Source: S&P Global Ratings, Casper R Andersen

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.

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.

Table 3

Chart 6

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.

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.

Table 4

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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.

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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