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, despite challenging conditions, solid economies, stable issuer ratings and outlooks, and strong sovereigns will continue to support ratings stability for both Norwegian and Finnish covered bonds.

Overview: Growing Covered Bond Markets

Both Norway and Finland have well-established covered bond markets. In the past decade, issuance has grown steadily in both jurisdictions. The Norwegian market is the 10th-largest European market and the Finnish market is the 14th-largest. Together, the two countries account for below 6% of the European benchmark market, with Norwegian banks issuing approximately 3x the volume of Finnish peers. So far covered bond issuance from Norway has been below 2022 levels and mainly issued as floating rate covered bonds. Finnish issuers have been comparably active following the update of the Finnish covered bond framework, but issuance may end up lower than in 2022 due to the decrease in new loan origination.

Increase in central bank rates in both Finland and Norway and increased volatility in general bank funding costs have also increased the cost of covered bond funding. Although both mortgage markets are primarily variable rate markets, banks in Norway use standard variable rates. These rates may not always cover the full increase in the cost of covered bond funding, for example for competitive reasons. Constant annuity loans in Finland means that the amounts paid by the customers will not change as long as the current paid amount covers the increasing interest rates. If mortgage payments do not increase in line with the increase in the cost of covered bond funding, credit enhancement commensurate with the current ratings is likely to increase, all else equal.

Norwegian covered bonds legislation was adopted in June 2007 and updated in June 2020 to reflect the EU covered bond harmonization directive. 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 volume outstanding). Most loans are floating-rate and Norwegian krone (NOK)-denominated.

Finland first adopted its legal framework for covered bonds in 1999. Several amendments have followed since, most recently, the legislative framework adopting the harmonized EU legal framework took effect July 8, 2022. 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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Monetary policy tightens against high inflation

Norway.   After lowering its policy rate to 0% from 1.5% to dampen the negative effects of COVID-19, Norges Bank increased the rate eight times to 2.75% in 2021-2022. On March 22, 2023, Norges Bank's Monetary Policy and Financial Stability Committee raised the policy rate to 3%. Given high inflation, which we project will fall slightly to 4.6% in 2023 from 5.8% in 2022, we expect Norges Bank to increase the rate at least once more in 2023 to 3.5%, before possibly cutting rates again in 2024.

Banks' lending rates have risen, but not to the same degree. According to Norges Bank, about 85% of the policy rate increase since September 2021 has passed through to residential mortgage rates. At Jan. 31 2023, the average interest rate on mortgages was 4.1%, and we expect this to increase during this year as the policy rate rises. Higher mortgage rates will put downward pressure on house prices in 2023. According to Norges Bank, house prices are projected to fall 4% through fourth-quarter 2023, then rebound from the start of 2024 as residential mortgage rates stabilize.

Finland.   In response to interest rate hikes from the European Central Bank since June 2022, mortgage rates in Finland rose rapidly in second-half 2022. Average interest rates on new mortgages and new corporate loans have also increased sharply, which has put downward pressure on the Finnish housing market.

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Recent market developments

Norway.   In December 2022, the Norwegian Ministry of Finance amended lending regulation requirements on debt-servicing ability such that lenders must ensure customers have sufficient funds to cover regular expense after an interest rate increase of 3 percentage points, which is subject to an interest rate floor of 7 percentage points. The previous requirement was to cover regular expense after an interest rate increase of at least 5 percentage points.

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 of 85%, maximum debt-to-income ratio 5x gross annual income, and geographic flexibility ratio of 10% (8% in Oslo) are unchanged. The regulation will be in force until Dec. 31, 2024.

Finland.   With the aim of curbing household debt, a government package of macroprudential enhancements will take effect July 1, 2023. Main changes include the maximum loan maturity to 30 years for housing loans and housing company loans, the 60% LTV limit on housing company loans for new construction, and an earlier amortization requirement following completion.

Furthermore, new borrower-based macroprudential tools--debt-to-income or debt-service-to-income cap--would address household vulnerabilities. While the Financial Supervisory Authority (FIN-FSA) recommended a maximum debt-servicing burden, implementing these measures in a binding manner would require legislative changes.

Finnish authorities are committed to further enhancing their systemic risk monitoring framework, which includes addressing data gaps and strengthening the analysis of granular data. The positive credit register to record individual borrower data is expected to be operational in 2024 and markedly improve the quality of data for macroprudential analysis and policymaking.

Implementation of the EU's Covered Bond Directive

Finland implemented the Covered Bond Directive into national legislation via the Covered Bond Act (CBA). The CBA took effect March 11, 2022, applies to covered bonds issued since July 8, and replaces the Finnish Act on Mortgage Credit Bank Activity (the MCBA) for new issuances.

Norway published new legislation at the end of June following European Economic Area (EEA) ratification of the EU Covered Bond Directive. The amended law took effect July 8 and covers existing bonds and premium covered bond issued after that date.

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 the cover pool may include. Finanstilsynet appoints a cover pool monitor to regularly review compliance, oversee the cover pool register, and ensure that the pool's value always exceeds the issued covered bonds. The law also stipulates that the issuer must be a specialized mortgage credit institution and obtain authorization from Finanstilsynet.

A mortgage credit institution can include mortgage credit assets secured on residential and commercial properties within the EEA or Organization for Economic Cooperation and Development (OECD), and public sector credit assets granted to or guaranteed by a public body within the EEA and OECD. It may also include supplementary assets, such as securities issued by eligible financial institutions within the EEA or OECD.

Under the updated legislation, issuers must have 5% overcollateralization, up from 2% previously. Maximum LTV increased to 80% from 75% and secondary homes to 80% from 60%. Finally, the limit on supplemental assets is removed (it had been 20%).

The law introduces a 180-day liquidity requirement whereby the cover pool must include sufficient substitute assets to meet the maximum net outflow connected to the covered bonds for the upcoming 180-day period. Issuers may consider the extension of the covered bonds' maturity in the 180-day calculation, but this must preapproved based on the FSA's objective criteria. We understand this only applies to bonds with extension issued under the new law; existing soft-bullet bonds remain grandfathered.

We understand the appointment of an independent cover pool monitor, a role previously undertaken by the issuer's auditor, is still pending, but will likely be taken on by alternate auditors.

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

On Jan. 1, 2019, a resolution regime similar to the EU's Bank Recovery and Resolution Directive took effect in Norway.

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Legal framework in Finland

Finland implemented the Covered Bond Directive via the CBA on July 8, providing the legal framework for issuing Finnish covered bonds. Bonds issued before July 8 will be grandfathered.

The MCBA and CBA provides the eligibility criteria. Issuers can include mortgage assets secured on residential property in any eurozone country, and substitute assets. 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. Derivatives must be registered in the cover register and survive the issuer's insolvency. The derivative contracts rank pari passu with the covered bonds.

Under the MCBA, issuers must have 2% overcollateralization on a net present value (NPV) basis, while under the CBA, the requirement is 2%, but 5% on an NPV basis if certain requirements of article 129 of the Capital Requirements Regulation are not met. Also, pursuant to the MCBA, the total interest accrued on the cover assets during any successive 12-month period must cover interest on the covered bonds and payments to derivative counterparties.

The CBA introduced a 180-day liquidity requirement whereby the cover pool must include sufficient substitute assets to meet the maximum net outflow connected to the covered bonds during the upcoming 180-day period. We understand that, in calculating the net outflow related to the covered bonds, issuers may consider the extension of the covered bonds' maturity.

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

Under the MCBA, covered bondholders and derivative counterparties have recourse toward 70% of the residential properties' and 60% of commercial estate properties' market value. Under the CBA, this priority of payment right extends to the entire value, although only 80% of the market value of residential properties and 60% of the market value of commercial estate properties can be included in determining overcollateralization.

After a mortgage bank enters liquidation, Finanssivalvonta will appoint a supervisor to oversee covered bondholders' interests. While the bankruptcy trustee manages both the insolvency estate and the covered bonds, the supervisor ensures there is no conflict of interest between the secured and unsecured bondholders. If necessary, the supervisor can ask the bankruptcy trustee to sell assets for payments on the covered bonds, enter derivative transactions, and secure liquidity to fulfill the obligations related to the covered bonds.

Under the MCBA, the administrator, upon the demand or consent of the supervisor, could accelerate covered bond payment if the cover tests cannot be fulfilled. We understand that, under the CBA, acceleration can only occur (upon the request or approval of the supervisor) if the overcollateralization requirements cannot be met. We consider this scenario unlikely to affect ratings, because our credit and cash flow analysis accounts for the cover pool's ability to service payments on the covered bonds.

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Table 1

Currency of issuance

Large Norwegian issuers do not rely solely on NOK-denominated issuance for their funding needs and more than half of covered bond issuance are in foreign currencies, mainly euro. Currency mismatches between assets and liabilities generally do not affect our view of risk, given that cross-currency swaps mitigate them. A number of smaller Norwegian issuers rely mainly on the growing NOK market for issuance because the costs of cross-currency swaps and the difficulty in achieving the 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 denominated in foreign currency.

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Mortgage Market Overview: Macroprudential Measures Support Housing Markets

Norway

We expect real GDP growth to decelerate to 0.8% in 2023 after a strong growth of 3.3% in 2022. This stems from weaker household consumption following high inflation and interest rates, tighter monetary conditions, and subdued global and national demand. We also expect oil and gas prices to fall from 2022's high levels. We do not anticipate any material direct impact from the Russia-Ukraine war on economic growth because economic ties are limited (less than 1% of exports for both). For 2024-2026, we expect real GDP growth will average 1.5% annually, supported by recovering private consumption as inflation declines, as well as a rise in investment as markets and supply chains normalize.

The labor market remains tight in Norway, with record low unemployment, at 3.2% in 2022, and labor supply constraints in many sectors. However, due to weaker economic activity and the inflow of jobseekers, we expect unemployment to increase to 3.6% in 2023 and peak at 4.0% in 2025.

Norwegian household debt to disposable income, at 227% as of Sept. 30, 2022, is one of the highest among OECD countries. We expect it to remain near this level over the next two years. Although we consider household debt high, the housing market is cooling. Prices fell in autumn 2022, affected by loan interest rates that have risen following Norges Bank's policy rate hikes since 2021. We expect policy rate hikes to continue in 2023. Over the next two years, we project a slowdown in house price growth due to higher interest rates, stable residential construction, and low population growth. We consider financial supervision in Norway strong, we expect authorities to implement macroprudential policies if needed, and banks have reduced their related risk exposure in recent years.

We view the Norwegian housing market as being overvalued by approximately 19%. As a result, we think measures aimed at preventing overheating in the housing market will likely be tightened and remain for the foreseeable future.

Growth in the building stock and new construction of residential dwellings has long been significantly below the general population growth. This has likely contributed to, and continue to support, strong demand and price growth in the Norwegian housing market.

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Finland

Despite the conflict in Ukraine, real GDP growth in Finland was 2% in 2022, driven by strong domestic demand in first-half and less trade exposure to Russia. Although the conflict's effects will persist well into 2023, we expect the Finnish economy will remain resilient and absorb the shock from the loss of trade with Russia and the weaker demand from its key trading partners. We project economic growth will gradually approach 1.3%-1.5% from 2024, which will be increasingly tested by structural constraints, including lackluster productivity growth amid a shrinking employment pool.

Although employment has improved recently, we expect a slight deceleration as a skills mismatch in the labor market become more evident and the labor market tightens. We expect unemployment to remain at 6.5%-6.7% despite high vacancies and government reforms to fill gaps by investing in infrastructure and research and development.

Although Finnish household debt remains lower than that of other Nordic countries, rising interest rates, alongside high inflation, will weaken households' disposable income and consumption, given that more than 90% of mortgage loans are at variable rates, although more than a third of borrowers have an interest rate hedge. We expect households' sound financial buffers and a prevailing strong social safety net and heightening demand for interest rate hedges on mortgages will continue to underpin the private sector's solid repayment capacity.

Amid rising interest rates and slowing economy, Finnish housing demand declined in 2022. According to Statistics Finland, in 2022, the total transaction of existing dwellings fell about 20%. Sales of new homes declined more than those of existing homes, by about 48%. House price growth slowed to 1.4% (year-on-year) in September 2022, from 4.9% in September 2021. We expect that rising interest rates, high inflation, and weaker housing demand will mean house price declines. On the other hand, the strong employment situation and wage increases will support housing market overall, in our opinion.

We assess the Finnish housing market as being slightly undervalued, by 1.1%. Therefore, we expect authorities to continue to consider measures supporting house prices, especially in those regions where prices are under pressure.

Growth in construction of residential dwellings has long been significantly above the general population growth. This has likely kept house price increases lower than Scandinavian neighbors.

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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, 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 March 31, 2015).

In Norway, covered bonds may be backed by both residential (Boligkreditt) and commercial (Naeringskreditt) mortgage loans, but these asset types cannot be combined within the same pool.

In Finland, a maximum of 10% of the cover pool may consist of commercial real estate unless otherwise defined in the program's terms and conditions. Up to 20% of the cover pool can consist of substitute assets. However, the limitations do not apply to assets used to cover the covered bond law's liquidity requirements.

Floating-rate markets

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

In Norway, these loans are not directly linked to market rates, such as the Norwegian Interbank Offered Rate, 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 six weeks' notice. This introduces basis risk, 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 consider this risk in our cash flow analysis.

For Finland, floating-rate loans are generally tied to an index, mostly 12-month Euro Interbank Offered Rate, and reprice at those intervals.

Interest-only or amortization?

Most of the loans in the Norwegian market have a short- to medium-term interest-only repayment profile before reverting to amortization. These loans only pay interest for usually the first five years.

The Finnish market almost exclusively constitutes amortizing loans. As a result, mortgage loan maturities are generally comparably shorter in Finnish mortgage pools, and therefore their weighted-average asset maturity is shorter than in Norwegian pools. The shorter asset maturity positively affects our cash flow analysis, leading to a relatively lower asset-liability maturity 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 withdraw the undrawn amount 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 that the repayment profile might be switched and assume payment shock could follow.

Tenant-owner rights.  To purchase the right to live in a condominium apartment (tenant-owner right) in Norway, borrowers typically become shareholders of the housing cooperative or association that owns and manages the unit's building. Borrowers need to pay monthly fees to the housing association, and these amounts are normally included in the affordability assessment for the tenant-owner rights mortgage. If one or more right-holders fail to pay their fees, the other members become liable. Moreover, debt the cooperative defaults on would be redistributed pro rata among shareholders.

We view tenant-owner right loans with low seasoning as sensitive to increases in fees to the housing association, or a potential increase in the borrower's debt due to an association default.

Finland-specific features

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

Installments must always cover interest payments, so when interest rates go up the total installment will include a higher interest component. This results in an accumulation of principal, which in turn leads to the loan maturity extending, while for some loans the principal outstanding is due at maturity. The principal of these loans could accumulate to a level that causes a potential payment shock and introduce higher credit risk, in line with our criteria.

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Intermediate loans.  Intermediate loans offer smaller banks covered bond funding while the securing mortgage loans remain on their balance sheet. These loans are backed by mortgage loans that are registered in the issuer's cover pool, but remain on the originator's balance sheet and are only transferred if the bank cannot repay the intermediate loan. We consider the security of these comparable with that of 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.

Covered bond issuers usually swap the related interest risk to match the characteristics of the intermediate loans. We consider the underlying collateral as the cover pool asset, so the characteristics of the liability swap might not match those of the mortgage loans. In our view, this can introduce interest and basis risk.

Comparison Of Norwegian And Finnish Covered Bond Programs

In most of our rated Norwegian programs, foreclosure frequency has remained stable. Loss severity has decreased in most of Norwegian pools driven by a lower current LTV ratio.

In most rated Finnish programs, the credit coverage (foreclosure frequency and loss severity) has also remained stable. In a few remaining programs, foreclosure frequency has increased, mainly due to a shorter seasoning of the portfolio, while the increase in loss severity is mainly driven by a slightly higher current LTV ratio.

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Green covered bonds and ESG considerations

Norway has quickly embraced green covered bonds. DnB and SpareBank 1 Boligkreditt helped pave the way for green covered bonds, followed by Nordea Boligkreditt and a number of saving banks and associated issuers, including Sparbanken Vest, Eika Boligkreditt, and Eiendomskreditt.

In Finland, OP Mortgage bank announced the first Finnish green covered bond framework, with Nordea Mortgage Bank following suit. Issuers are tapping into strong demand and interest from investors who normally might not enter 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 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, although these loans make up a limited share of the cover pool. In terms of governance, the majority of Norwegian and Finnish issuers are committed to maintaining a minimum level of Overcollateralization commensurate with the rating, and six-month liquidity risk is covered by the bonds' soft-bullet repayment structure.

Outlooks: 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 is the gap between available credit enhancement and target credit enhancement, which is generally tighter in Finland.

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Scenario Analysis: Strong Resilience To House Price Drops

For both jurisdictions, in our previous publication, we carried out a scenario analysis with large drops in house prices to assess whether these would affect the overcollateralization commensurate with our ratings. We tested the effect of house price drops of 20% and 30%, which is more severe than the previously largest house price drops in both countries. We consider the outcome of the previous analysis to remain meaningful, given that most programs benefit from an available credit enhancement well above the required overcollateralization for the ratings and house prices have not significantly changed since our previous review.

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 Q2 2023: The Implications Of Rising Interest Rates, April 12, 2023
• Economic Outlook Eurozone Q2 2023: Rate Rises Weigh On Return To Growth, March 27, 2023
• Norway, March 13, 2023
• Covered Bonds Outlook 2023: Sailing Through Choppy Waters, Dec. 6, 2022
• Economic Outlook Eurozone Q1 2023: Reality Check, Nov. 28, 2022
• Finland, Oct. 31, 2022
• Banking Industry Country Risk Assessment: Norway, Aug. 5, 2022
• European Covered Bonds Reach Harmonization Milestone As The Journey Continues, July 12, 2022
• Banking Industry Country Risk Assessment: Finland, June 1, 2022
• Glossary Of Covered Bond Terms, April 27, 2018

Related Transaction Updates

• Transaction Update: Oma Savings Bank PLC (Mortgage Covered Bond Program), Jan. 17, 2023
• Transaction Update: Eiendomskreditt AS (Commercial Mortgage Covered Bonds Program), Jan. 12, 2023
• New Issue: The Mortgage Society Of Finland CBA Covered Bond Program, Nov. 28, 2022
• New Issue: Sp Mortgage Bank PLC CBA Mortgage Covered Bond Program, Nov. 1, 2022
• New Issue: POP Mortgage Bank PLC Covered Bond Program, Sept. 23. 2022
• Transaction Update: OP Mortgage Bank, July 5, 2022
• Transaction Update: DNB Boligkreditt AS (Legislation-Enabled Mortgage Covered Bonds), June 13, 2022
• Transaction Update: Storebrand Boligkreditt Mortgage Covered Bond Program, June 9, 2022
• Transaction Update: The Mortgage Society of Finland (Mortgage Covered Bond Program), June 6, 2022
• Transaction Update: Sp Mortgage Bank PLC (Mortgage Covered Bond Program), Nov. 3, 2021
• Transaction Update: OP Mortgage Bank, Aug. 26, 2021
• Transaction Update: Bank of Aland PLC, June 14, 2021