those of peer countries. Consequently, the available credit enhancement is also lower relative to peer countries' programs.

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Scenario Analysis: Dutch Covered Bonds Withstand House-Price Corrections

Despite a strong economy, we have carried out a scenario analysis with large drops in house prices to gauge whether these would affect the overcollateralization that is commensurate with our rating. We have decided to test this scenario analysis using house price drops of 20% and 30% because 20% is the drop seen after the financial crisis between 2008 and 2014.

Table 6 shows the impact of the house price decline on our WALS calculation. The overcollateralization in line with the current rating does not increase significantly. These hypothetical house price drops do not affect the achievable rating on any of the programs either.

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Related Criteria

• Global Methodology And Assumptions: Assessing Pools Of Residential Loans, Jan. 25, 2019
• Covered Bond Ratings Framework: Methodology and Assumptions, June 30, 2015
• Covered Bonds Criteria, Dec. 9, 2014
• Methodology For Assessing Mortgage Insurance And Similar Guarantees And Supports In Structured And Public Sector Finance And Covered Bonds, Dec. 7, 2014

Related Research

• Credit Conditions EMEA: Lingering in the Lowzone, Sept. 30, 2019
• Europe's Housing Markets Lose Speed As The Economy Weakens, Sept. 24, 2019
• Global Covered Bond Characteristics And Rating Summary Q3 2019, Sept. 10, 2019
• Global Covered Bond Insights Q3 2019, Sept. 10, 2019
• S&P Global Ratings' Covered Bonds Primer, June 20, 2019
• Summary: Netherlands, May 17, 2019
• Harmonization Accomplished: A New European Covered Bond Framework, April 18, 2019
• Glossary Of Covered Bond Terms, April 27, 2018
• An Inside Look At Conditional Pass-Through Covered Bonds, May 25, 2017

Related Transaction Updates

• Transaction Update: ING Bank N.V. (Mortgage Covered Bonds), Sept. 13, 2019
• Transaction Update: ING Bank N.V. Covered Bond Program, July 29, 2019
• Transaction Update: Van Lanschot N.V. Conditional Pass-Through Mortgage Covered Bond Program, April 25, 2019
• Transaction Update: NIBC Bank N.V. Covered Bond Programme, April 16, 2019
• Transaction Update: Aegon Bank N.V., Jan. 15, 2019
• Transaction Update: NN Bank N.V. (Conditional Pass-Through Covered Bond Program), Jan. 8, 2019