The balance principle

In reality, the Danish mortgage credit system is without liquidity and refinancing risk. This is due to the balance principle, the backbone of the Danish mortgage credit system.

An important factor for investor security in Danish mortgage bonds is the balance principle. The principle safeguards a very close connection between the payments from the borrowers to the mortgage banks and the mortgage banks' payments to the bond owners.
 

The balance principle is a central concept in the Danish mortgage credit model. The balance principle means that there is a close match between the bonds and the mortgage loans issued. For example, a mortgage bank issues and sells 30-year bonds with a fixed interest of 5 pc at a value of DKK 1m in order to issue and pay out a 30-year mortgage credit loan with a fixed interest of 5 pc to the amount of DKK 1m. This is called match-funding.

This means that there at all time are complete transparency in the Danish mortgage system. The mortgage banks have used an effective balance principle in combination with close coupling between listed mortgage bonds and the loans granted. This is the foundation of the marketbased prepayment system, which offer borrowers flexible possibilities for prepaying their loans - whenever they want and without any negotiation with the issuer. This is unparalleled in Europe.

In addition, the balance principle means that the mortgage credit system has a very low degree of financial risk, which contributes positively to financial stability.
 

Limited risk

Both liquidity and refinance risk is being avoided in the Danish mortgage credit system. With the balance principle and the practice that the mortgage banks follow, there is a complete match between the loans and the bonds issues, hence also between payments on the borrower side and the bond side. When re-financing takes place of e.g. one-year ARM loans, the new interest – irrespective of whether it is higher or lower than the previous interest – is transferred fully to the borrower. 
 

That way the mortgage banks carry no significant financial risk, except for the risk that the borrower may default on his payments. This is the so-called credit risk. This risk is not supposed to be a burden on the bond holder, and so the mortgage banks have a statutory obligation to hold sufficient reserves to be able to handle such situations. No bond holder has suffered financial loss for the more than 200 years during which the Danish mortgage credit system has been in function.

Balance provides transparency 

The balance principle, with the use of match-funding, provides transparency. This is true for the borrowers who may easily understand the size of their repayment amounts, interest and fees. It is also true for the bond holders who know that the mortgage banks and the issued bonds carry a very limited risk.

Transparency creates trust. Trust creates stability. Stability means low risk. Low risk means that investors reduce their demands on return on their investment. The bottom line is relatively low interest rates on home and property loans. This way, the Danish mortgage credit system is designed to the advantage of the borrowers.

Here is a film that explains the concept behind the balancing principle