In its Covered Bond Market Insights reports, S&P Global Ratings presents the Norwegian and Finnish covered bond markets, explains how the relevant legal framework works, provides an overview on the mortgage markets, and compares key characteristics of the existing programs.

In our view, solid economies, stable ratings and outlooks on most issuers, and strong sovereigns will continue to support ratings stability for both Norwegian and Finnish covered bonds despite the COVID-19 pandemic.

As vaccine rollouts in several countries continue, S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic and its economic effects. Widespread immunization, which certain countries might achieve by midyear, will help pave the way for a return to more normal levels of social and economic activity. We use this assumption about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Overview: Growing Covered Bond Markets

Both Norway and Finland have well-established covered bond markets. In the past decade, both jurisdictions have experienced stable growth in issuance volumes. The Norwegian market is the seventh largest European market while the Finnish market is the 14th largest. Together, the two countries account for just below 10% of the European benchmark market, with Norwegian banks issuing more than three times the volume of their Finnish peers.

The Norwegian covered bonds legislation was adopted in June 2007. Cover pools are primarily secured by Norwegian residential mortgages and mortgages backed by tenant-owner rights. Most loans are floating rate and all are Norwegian krone (NOK) denominated.

The first legal framework for covered bonds in Finland was adopted in 1999. Several amendments have followed since then, most recently in 2010 when the special banking principle was abolished, allowing universal banks to issue covered bonds. Cover pools are generally secured by Finnish residential mortgages and, to a lesser extent, loans to housing cooperatives. All loans are euro-denominated and mainly floating rate.

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Government stimulus following COVID-19

Following the outbreak of the COVID-19 pandemic, the European Central Bank (ECB) announced a significant bond purchase facility, the Pandemic Emergency Purchase Programme (PEPP), on March 18, 2020. The program was announced as a €750 billion asset purchase program until at least June 2021. At the beginning of June and again in December 2020, the program was increased to €1,850 billion. The program is designed to keep capital markets functioning, liquidity flowing, and encouraging banks to extend capital to keep the economy going. We expect the ECB's monetary policy to remain loose at least until 2023. The PEPP comes on top of the existing Asset Purchase Programme (APP) and we expect that covered bond yields will remain at historically low levels.

In mid-March, Norges Bank launched a number of market operations to improve market liquidity. It eased collateral requirements for loans to banks and allowed banks to fully finance covered bond issuances from their own mortgage companies using loans from Norges Bank. After hiking rates three times in 2019, in the spring of 2020, Norges Bank lowered its policy rate to 0% from 1.5%, to dampen the negative effects of the coronavirus outbreak. Recent indication from Norges Bank point toward an earlier than expected post-COVID-19 interest rate hike, but other tools remain available should it be required to ease conditions further.

The Norwegian government introduced large financial packages to support the economy, including reforms to support businesses and individuals affected by the coronavirus outbreak and falling oil prices. Fiscal spending includes various measures to help ease the economic impact of lockdown measures and to help employment rates to recover swiftly. Support packages in Norway have been large and consist of guarantees to business of Norwegian krone (NOK) 130 billion, deferral of taxes--including the value-added tax--of NOK230 billion, and additional fiscal spending amounting to almost NOK200 billion. This support totals about 15% of GDP.

European covered bond framework under implementation

In September 2019, the European Parliament approved 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, expected 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 Finnish 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).

Norway is not a member of the EU and the harmonization directive is not currently a part of the EEA agreement. Regardless, Norway was the first country to publish a consultation note followed by a public hearing, which ended in August 2020. Generally, the Norwegian legislation requires few changes to live up to the harmonization directive. The proposal maintains the specialist banking principles while introducing two designations for covered bonds: premium (plus) and standard. It proposes to increase maximum loan-to-value (LTV) ration for residential properties to 80% from 75% and an increase in minimum overcollateralization to 5% from 2%. The proposal also includes a 180-day liquidity buffer, calculated without considering potential extensions, but considering existing liquidity coverage ratio (LCR) requirements. Based on the proposal, and despite a lack of clarity on extension triggers, we expect the Norwegian covered bond framework to comply with the EU directive. The revised legislation will be implemented in accordance with the timeline defined in the directive.

Recent market developments

The Finnish and Norwegian financial authorities (Finanssivalvonta and Finanstilsynet) follow the COVID-19-specific recommendations from the European Banking authority (EBA). Additionally, Norway cut the key policy rate to 0%, the mortgage loan regulation was in part temporarily suspended (until Sept. 30, 2020) to allow increased use of deferred amortization, and the countercyclical capital buffer requirement was lowered. Finanstilsynet has since proposed to tighten the current mortgage regulation, which currently includes an LTV ratio cap at 85%, a maximum debt-to-income ratio of five times the gross annual income (4.5 times proposed), a minimum payment requirement of 2.5% if the LTV ratio exceeds 60%, and a flexibility ratio of 10% (8% in Oslo) with a proposed rate of 5% nationally.

Finnish regulators lowered solvency requirements and reversed an earlier LTV ratio cap to 90% from 85% in June 2020 to further support the housing market. In both housing markets, significant price differences exist between the larger cities (mainly the capitals) and rural areas, and the lending limitations are more relevant in the capitals. In both countries, banks have offered short-term amortization relief (grace periods), and customer take-up of interest-only loans has been notable, reflecting relatively easy accessibility, but levels are now normalizing again.

The extraordinary support by the central banks and labor market support have bolstered house prices, and even led to house price rises.

Covered Bond Frameworks: Seasoned Legislations Protect Credit Quality

Legal framework in Norway

The Norwegian covered bond law defines the eligibility criteria for the type of assets that may and may not be included in the cover pool. Finanstilsynet appoints an independent inspector to regularly review compliance, oversee the register for the cover pool, and ensure that the value of the cover pool always exceeds the issued covered bonds. The law also stipulates that the issuer must be a specialized credit institution and obtain a license from Finanstilsynet.

A mortgage credit institution can include mortgage credit assets secured on residential and commercial properties within the European Economic Area (EEA) or the Organisation for Economic Co-operation and Development (OECD), and public sector credit assets granted to or guaranteed by a public body within the EEA and the OECD. It may also include supplementary assets, i.e., securities issued by eligible financial institutions within the EEA or the OECD.

According to the Norwegian covered bond law, in the event of issuer insolvency, bondholders have an exclusive preferential claim on the cover pool. Should an event occur, an administrator will be appointed to administer the cover pool and to ensure timely payments.

On Jan. 1st 2019, a resolution regime similar to the EU's Bank Recovery and Resolution Directive (BRRD) came into effect in Norway (see "Norway's Adoption Of BRRD Resolution Regime Results In Additional Ratings Uplift For Norwegian Covered Bonds," published on Jan. 2, 2019).

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Legal framework in Finland

The Finnish Mortgage Bank Act (MBA), passed in 1999 and amended in 2003 and 2010, provides the legal framework for issuing Finnish covered bonds.

The MBA provides the eligibility criteria. Issuers can include mortgage assets secured on residential property located in any eurozone country, and substitute assets. Only collateral that is in the same currency as the covered bonds may be entered in the bond register.

This legislation provides covered bond investors with the right to receive payments before any other claim, according to the original terms and conditions of the covered bonds. This means that the holder of a covered bond has a preferential claim on the cover pool in the event of default.

The cover pool assets must be registered and kept separate from the issuer's other assets. The information in the register must be reported monthly to Finanssivalvonta. The counterparties to derivatives contracts are also included in the register and must survive the issuer's insolvency. The derivative contracts rank pari passu with the covered bonds.

After a mortgage bank has been placed in liquidation, Finanssivalvonta will appoint an attorney to supervise the interest of the covered bondholders. While the bankruptcy trustee manages both the insolvency estate and the covered bonds, the attorney ensures that there is no conflict of interest between the secured and unsecured bondholders. If necessary, the attorney can ask the bankruptcy trustee to conclude necessary derivative contracts and sell collateral or transfer liabilities to another approved bank or, subject to the Finnish FSA's approval, accelerate the covered bond repayments.

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Overcollateralization and liquidity tests

The covered bond laws in both countries require the value of the assets to be higher than the value of the liabilities at all times. Additionally, issuers must include 2% overcollateralization. There is currently no requirement for the issuer to cover the maximum liquidity need within the next 180 days. As most covered bonds are issued with a soft-bullet format, we do not adjust the potential rating uplift for lack of liquidity coverage.

Currency of issuance

Large Norwegian issuers do not rely solely on NOK-denominated issuance for their funding needs and more than half of the issuance of covered bond are denominated in foreign currencies, mainly euro. Currency mismatches between assets and liabilities do not affect our view of risk, given that they are mitigated via cross-currency swaps.

A number of smaller Norwegian issuers rely mainly on the growing NOK market for issuance as the costs of cross-currency swaps and the difficulty in achieving benchmark size make foreign currency issuance uneconomical.

Due to their economic and monetary union membership and the large euro investor base, Finnish issuances are typically not in foreign currency.

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Mortgage Market Overview: Manageable Economic Initiatives Support Housing Markets

We expect that the Norwegian economy will shrink by 2.2% in 2020, followed by a rebound in 2021 as the economy begins to recover from the coronavirus pandemic. The government is using its fiscal flexibility to limit COVID-19's economic impact, and fiscal headroom remains very strong with sizable buffers available (see "Norway 'AAA/A-1+' Ratings Affirmed; Outlook Stable," published on Sept. 11, 2020).

Norwegian household debt to disposable income stood at 227% at year-end 2019, one of the highest ratios among countries of the OECD, and we forecast it will rise by 3% annually through 2023. We believe that the accumulated imbalances could pose an economic risk. Housing leverage also remains high.

In our view, the increased housing supply and the government's tightening of macroprudential measures in recent years form the foundation for the housing market's stabilization. However, home ownership encouraged by generous tax incentives, low interest rates, and low unemployment continue to push house prices higher, particularly in the capital region.

We currently view the Norwegian housing market as being overvalued by roughly 20%, partly a result of temporary easing of macroprudential measures due to COVID-19. As a result, we believe it is likely that the measures aimed at preventing overheating in the housing market will be tightened and remain in place for the foreseeable future.

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Due to the domestic and external fallout from the COVID-19 pandemic, we anticipate Finland's real GDP will contract by 4.5% in 2020. We expect the country's recovery and medium-term growth prospects will be tested by structural constraints that include lackluster productivity growth amid a shrinking employment pool. We also expect government reform activity will pick up speed in order to counter inefficiencies in the labor market.

In the meantime, the strength of the economic recovery will largely depend on private consumption and a gradual resurgence of demand from Finland's key EU trading partners, which we expect will be supported by measures from the EU. Even though we expect the economy will contract by a comparatively modest 4.5% in 2020, we believe recovery could face structural headwinds because dampened employment levels, a loss of cost competitiveness, and labor market inefficiencies present a drag on potential. (see "Finland 'AA+/A-1+' Ratings Affirmed; Outlook Stable," published on Sept. 4, 2020).

We observe that, despite significantly decreased housing market activity since April 2020, COVID-19 has so far had not had a major effect on the real estate market. In our base case, we forecast moderate credit losses from households, despite increasing unemployment and more muted credit demand, before returning to pre-pandemic levels in 2021-2022.

We currently assess the Finnish housing market as being slightly undervalued by about 2%. Therefore, we expect authorities to continue to consider measures to support house prices, especially in those regions where prices are under pressure.

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Features Of Norwegian And Finnish Cover Pools

Norwegian and Finnish covered bond transactions are generally backed by residential cover pools. In these pools we mainly see detached homes and condominium apartments, but also housing cooperatives, which we treat as commercial assets under our criteria (see "Methodology And Assumptions: Analyzing European Commercial Real Estate Collateral In European Covered Bonds," published on March 31, 2015).

In Norway, cover bonds may be backed by both residential (Boligkreditt) and commercial (Næringskreditt) mortgage loans, but these two asset types are not be combined within the same pool. Substitute assets may only amount to 20% of the cover pool (30% for a limited amount of time with the consent of the Norwegian FSA).

In Finland, at least 90% of the cover pool must consist of residential mortgage loans, loans to housing associations, public sector loans, and substitute assets. Commercial mortgage loans can account for 10% of the cover pool at most. Here too, up to 20% of the cover pool can consist of substitute assets.

Floating-rate markets

Most mortgage loans in the Norwegian and the Finnish market are floating-rate loans.

In the case of Norway, these loans are not directly linked to market rates, such as the Norwegian Interbank Offered Rate (NIBOR), but to an internal rate that is mainly determined by the lender's cost of funding, competition, and the borrower's risk profile. When resetting this interest rate, lenders must give the borrower a six-week notice. This introduces a certain degree of basis risk in the transaction, given that a sudden increase in interest rates could have immediate consequences for the cost of funding, whereas there would be a lag in passing this increase on in the form of higher mortgage interest rates. We considered this risk in our cash flow analysis.

In the case of Finland, floating-rate loans are generally tied to an index, mostly 12-month Euro Interbank Offered Rate (EURIBOR), and reprice at such intervals.

Interest-only or amortization?

Most of the loans in the Norwegian market have a short-term interest-only repayment profile, before reverting to amortization. These loans pay interest-only at start, usually for the first five years, and switch to amortizing thereafter.

The Finnish market, on the other hand, almost exclusively comprises amortizing loans. As a result, mortgage loan maturities are generally shorter in Finnish mortgage pools, and therefore the weighted-average asset maturity is shorter compared with Norwegian pools. The shorter asset maturity has a positive effect on our cash flow analysis, as it leads to a relatively lower asset-liability mismatch.

Norway-specific features

Flexible loans.   The loan product gives borrowers the option to draw only part of the amount granted by the lender. Interest is calculated on the drawn amount, which is repaid entirely at maturity. At any time, the lender can decide to withdraw the undrawn amount of the loan and switch the repayment profile of the drawn amount from interest only to amortizing.

From a credit risk perspective, we only consider the drawn loan amount and do not view this product type as intrinsically more risky than other loans. We do however consider the fact that the repayment profile might be switched and assume a certain degree of payment shock could arise due to such a switch.

Tenant-owner rights.  In order to purchase a right to live in a condominium apartment (tenant-owner right) in Norway, borrowers typically become shareholders of the housing cooperative (association) that owns and manages the building where the unit is located.

Borrowers need to pay monthly fees to the housing association, and such amounts are normally included in the affordability assessment for the tenant-owner rights mortgage. If one or more of the right-holders fail to pay their fees, the other members become liable. Moreover, should the housing cooperative default on its own debt, it would be redistributed on a pro rata basis among the shareholders.

We consider tenant=owner right loans with low seasoning to be sensitive to increases in fees to the housing association, or a potential increase in the borrower's debt due to a default of the association.

Finland–specific features

Constant annuities.  Constant annuity loans are a common feature in Finnish cover pools. Instalments are calculated at disbursement, based on the initial maturity, with the amount including both principal and interest in each period. The instalment is the same throughout the loan's life.

Instalments must always cover interest payments, so when interest rates go up the total instalment will consist of a higher interest component. This results in an accumulation of principal, which in turn leads to an extension of the maturity of the loan, while for some loans the outstanding principal amount is due at maturity. Such loans attract an adjustment of credit risk in line with our criteria.

A significant present of floating-rate constant annuity loans in a cover pool represents, in the current low-interest rate environment, a positive factor in our cash flow analysis. This is because amortization is steeper, thereby reducing the asset-liability mismatch in the transaction.

Intermediate loans.  Intermediate loans offer smaller banks covered bond funding while the securing mortgage loans remain on their balance sheet. These loans to the smaller banks are backed by mortgage loans that are registered in the issuer's cover pool, but remain on the balance sheet of the originator and are only transferred if the bank is not able to repay the intermediate loan.

We consider the security of the collateral backing intermediary loans to be comparable with direct transferred mortgage loans. In the stressed rating scenario, we expect banks not to repay the intermediate loans and therefore consider all collateral backing the intermediary loans as already transferred to the cover pool.

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Green covered bonds emerge

Norway has been quick to embrace green covered bonds. DnB & SpareBank 1 Boligkreditt helped pave the way for green covered bonds, and a number of saving banks (Sparbanken) have since followed suit with successful green covered bond issuances (see "Are Covered Bonds Becoming More Sustainable?," published on Sept. 6, 2019). Recently OP Mortgage bank announced the first Finnish green covered bond framework. The issuers are tapping into strong investor demand and interest from investors who normally do not invest in the covered bond market. The green covered bond market remains limited in size, but with increasing local covered bond investor interest, we expect Norwegian and eventually Finnish covered bond issuers will join the forefront of developments within this expanding segment.

Ratings Outlook: Not All Issuers Have Unused Notches Of Uplift

Both Norwegian and Finnish covered bonds benefit from investment-grade rated issuers, the first recourse for bondholders. Most of the rated programs benefit from at least one unused notch of uplift, which would protect the rating on the covered bonds in the event of an issuer downgrade. Counterparty risk and recent negative rating actions mean that some issuers no longer have unused notches of uplift available.

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Norway and Finland are comparable in terms of average target credit enhancement, which is the overcollateralization commensurate with the maximum collateral-based uplift. Where we register a difference between the two jurisdictions is in the gap between available credit enhancement and target credit enhancement, which is generally tighter in Norway.

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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
• Methodology And Assumptions: Analyzing European Commercial Real Estate Collateral In European Covered Bonds, March 31, 2015
• Methodology And Assumptions For Assessing Portfolios Of International Public Sector And Other Debt Obligations Backing Covered Bonds And Structured Finance Securities, Dec. 9, 2014
• Covered Bonds Criteria, Dec. 9, 2014

Related Research

• Norway 'AAA/A-1+' Ratings Affirmed; Outlook Stable, Sept. 11, 2020
• Finland 'AA+/A-1+' Ratings Affirmed; Outlook Stable, Sept. 4, 2020
• Global Covered Bond Characteristics And Rating Summary Q4 2020, Dec. 17, 2020
• Global Covered Bond Insights Q4 2020, Dec. 17, 2020
• Danish Covered Bonds: Proposal Outlines Harmonization Plan, Nov. 25, 2020
• Danish Covered Bond Market Insights 2020, Oct. 21, 2020
• Swedish Covered Bond Market Insights 2020, Sept. 11, 2020
• The Mortgage Society of Finland Covered Bonds Outlook Revised To Negative; 'AAA' Ratings Affirmed, June 3, 2020
• Harmonization Accomplished: A New European Covered Bond Framework, April 18, 2019
• Norway's Adoption Of BRRD Resolution Regime Results In Additional Ratings Uplift For Norwegian Covered Bonds, Jan. 2, 2019
• Glossary Of Covered Bond Terms, April 27, 2018

Related Transaction Updates

• Transaction Update: OMA Savings Bank PLC (Mortgage Covered Bond Program), Dec. 18, 2020
• Transaction Update: Sp Mortgage Bank PLC (Mortgage Covered Bond Program), Oct. 7, 2020
• Transaction Update: OP Mortgage Bank, Oct. 6, 2020
• Transaction Update: Eiendomskreditt AS (Commercial Mortgage Covered Bonds Program), July 3, 2020
• Transaction Update: Storebrand Boligkreditt Mortgage Covered Bond Program, June 19, 2020
• Transaction Update: The Mortgage Society of Finland (Mortgage Covered Bond Program), May 7, 2020
• Transaction Update: Bank of Aland PLC (Category SWE Mortgage Covered Bonds), April 9, 2020
• Transaction Update: DNB Boligkreditt AS (Legislation-Enabled Mortgage Covered Bonds), March 20, 2020
• Transaction Update: Bank of Aland PLC, Sept. 16, 2019
• Transaction Update: Gjensidige Bank Boligkreditt AS (Mortgage Covered Bonds Program), June 12, 2019