this kind of interest rate risk.<sup>126</sup> It requires the MCI, when issuing bonds, to assure that every year the total payments received by the MCI from its borrowers are equal to the total of the payments to its bondholders. In practice, this is achieved by the MCI issuing a bond or a portfolio of bonds each time a loan is granted and with precisely the same repayment profile and lifetime as the loan.<sup>127</sup> This also eliminates liquidity risk with the MCI. Thus, put very simplistically, the risk of the MCI is limited to credit risk, i.e., the risk on its borrower's ability to meet their obligations.<sup>128</sup>

# **Box 8:  Regulation of Danish MCIs: a historical snapshot**

# **<mark>The earliest years</mark>**

<mark>In 1795, a fire roared in Copenhagen and one fourth of the city was burned to the ground. To rebuild the city vast sums were needed. At that time, the maximum interest rate was fixed by law at four percent, and financing was traditionally granted as personal loans without security. The supply of credit was consequently scarce. The need for security became the most important element for the lenders.</mark> <mark>In 1797, a group of wealthy citizens in Copenhagen founded the first Danish MCI. It would provide loans secured by a mortgage on real property and with joint and several liability for the borrowers by issuing negotiable debt securities. A similar system had been introduced in Germany in 1769.</mark> <mark>The first Danish mortgage act was passed in 1850, and soon after new MCIs were established. Loans were secured on a first mortgage. Loans could not exceed 60 percent of the value of a property, the value of the bonds could not exceed the value of the mortgages, and the loans had to be amortized. Loans with a 60 year maturity were standard.</mark> <mark>In 1895, second-mortgage credit institutions (in Danish: Hypotekforeninger) were introduced. The limit on first-mortgage loans to 60 percent of the value of the property and the mutuality of the existing first-mortgage associations contributed to a very strict lending policy. The secondmortgage credit institutions were allowed to grant loans of up to 75 percent of the value of the property</mark> 126 The U.S. home financing market closely resembles the Danish market, with callable mortgage-credit loans playing a decisive role. As a consequence of falling long-term interest rates, applications for mortgage-credit conversions to loans at lower interest rates reached a historically high level in the 3rd quarter of 2002. Since the U.S. mortgage-credit sector is not subject to the same balance principle as Danish mortgage-credit institutes the falling interest rates also had a negative impact on the financial situation of the mortgage-credit institutes (source: Danish Central bank, Danish Monetary Review, 4Q2002) 127 The MCI may still face interest rate risk when investing its own funds. Actually, an investment regulation (Mortgage Credit Act § 60) even forces an MCI to take on interest risk by requiring the MCI to invest at least 60 percent of its investment portfolio in listed bonds. This interest rate risk is, however, reduced by other provisions (Mortgage Credit Act § 64 and Executive Order No. 1417 of 22 December 2000 § 13), in effect limiting the maturity of its own funds to a maximum of that of the bonds.

128 The rating company Moody’s Investor Service noted the following about the balance principle in a Special Comment on Danish mortgage bonds (“Danish mortgage bonds – Highly secure financial instruments,” May 2002) “... _These regulations are the most detailed and restrictive Moody’s has seen so far and therefore provide significant support for the Danish mortgage system_ .” 82