Basel to ignite Danish Dynamite ?

Some weeks ago, we referred to Switzerland, Norway and Denmark amongst others as safe havens and their problems in having their currencies not to appreciate too fast (eg fx reserves of central banks, especially Switzerland). And their "dynamite" features are reflected by short term negative interest rates they offer to the investor. Today however I want to focus on some other aspects which might have some dynamite implications on a country such as Denmark, this time in the literal sense of the word.

As an introduction, we first have to take a look at a true sweet financial market sun spot, being the market for Danish covered (mortgage) bonds. Now covered bonds were created by Frederick "Barbarossa" the Great in Prussia anno 1769 (Pfandbriefe). These securities are debt securities backed by cash flows coming out of public loans or mortgages. In Denmark, they came to life after the Great Fire of Copenhagen in 1795 when almost 25% of the city went into ashes. So rebuilding the city urged for some kind of organized funding in the short term, hence the creation of structured credits such as covered mortgage bonds. Now today virtually all real estate needs in Denmark are financed with covered bonds. And make no mistake about the size of this market: it's huge. In fact, it's the third largest covered bond market world-wide. The size is around 460 bio USD or 370 bio EUR, comparable to Belgian GDP. And this mortgage bond market is about 5 times the size of the Danish public debt market, the latter being 63% of GDP or 47% when Maastricht definition is applied. Now despite this size and several crises over the recent past (Scandinavian crisis early nineties and 2008 global), this market has never experienced 1 default. Sure, some small savings banks in Denmark went bust since 2008 with no bail-outs, but as far as the covered bond market is concerned, no "accident de parcours" has been registered up until now.

The point today is not that this is about to change, rather, some new rules coming from out of Basel could have far reaching implications for banks and their liquidity rules. And they could destroy a market with all the best of intentions. Why ?

When stress testing bank balance sheets (imposing core tier 1 capital requirements etc), Basel also prescribes liquidity rules and gives a kind of rating score on this. And so various assets on the balance sheet receive a different credit/liquidity score. With what is currently on the table, it means however that Danish banks would be limited in the use of mortgage bonds to 40% of the total balance sheet. And in addition, Basel would prescribe that these assets are subject to a 15% haircut which turn them even less interesting for collateral purposes (sovereign bonds still have the so-called 0% weight on the balance sheet or not subject to haircuts in terms of collateral). Briefly, if Basel is imposed, it would cause a considerable sell-off on the market for Danish mortgage bonds and it will be primarily Danish banks effectively destroying their own domestic playground.

Now several Danish lobby groups have been urging Basel time after time to reconsider these new liquidity drafts dating from 2010. But it has struggled to push through its points of view, merely for the simple reason that the country is not a member of the Basel Committee. So when you are not an insider, it's fairly difficult of course to change the system. So the mouse that roared is likely to be devoured by the bad pussy cat ? Not necessarily, because we have another animal wandering around in the room, and this time it concerns a big elephant : EMU.

The ECB and the Bank of France for instance have also hammered on changing this proposal because depending on the tough stance you take on haircuts (risk weighting - collateral purpose), banks will have a problem in meeting certain requirements. And my other personal main argument would be that when quantitative easing takes place - sending a lot of government bonds to the balance sheet of the central bank - there is not much 0% weight collateral left to circle around free in the system (same argument for US counterproductive QE). No wonder some are complaining that "Basel hampers efforts of central banks to combat the crisis because it curtails lending and implement monetary policy". Now we all know by now that 06/09 is an important date to note (next ECB bazooka council). Coincidentally or not, the talks on re-drafting the Basel liquidity rules resume on 05/09. For the Danes and others it might imply D-Day, this in terms of "Decision", "Disembarcation" and most of all, "Dynamite".