Time To Load Up On Denmark CDS - Moody's Cuts Nine Danish Financial Institutions: Luxor Thesis In Play

Last time we looked at Denmark it it was in the context of Luxor Capital which had some very ugly things to say about the Scandinavian country in "Rotten Contagion To Make Landfall In Denmark: CDS Set To Soar As Hedge Funds Target Country." Now, 6 months later, Moody's has finally gotten the memo: "Moody's Investors Service has today downgraded the ratings for nine Danish financial institutions and for one foreign subsidiary of a Danish group by one to three notches. The short-term ratings declined by one notch for six of these institutions. The rating outlooks for five banks affected by today's rating actions are stable, whereas the rating outlooks for two banks and for all three specialised lenders affected by today's rating actions are negative  The magnitude of some of today's downgrades reflects a range of concerns, including the risk that some institutions' concentrated loan books deteriorate amidst difficult domestic and European conditions, with adverse consequences on their ability to refinance maturing debt. The latter concern is exacerbated by structural changes in the terms of Danish covered bonds and the mix of underlying assets that lead to increased refinancing risk. While Moody's central scenario remains that financial institutions show some resilience to what will likely be a prolonged difficult environment - and the revised rating levels for most Danish financial institutions continue to reflect low risks to creditors - today's rating actions reflect the view that these risks have increased."

More from Moody's:

Today's rating actions reflect two key sets of drivers:

1. A difficult operating environment, weakening asset quality and low profitability. Danish financial institutions face sluggish domestic economic growth, weakening real estate prices and higher levels of unemployment, as well as the risk of external shocks from the ongoing euro area debt crisis. Asset quality is deteriorating, and these pressures are expected to continue, exacerbated by (i) the junior-lien status of most mortgages in the loan books of Danish banks, and (ii) for specialised lenders, their concentrated exposure to certain sectors which leave them vulnerable to sector downturns. Further, Danish financial institutions' weak profitability limits their ability to absorb losses in this environment.

2. Substantial market-funding reliance of most financial institutions increases vulnerability. Most market funds are in the form of covered bonds which have historically been a stable funding source. But structural changes to that market have increased refinancing risk, posing a particular concern for mortgage credit institutions whose access to alternative funding is limited.

Additional drivers specific to individual rated institutions are detailed below.

Moody's recognises several mitigating factors that have limited the extent of today's downgrades, but they do not fully offset the above-mentioned concerns. These mitigating factors include (i) the still-moderate level of problem loans at many institutions, and their relatively good levels of capitalisation; (ii) sound government finances (as reflected in Denmark's Aaa government bond rating, with a stable outlook), (iii) the considerable (though not necessarily liquid) wealth of Danish households; and (iv) the high level of social security, which provides a level of support for borrowers and the economy.


The rating outlooks are stable for most banks affected by today's actions. Stable rating outlooks reflect Moody's view that currently-foreseen risks are incorporated in the revised rating levels. The negative rating outlooks for two banks incorporate issuer-specific factors. The negative outlooks for Danish mortgage credit institutions and for Danmarks Skibskredit reflect their near-exclusive reliance on covered bond funding, and for mortgage institutions also increased refinancing risk as a result of growth in covered bonds that fund adjustable-rate mortgages.


The average senior long-term ratings for Danish financial institutions are now at Baa1, on an asset-weighted basis. This average reflects the impact of the above-described downside risks on standalone financial profiles and limited support-driven ratings uplift. Moody's believes that Danish banks and credit institutions are in a weaker position relative to their Nordic peers to manage the credit risks emanating from the challenging domestic operating environment.


Today's changes to issuers' senior ratings can be summarized as follows:


1. Danske Bank (deposit rating Baa1, standalone bank financial strength rating (BFSR) C- / baseline credit assessment (BCA) baa2) was downgraded by two notches, and its short-term rating downgraded to P-2 from P-1. Danske's Finnish subsidiary Sampo Bank (deposits A2; BFSR C- / BCA baa1) was downgraded by one notch.

2. Jyske Bank (deposits Baa1; BFSR C- / BCA baa2) was downgraded by two notches, and its short-term rating downgraded to P-2 from P-1.

3. Sydbank (deposits Baa1; BFSR C- / BCA baa2) was downgraded by two notches, and its short-term rating downgraded to P-2 from P-1.

4. Spar Nord Bank (deposits Baa3; BFSR D+ / BCA baa3) was downgraded by one notch. The bank's short-term rating was downgraded to P-3 from P-2.

5. Ringkjobing Landbobank (deposits Baa1; BFSR C- / BCA baa1) was downgraded by one notch. The bank's P-2 short-term rating was affirmed.


1. Nykredit Realkredit (issuer rating Baa2) was downgraded by three notches. Its subsidiary Nykredit Bank (deposits Baa2; BFSR D+ / BCA baa3) was downgraded by three notches. Short-term ratings for both institutions were downgraded to P-2 from P-1.

2. DLR Kredit (issuer rating Ba1) was downgraded by three notches.

3. Danmarks Skibskredit (issuer rating Baa2) was downgraded by three notches.

The Aaa ratings on government guaranteed debt issued by these institutions are not affected by today's rating actions.



The operating environment in Denmark is characterized by weak economic growth, weakening real estate prices and higher levels of unemployment. The International Monetary Fund (IMF) projects Denmark's gross domestic product (GDP) growth for 2012 at a low 0.5%. Low economic growth constrains credit demand, whilst prolonged stagnation strains debtors' ability to repay their loans. Both trends will likely affect loan performance. Unemployment has risen, albeit from very low levels. Another factor weighing on the Danish economy is the weakened real estate market.

In addition, Danish households are susceptible to adverse conditions because of their high debt burden. Total financial liabilities of households amounted to 142% of GDP at year-end 2010, about twice as high as the 79% European Union average. Furthermore, the large size of the Danish financial sector increases the risk of negative feedback effects between a weakening economy and the health of financial institutions.

Further shocks may also emanate from the ongoing euro area debt crisis. While not a euro member, Denmark's small, open economy and its financial markets are integrated into the EU, and neither would be immune from further external shocks.

The above-described adverse conditions have already led to moderately higher problem loans, contained in part by historically-low interest rates which reduce debt service costs. Moody's expects further asset quality deterioration, particularly if real estate prices fall further and/or interest rates increase.

These asset quality concerns are exacerbated by Danish banks' providing either second or sequential-lien loans, given the practice of banks to transfer originated first-lien loans to mortgage credit institutions. Moody's believes that in a stress scenario this junior position leads to many Danish banks being at risk of higher levels of losses than similar institutions in other markets.

Meanwhile, Danish mortgage and shipping credit institutions tend to focus on specific sectors, for example commercial and household mortgages, agriculture, or shipping. As such, they are particularly exposed to a downturn in these sectors.

Finally, Danish financial institutions' low profitability limits their ability to absorb losses. Low and even negative credit growth, paired with the low interest environment, has negatively affected banks' interest and fee income, even as institutions have increased lending margins. Accordingly, pre-provision earnings of Danish financial institutions are limited and have in 2011 been largely absorbed by provisioning costs. Danish banks have improved capital, but low profitability means there is limited capacity to absorb additional losses without eroding capital.


Moody's views the reliance of many Danish financial institutions on wholesale market funding as a weakness, because it leaves them vulnerable to potential sudden changes in investor sentiment. Moody's recognises the historical stability of the Danish covered bond market, on which many domestic financial institutions rely, directly or indirectly, for large parts of their funding. However, Moody's is increasingly concerned by the dependence of Danish institutions on the uninterrupted functioning of that market, particularly given changes to its structure that increase refinancing risk.

The Danish covered bond market has shifted from long-term issuance that matched mortgage duration, to covered bonds of shorter maturities (funding adjustable-rate mortgages, ARMs, with annual rate adjustments). The maturity mismatch between long-term mortgages and the covered bonds funding them raises issuers' exposure to refinancing risk very significantly. This is a credit negative, as refinancing risk has materialised repeatedly in global funding markets over the course of the financial crisis, even for ostensibly reliable and resilient sectors.

Our ratings downgrades on specialised mortgage lenders are larger than for Danish banks. Given their near-complete reliance on covered bonds, specialised lenders would likely struggle to access alternative funding sources in a funding stress scenario. Furthermore, most Danish covered bonds require additional collateral to be provided if the market value of existing collateral falls. However, specialised issuers possess limited unpledged assets and may need recourse to unsecured markets or to support from Danmarks Nationalbank in a stress scenario.

In addition, we recognise that covered bonds play a central role in Denmark, amounting to DKK2.4 trillion, or approximately135% of GDP, at year-end 2011. They are widely issued by financial institutions who also hold them as liquid assets. Any issuer-specific problem would therefore likely spread and affect other institutions.

For Danmarks Skibskredit, we recognise that their market funding, via shipping bonds, continues to operate on a matched maturity basis that reduces refinancing risk, assuming continued asset performance. However, our rating downgrade reflects the risks associated with the institution's concentrated asset portfolio, combined with the reliance on this single market funding instrument.


Moody's has not changed its support assumptions for Danish financial institutions with respect to local or national governments. The senior long-term ratings for several institutions continue to be positioned one notch above their standalone credit assessments, as Moody's expects them to benefit from a degree of government support, if needed. Support-driven ratings uplift is, however, limited compared with other European systems, given that the Danish authorities have created a legislative and institutional structure which allows them to impose losses on banks' senior creditors, and have used this structure in the resolution of two small institutions.

Moody's recognises that large, more complex institutions are inherently harder to resolve without disruption to markets, and that the incentive for the government to provide support to bondholders is commensurately greater. Nevertheless, the clear desire of the Danish government to protect taxpayers by ensuring that bondholders bear losses, clear statements of intent to that effect and the legislative framework put in place argue for limiting systemic support uplift.

The subordinated debt and preferred stock ratings for seven of the affected financial institutions have been downgraded today by the same number of notches as their senior ratings. Subordinated debt at Danske Bank's Finnish subsidiary, Sampo Bank, was downgraded by three notches, following the removal of systemic support for these securities. The removal of support for this debt class reflects Moody's view that in Finland, systemic support for subordinated debt may no longer be sufficiently predictable or reliable to be a sound basis for incorporating uplift into Moody's ratings.


Today's rating actions follow Moody's decision to review for downgrade the ratings for 114 European financial institutions, including Danish banks, see "Moody's reviews ratings for European Banks", 15 February 2012 (http://www.moodys.com/research/Moodys-Reviews-Ratings-for-European-Bank…). The ratings of Danmarks Skibskredit had previously been placed on review for downgrade, see press release "Moody's reviews Danmarks Skibskredit's A2 ratings for downgrade, 25 November 2011 (http://www.moodys.com/research/Moodys-reviews-Danmarks-Skibskredits-A2-…).


Rating upgrades are unlikely in the near future for banks affected by today's actions, for the reasons cited above. A limited amount of upward rating momentum could develop for some banks if a bank substantially improves its credit profile and resilience to the prevailing conditions. This may occur through increased standalone strength, e.g. bolstered capital and liquidity buffers, work-out of asset quality challenges or improved earnings. Improved credit strength could also result from external support, e.g. via a change in ownership or improved systemic support.

While the current rating levels and outlooks incorporate a degree of expected further deterioration, ratings may decline further if (i) operating conditions worsen beyond current expectations, notably if Denmark's sovereign creditworthiness and economic environment encounter material negative pressure, leading to asset quality deterioration exceeding current expectations, and (ii) Danish banks' market funding access, via covered bonds or wholesale markets, experiences a sharp decline.



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And here is what was said in December:

Misquoting Shakespeare before the market open may seem like blasphemy but in a follow-up confirmation of a thesis we proposed back in July, Luxor Capital expands on the idea that something rotten is ahead for the state of Denmark. As with many of these crises, the heart of the Danish problems lie in a commercial and residential real estate boom and looming bust and with the capital/equity remaining so low in the Danish banking system (and a pitiful funding profile), it seems increasingly evident that public balance sheet support will become necessary (and perhaps not sufficient). How ironic that we pointed out, back in July, the probability that Germany will need two insolvency funds, a South-facing and now a North-facing one. Having traded in the mid 20s during H1 2011, CDS now stands at 106bps (off its September peak of 158bps) and given the interest we are seeing from hedge funds in this relatively lower cost short, we suspect this week's modest decompression will accelerate.



After dedicating 20 of the 21 pages of its Q3 Letter (courtesy of ValueWalk), Luxor's conclusion in its Death to Denmark thesis is as follows:

In summary, we believe a housing crisis is looming in Denmark. Whether Danes grow into current home prices over an extended period of time (as the Danish central bank predicts) or home prices violently correct downward will determine the fate of the banking sector and with it the market’s estimation of the sovereign’s solvency. Our experience with levered assets is they tend to re-price on the downside much quicker than they appreciated on the upside.


Denmark could be particularly susceptible to this in the wake of the upcoming contraction in private credit in Europe. We find the senior bonds in the Danish banks to be among our best risk-adjusted shorts in the portfolio. The Danish regulators have already exercised their authority to impose losses on senior bank creditors in the recent bank failures; we would expect them to do the same in the future should a banking crisis emerge. In our estimation, the senior bonds are the de facto equity in the Danish banking system and they are trading at 3-4% yields.


Given the paltry equity in the Danish banking system and the reckless funding profile of the banks, we fear the government will eventually be saddled with much of the banking systems’ liabilities in the event of a full blown housing crisis. Given the size of the bank liabilities to the sovereign and the acceleration the sovereign would be facing in its own leverage saddled with such an economy, this outcome would lead to considerably wider credit spreads, if not an ultimate default on the sovereign.


While we would stress that none of these negative outcomes are probable, we believe they should be of reasonable concern to bondholders of sovereign and bank debt in Denmark. For this reason alone, we find the current trading levels of these securities materially over-priced.

As a reminder, back in July we made a special prediction about precisely a day like today:

S&P said that "In our base-case assumption, we estimate the gross loss due to additional bank failures to be Danish krona (DKK) 6 billion-DKK12 billion over a given three-year period. If the losses are larger than we expect, we would have to reassess our ratings on individual Danish banks, based on the impact of the fallout on each. Eleven banks have failed in Denmark since 2008. Although the banks were small by international standards, it is nevertheless an unusually high number for a developed market where bank defaults are generally rare events and extraordinary government support mostly averts losses to senior creditors. While the Danish regulatory authorities accept the concept of systemically important institutions, they have so far given no formal indication of which institutions fall under this definition. In our opinion, the banks we rate would be considered systemically important and therefore may receive extraordinary government support, beyond that defined in the country's established bank resolution scheme." So according to the rating agency any country that dares to avoid the Paulson-Summers TBTF doctrine is in prompt need of annihilation if we read this right. Either way, this latest black swan means that the crisis is creeping ever closer to Germany, which now has to fund two insolvency fronts: a southern and a north one. And when S&P finally puts France on downgrade review, the time to panic will have come and gone.

France is now on downgrade review... and the market refuses to accept reality.

Denmark sovereign CDS remain notably rich to their recent wides and well below peers from a cost of carry perspective offering a relatively low cost long vol position that is yet to be crowded out.

Finally, below is the full Luxor thesis which is finally in play again and hasn't changed one bit: