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.

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 10th largest European market while the Finnish market is the 14th largest. Together, the two countries account for below 7% of the European benchmark market, with Norwegian banks issuing approximately 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. A few issuers specialize in commercial real estate or public sector loans (below 2% of the outstanding volume). Most loans are floating rate and 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 during the COVID-19 pandemic

Following the outbreak of the COVID-19 pandemic, the European Central Bank (ECB) announced the Pandemic Emergency Purchase Programme (PEPP) on March 18, 2020. The program's total value is €1,850 billion. We expect the central bank to phase out net purchases under the PEPP in March 2022. Tapering the Asset Purchase Programme (APP) will probably not appear on the agenda before end-2023.

In the spring of 2020, Norges Bank lowered its policy rate to 0% from 1.5%, to dampen the negative effects of the coronavirus. Following its strong economic rebound from the pandemic, Norges Bank raised its interest rate to 0.25% in Q4 2021. This was followed by a further increase to 0.5% and more hikes are expected in 2022. The policy rate hike is to reduce the risk of macroeconomic imbalances resulting from rising house prices and high household indebtedness.

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. We estimate that total support packages in 2020-2021, including forgone revenue and off-budget spending, amount to about Norwegian krone (NOK) 360 billion, or 12% of 2020 GDP.

Many of these programs have not been fully used, so the actual impact on government finances and liquidity will likely be much lower. Still, we do not exclude the possibility of additional extensions or support.

The Finnish government has introduced significant support measures to mitigate the COVID-19 outbreak. On top of direct fiscal measures, the central government guarantees authorizations worth about 4% of GDP as part of COVID-19 support packages to businesses, even the take-up under these arrangements is limited.

Recent market developments

The Finnish and Norwegian financial authorities (Finanssivalvonta and Finanstilsynet) followed the COVID-19-specific recommendations from the European Banking Authority (EBA). Additionally, the mortgage loan regulation was in part temporarily suspended until Sept. 30, 2020 to allow increased use of deferred amortization. The countercyclical capital buffer requirement was also lowered.

In December 2020, the Norwegian Ministry of Finance extended regulatory requirements for new residential mortgage loans. The loan-to-value (LTV) ratio cap for residential loans remains at 85%, maximum debt-to-income ratio remains five times gross annual income, and a geographic flexibility ratio of 10% (8% in Oslo) is unchanged.

In March 2020, Norges Bank temporarily removed the 20% maximum ISIN limit to its repo collateral guidelines. Under the temporary rule, there was no upper limit on the collateral pledge per ISIN, allowing banks to post up to 100% of covered bonds issued as repo collateral. However, the ISIN limit was tightened to 50% in February 2021 and as of Aug. 31, 2021 the old rules were re-established.

To support the Finnish housing market, the Finnish FSA (Finanssivalvonta) lowered solvency requirements and reversed an earlier LTV ratio cap for residential mortgage loans other than first-home loans to 90% from 85% in June 2020. In October 2021, as the housing market recovered from the COVID-19 pandemic, the loan cap was reset to the pre-pandemic level of 85%.

In both housing markets, significant price differences exist between the larger cities (particularly the capitals) and rural areas, and the lending limitations are more relevant in the capitals. Banks in both countries have offered short-term amortization relief (grace periods) and customer take-up of interest-only (IO) loans has been notable, reflecting relatively easy accessibility, but levels are now normalizing again.

COVID-19 has delayed the harmonization transposition into national law

The COVID-19 pandemic delayed the transposition process in most countries, including Finland. The final proposal has been submitted to the Finnish parliament for approval. The proposal includes the introduction of a 180-day liquidity buffer, the increase in the maximum LTV ratio for residential properties to 80% from 70%, and the increase in minimum overcollateralization (OC) to 5% from 2%.

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. The main proposed amendments are the introduction of two designations for covered bonds (premium (plus) and standard), the introduction of the 180-day liquidity buffer requirement, the increase in maximum LTV ratio for residential properties to 80% from 75%, and the increase in the minimum OC to 5% from 2%. On Dec. 17, 2021, the government proposed new legislation to implement the Covered Bond Directive. The Ministry of Finance is working with authorities in the other EEA/EFTA countries and the EU to incorporate the directive into the EEA Agreement before it applies in the EU on July 8, 2022. We expect that the new rules will enter into force in accordance with the timeline defined in the directive.

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. 1, 2019, a resolution regime similar to the EU's Bank Recovery and Resolution Directive (BRRD) came into effect in Norway.

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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% of OC. 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 due to lack of 180 days' 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: Macroprudential Measures Support Housing Markets

Norway

We expect real GDP growth to rebound by 3.2% in 2021 and 2.9% in 2022 following a relatively mild contraction of 0.8% in 2020. This is thanks to robust petroleum exports, support measures, and domestic consumption. For 2023-2024, we expect real GDP growth will average 2.25% annually, supported by still-solid private consumption and increased oil and gas exports and investments.

Norwegian household debt to disposable income, at 236% as of December 2020, is one of the highest among OECD countries. We expect it will increase further over the next two years due to increasing house prices. At the end of June 2021, the 12-month growth in house prices for the whole country was 12.5%. However, house price growth slowed down in second-half 2021, with the 12-month growth at the end of November 2021 at 6.6%. In our view, the key policy rate hike together with macroprudential measures will contain excessive lending demand. We consider financial supervision in Norway strong and expect authorities to implement further macroprudential policies if needed, while banks have reduced their related risk exposure in recent years.

According to Eiendom Norge (Real Estate Norway), new home sales were around 30,000 in 2021, somewhat weaker than pre-pandemic, which will result in lower housing construction in the coming years. In our view, the increased interest rate, in combination with moderate housing construction and low population growth, indicates a more moderate house price growth.

We currently view the Norwegian housing market as being overvalued by roughly 19%, 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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Finland

We expect the Finnish economy to record a real growth rate of 2.0% in 2021, with private consumption being a chief driver of the rebound thanks to the comprehensive nature of income support systems and directed government-financed schemes. We forecast these robust growth dynamics to extend into 2022 on the back of stronger exports, investments in machinery and construction, and dynamic private consumption.

Housing market transactions have remained dynamic over the past year and Finnish house prices, in tandem with mortgage loan growth, have increased. Further, Finnish household debt remains lower than that of other Nordic countries, as well as Switzerland. During the COVID-19 pandemic, long housing loans have been more popular and a large portion of new mortgages are granted to highly indebted borrowers. According to the Bank of Finland, in 2020 the typical debt-to-income ratio of new mortgage-borrowers was approximately 360%, against approximately 328% in 2018. New mortgages typically have an initial maturity of about 25 years, but longer maturities of some 30 or 35 years have become increasingly popular during the past two years. The median size of new mortgages has grown to €89,000 from €81,000 during the same period. We understand that the government is considering various means of containing overall household debt levels, among them a maximum home loan term and a debt-to-income limit, both endorsed by the central bank.

We currently assess the Finnish housing market as being slightly undervalued by about 3%. 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.

Comparison Of Norwegian And Finnish Covered Bond Programs

In our rated Norwegian programs, the credit coverage (foreclosure frequency and loss severity) has improved, mainly due to the application of revised guidance for criteria assessing residential loan pools. The improvement in foreclosure frequency is driven by the new LTV curve, which considers effective loan to value (ELTV) ratios (based on 80% OLTV/20% CLTV). In the previous criteria, only the original LTV ratio was considered. The decrease in loss severity is mainly driven higher thresholds for jumbo valuations under our revised guidance.

In most of our rated Finnish programs, foreclosure frequency has improved, mainly due to a lower share of constant annuity loans and the use of the new LTV curve considering ELTV ratios under the revised guidance for criteria assessing residential loan pools. Loss severity has increased in most Finnish pools, driven by a slight increase in the share of jumbo valuations.

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Green covered bonds and ESG considerations

Norway has been quick to embrace green covered bonds. DnB & SpareBank 1 Boligkreditt helped pave the way for green covered bonds, followed by a number of saving banks, including Sparbanken. Eiendomskreditt recently made successful green covered bond issuances. In Finland, 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.

Environmental and social credit factors are typically credit neutral in our analysis of Norwegian and Finnish mortgage covered bonds. We consider loans to housing associations in some Finnish programs as a potential social factor, however, these loans make up a limited percentage of the cover pool. In terms of governance, most of Norwegian and Finnish issuers are committed to maintaining a minimum level of OC to commensurate with the rating, and six-month liquidity risk is covered by the bonds' soft-bullet repayment structure.

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.

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

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Scenario Analysis: Strong Resilience To House Price Drops

For both jurisdictions we have carried out a scenario analysis with large drops in house prices to assess whether these would affect the OC commensurate with our rating. We have tested the effect of house price drops of 20% and 30%, which is more severe than the hitherto largest house price drops in both countries. Specifically, in Norway, from 1970 onward, the sharpest decrease occurred between 1988 and 1989, equal to -9.68%, while in Finland we registered a -17.62% drop between 1992 and 1993.

Of the four Norwegian programs that we rate, we have tested three of them, given that the Eiendomskreditt AS cover pool is made entirely of loans backed by commercial real estate. For Finland, we have excluded Bank of Aland PLC's Category SWE covered bond program, since the loans included in the cover pool are backed by Swedish real estate.

Tables 8 and 9 shows the effect of the house price decline on our weighted average loss severity calculation and the OC commensurate with the rating. The OC 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
• 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

• Global Covered Bond Insights Q4 2021, Dec. 13, 2021
• Covered Bonds Outlook 2022: Performance Stable As Support Schemes Wind Down, Dec.9, 2021
• Eurozone Economic Outlook 2022: A Look Inside The Recovery, Nov. 30, 2021
• Danish Covered Bond Market Insights 2021, Nov. 2, 2021
• Norway, Sept. 13, 2021
• Finland, Sept. 6, 2021
• Covered Bond Harmonization In The EU Remains A Work in Progress, July 13, 2021
• Glossary Of Covered Bond Terms, Apr. 27, 2018

Related Transaction Updates

• Transaction Update: Oma Savings Bank PLC (Mortgage Covered Bond Program), Dec. 22, 2021
• Transaction Update: Sp Mortgage Bank PLC (Mortgage Covered Bond Program), Nov. 3, 2021
• Transaction Update: Eiendomskreditt AS (Commercial Mortgage Covered Bonds Program), Sept. 13, 2021
• Transaction Update: OP Mortgage Bank, Aug. 26, 2021
• Transaction Update: Storebrand Boligkreditt Mortgage Covered Bond Program, Aug. 5, 2021
• Transaction Update: Nordea Direct Boligkreditt AS (Mortgage Covered Bonds Program), Jun. 24, 2021
• Transaction Update: DNB Boligkreditt AS (Legislation-Enabled Mortgage Covered Bonds), Jun. 22, 2021
• Transaction Update: Bank of Aland PLC, Jun. 14, 2021
• Transaction Update: Bank of Aland PLC (Category SWE Mortgage Covered Bonds), Jun. 14, 2021
• Transaction Update: The Mortgage Society of Finland (Mortgage Covered Bond Program), May 27, 2021
• New Issue: OP Mortgage Bank, May 24, 2021