Transaction Update: DnB NOR Boligkreditt AS Covered Bond Programme

Transcription

1 December 17, 2010 Transaction Update: DnB NOR Boligkreditt AS Covered Bond Programme Residential Mortgage-Backed Covered Bonds Issued By DnB NOR Boligkreditt AS Primary Credit Analyst: Jussi Harju, London (44) ; Secondary Credit Analyst: Karlo Fuchs, Frankfurt (49) ; Surveillance Credit Analyst: Niclas Aschenbrenner, London (44) ; Table Of Contents Program Update Rationale Outlook Strengths, Concerns, And Mitigating Factors Covered Bond Program Structure Structural Enhancements Market, Liquidity Risk, And Hedging Structure Credit Analysis Cash Flow Analysis Issuer Norwegian Housing Market 1

2 Table Of Contents (cont.) Legal Framework Ongoing Surveillance Appendix Definitions Related Criteria And Research 2

3 Transaction Update: DnB NOR Boligkreditt AS Covered Bond Programme Residential Mortgage-Backed Covered Bonds Issued By DnB NOR Boligkreditt AS Ratings Detail Description of the notes Rating* Amount Outstanding amount (mil. NOK equivalent) "Obligasjoner med fortrinnsrett" (Norwegian legislation-enabled covered bond) AAA/Stable 288,380 U.S. covered bond program (Norwegian legislation-enabled covered bond) Euro covered bond program (Norwegian legislation-enabled covered bond) AAA/Stable Up to $8 billion N/A AAA/Stable Up to 45 billion N/A *Standard & Poor's ratings address timely payment of interest and ultimate principal according to the original terms and conditions of the covered bonds. N/A Not applicable. Standard & Poor's Five-Step Covered Bond Rating Process Step 1: Calculation and classification of the asset-liability mismatch Asset-liability mismatch Low=0% Step 2: Program categorization Category 2 Step 3: The maximum potential covered bond rating The maximum potential rating uplift (notches) 6 ICR (DnB NOR Bank ASA) A+/Stable/A-1 Notches between ICR and maximum potential rating (notches) 4 Step 4: Cash flow and market value analysis Target credit enhancement (%) 16.3 Available credit enhancement (%) 27.5 Step 5: The covered bond rating Rating Outlook AAA Stable ICR Issuer credit rating. Key Features Of The Cover Pool as of Aug. 31, 2010 Collateral description Residential mortgages (98.5%) and loans to housing associations (1.5%) Country of origin Kingdom of Norway (100%) Collateral description Norwegian residential mortgage loans originated in Norwegian kroner Current balance of the cover pool (bil. NOK) Number of loans 362,452 Weighted-average LTV ratio (%)* 55.4 Geographic distribution Oslo region: 24.3%. Three cities (Trondheim, Stavanger, and Bergen): 10.6%. Rest of Norway: 65.1% Product types Repayment mortgages and mortgages with an interest-only period that revert to repayment mortgages 3

4 Key Features Of The Cover Pool as of Aug. 31, 2010 (cont.) Weighted-average maturity (years) 22.0 Average loan amount (NOK) 1,014,546 Largest loan (NOK) 99,494,330 Weighted-average seasoning (months) 22 Floating interest rate loans (%) 94.2 Fixed interest rate loans (%) 5.6 Repayment loans (%) 61.7 Loans with an interest-only period (%) 38.3 Payment in arrears (%) 0.25 *Based on loan-level data and valuation haircuts applied by Standard & Poor's. Key Characteristics Of The Mortgage Covered Bond Program* Weighted-average foreclosure frequency (%) Weighted-average loss severity (%) Weighted-average recovery period (years) 1.5 ALMM (%) 0.00 Weighted-average maturity of assets (years) 13.5 Weighted-average maturity of liabilities (years) 6.5 Outstanding balance of cover pool assets (bil. NOK) Outstanding balance of covered bonds (both programs, bil. NOK) Available credit enhancement 27.5% on a nominal basis Target credit enhancement (%) 16.3 *For definitions, see "Appendix". As of August As of Oct. 14, 2010, when the U.S. dollar bonds were issued. Supporting Ratings DnB NOR Bank ASA as bank account, interest rate, and currency swap provider A+/Stable/A-1 Program Summary Program structure Covered bond type Governing law Issuer Parent company of the issuer Originator, servicer, and administrator Independent inspector appointed by the Norwegian Financial Supervisory Authority Clearing and settlement Listing DnB NOR Boligkreditt's U.S. covered bond program and euro program constitute a framework under which it has the opportunity to continuously raise funds with covered bonds up to $8 billion and 45 billion, respectively "Obligasjoner med fortrinnsrett" (Norwegian legislation-enabled covered bond) English and Norwegian law DnB NOR Boligkreditt AS DnB NOR Bank ASA DnB NOR Bank ASA Ernst & Young AS DTC, Euroclear, Clearstream, Luxembourg Luxembourg Stock Exchange Program Update Standard & Poor's Ratings Services is publishing this transaction update for DnB NOR Boligkreditt AS's (DnBB) covered bond programs following the inaugural $2 billion issuances by DnBB under the newly established $8 billion 4

5 covered bond program ("U.S. program") on Oct. 14, 2010, we assigned a AAA/Stable credit rating to the new issuance and affirmed our ratings on all outstanding residential mortgage covered bonds issued by DnBB under its existing 45 billion covered bond program ("euro program"). These covered bonds are backed by the same collateral pool as the covered bond issued under the U.S. program, and covered bonds issued out of both covered bond programs are unsubordinated obligations of the issuer and rank pari passu among themselves. DnBB made its first covered bond issuance in June 2007 and has issued about NOK288.4 billion (an equivalent of 35.9 billion) under the program. All of the covered bonds issued, including jumbo series and smaller private placements, rank pari passu with each other. DnBB updated the base prospectus for its 45 billion covered bond program in June 2010 when the program limit increased to 45 billion from 40 billion. Since this program update, DnBB has established an $8 billion covered bond program that is backed by the same cover pool. Since our last transaction update in July 2008, the balance of the residential mortgage assets has increased substantially to NOK367.7 billion ( 45.8 billion) from NOK84.2 billion ( 10.5 billion). At the same time, the balance of the outstanding covered bonds has increased to NOK288.4 billion ( 35.9 billion) from NOK77.1 billion ( 9.71 billion). Rationale The regular review of the covered bond ratings for this transaction is part of our general rating and surveillance process of covered bonds. For our rating analysis and this transaction update, we have reviewed the asset and cash flow information provided as of Aug. 31, 2010 (which includes the new issuance). Applying our covered bond criteria, the asset-liability mismatch (ALMM) and the program characteristics of DnBB's cover pool allow for a six-notch elevation from the issuer credit rating (ICR). Reflecting our assessment of the target credit enhancement (TCE) in combination with the available credit enhancement, on Oct. 14, 2010, we assigned a 'AAA' credit rating to the $2 billion covered bond issued under DnBB's U.S. program, and we affirmed the 'AAA' rating on the covered bonds issued under DnBB's euro program. Outlook The stable outlook reflects that adverse movements in the ICR or the ALMM measure would not automatically result in a change to the covered bond rating. The issuer could suffer either a two-notch downgrade to 'A-' or the ALMM category could deteriorate to "high", and the issuer would be still be able to maintain the 'AAA' rating, provided that the available credit enhancement is greater than the TCE. The 'AAA' credit rating we assigned to DnBB's covered bonds reflects our expectation of timely payment of interest and repayment of principal on the final maturity date or on the extended maturity date (12 months after the final maturity date) where applicable. Strengths, Concerns, And Mitigating Factors Strengths Rating stability: The combination of the ALMM measure of "low" and the program categorization of 2, allows a potential elevation of up to six notches above the ICR, whereas only four notches are currently needed to maintain the 'AAA' rating. Credit risk: We consider the cover pool to be granular and to have sound credit quality. This is evidenced by low 5

6 loan-to-value (LTV) ratios, relatively low average loan sizes, and geographic distribution that approximately follows the normal population distribution in the local regions (apart from some concentration in the Oslo and Eastern regions), and the fact that as long as the issuer is solvent, loans in arrears for more than 90 days will not be accounted for when calculating the available overcollateralization. Market risk is addressed by derivatives that are registered to the cover pool and comply with Standard & Poor's current criteria, to ensure that entering into derivative agreements to mitigate market risk does not introduce additional credit risk to the program and to ensure that the derivatives would not terminate in the potential insolvency of the issuer. Overcollateralization is above the regulatory minimum requirements and commensurate with the 'AAA' rating. ALMM risk: We have continuously observed an active management aimed at maintaining a "low" ALMM risk profile. Concerns Credit risk: The dynamic nature of the cover pool may result in a change in the credit quality and composition of the cover pool assets. The current cover pool has a seasoning of approximately two years, with nearly one-third of the cover pool being originated during the last 12-month period. This has not changed since our last transaction update in July 2008, as the cover pool has grown substantially and the newly added loans have been less seasoned than the loans that were in the cover pool. Furthermore, the mortgages originated during recent years were originated in a highly competitive environment, which has resulted in a declining average margin. Market risk: The income on the loans is denominated in Norwegian kroner, and the issuer has issued and will continue to issue covered bonds in currencies other than Norwegian kroner. Furthermore, the cover pool assets have various interest rate products and types, which may be based on a different interest basis and/or may have different reset dates than the covered bonds issued. Overcollateralization: Although DnBB is committed to comply with the regulatory matching requirements and may provide more overcollateralization than required by law, there is no legally binding obligation for the issuer to provide overcollateralization to maintain the current rating (which might require more overcollateralization than required by law). The overcollateralization that currently supports the assigned ratings could, therefore, at management discretion, decline to the sole minimum, which may not always be sufficient to support the currently assigned ratings. ALMM risk: The maturity profile of assets and the liabilities issued under the program is uneven, in our view. The weighted-average maturity of the cover pool assets is approximately 13.5 years, whereas the weighted-average maturity of the liabilities is approximately 6.5 years. This increases the pressure on the cover pool assets to provide sufficient cash flows to meet the timely interest and ultimate principal payments on the covered bonds under stressed market conditions if DnBB becomes insolvent. Mitigating factors Credit risk: We monitor the cover pool quarterly (or more often if necessary) to assess whether the credit quality of the cover pool remains commensurate with the assigned ratings. Furthermore, if DnB NOR decides to include new asset types to the cover pool, it will notify us beforehand so we can assess the impact of the new assets to the credit quality of the cover pool. Market risk: The issuer has entered into derivative agreements to mitigate the impact of market risks. These derivatives are registered to the cover pool and comply with Standard & Poor's current criteria to ensure that entering into derivative agreements to mitigate market risk does not introduce credit risk element to the program, and to ensure that the derivatives would not terminate in the potential insolvency of the issuer. 6

7 Overcollateralization: We hold regular discussions with the issuer to assess its willingness to provide sufficient overcollateralization to support the assigned rating. Currently, we are of the opinion that the issuer intends to provide sufficient overcollateralization to support the assigned rating, and that DnBB has the sufficient financial strength to provide additional overcollateralization if necessary. We will continuously monitor the financial strength of DnBB and DnB NOR. ALMM risk: The liquidity gap in stressed market conditions is taken into account in our cash flow analysis when calculating the TCE commensurate with the maximum achievable rating. This takes into account stressed defaults, lower and higher than expected prepayments, and substantial moves in interest rates. When the projected stressed asset cash flows are not sufficient to meet the interest and principal payments due on the covered bonds in our cash flow analysis, we assume that part of the cover pool assets are sold at distressed prices to meet these payments. The timeliness aspect between the time when the payments come due on the covered bonds, and when the sales proceeds are available, is also mitigated by the issuance of covered bonds with extendible maturities which means that if DnBB does not have sufficient funds to redeem the covered bonds, the redemption may be deferred by up to 12 months. We believe that these features should allow sufficient mitigation of refinancing risk if the issuer becomes insolvent shortly before the covered bonds' scheduled maturity. During the extension period, we understand that a bankruptcy administrator should be able to contract liquidity or monetize a sufficient amount of assets to repay maturing covered bonds. Covered Bond Program Structure DnBB is a subsidiary of DnB NOR Bank ASA (A+/Stable/A-1) and was specifically set up to enable the group to issue covered bonds. DnBB is a limited company incorporated under the laws of the Kingdom of Norway and was originally established as a finance company on June 14, The Norwegian Financial Supervisory Authority (FSA) granted the issuer license to operate as a finance company on Aug. 11, 2005 and license to become a mortgage credit institution on May 9, DnBB issues covered bonds under both the U.S. and euro programs and these covered bonds represent unsubordinated obligations of the issuer and rank pari passu among themselves. The covered bonds issued under both programs have recourse to the issuer and to the same cover pool. Both of the programs are governed by Norwegian and English law, and the servicing and administration of the loans and the hedging agreements are governed by the same master documentation under both programs. The structure of DnBB's covered bond program is shown in chart

8 Structural Enhancements Overcollateralization According to the Norwegian covered bond law, the value of the cover pool from DnBB must always exceed the value of the outstanding covered bonds under the program on a net present value basis. However, it should be noted that prudent eligibility criteria for cover assets and the matching requirements do not automatically ensure that the provided overcollateralization that meets the minimum regulatory requirements is sufficient to maintain 'AAA' rating on the covered bonds. Although there is no other legally binding overcollateralization obligation except the matching requirements in the Norwegian covered bond law, we consider that DnBB intends and is able to maintain an overcollateralization level commensurate with the current 'AAA' rating. The current nominal overcollateralization amounts to about 28% and is based on the current cover pool balance. It takes into account all covered bonds (including the recent $2 billion issuance) issued as of the date of this report. 8

9 Downgrade language and rating triggers The rating triggers applied in the DNBB covered bond program are described in table 1. Table 1 Rating Triggers Role Bank account provider (direct support counterparty) Notification for borrowers to pay directly to DnBB's bank account Swap providers (derivative counterparties) Downgrade language Short-term rating of 'A-1' If DnB NOR's long-term rating falls below 'BBB-' The short-term rating for financial institutions is 'A-2' and for nonfinancial institutions is 'A-1' Extendable maturities One notable feature of both DnBB's covered bond programs is that all larger covered bond issues are issued with extendable maturities, so it can extend the maturity on any series of securities by up to 12 months from the scheduled maturity date. The purpose of this feature is to mitigate any refinancing risk if the issuer became insolvent before a security's scheduled maturity. Under this scenario, the issuer could refinance the maturing security through the issuance of further covered bonds, or could extend the maturity date of the maturing security by up to 12 months so that a new manager could be appointed, who could monetize assets to repay the maturing covered bonds. During the extension period, the covered bonds would continue to accrue interest that would be paid monthly. If DnBB fails to redeem a covered bond that has an extended maturity date on its scheduled maturity date, the covered bond's maturity date will be automatically extended on a monthly basis up to its extended maturity date. About 13% of the covered bonds issued under the program do not have the extendible maturity feature, which we also considered in our cash flow analysis of the program. Bank account provider DnB NOR Bank (A+/Stable/A-1) is appointed as bank account provider in this covered bond program. Mortgage payments from borrowers in the cover pool are paid by direct debit into DnBB's collection accounts at DnB NOR. Commingling risk occurs whenever cash belonging to DnBB is mixed with cash belonging to a third party, or is deposited into an account in the name of a third party, so that, if that third party becomes insolvent, the cash would be lost or delayed. The degree to which DnB NOR's insolvency would affect the asset cash flows depends on the collection account characteristics which in DnBB's case is limited, since most borrowers pay the mortgage payments by monthly direct debit. As soon as the cash is registered into the collection account, the cash is protected according to the Norwegian covered bond law, so the risk the covered bondholders might face if DnB NOR defaults would be a delay of the payments if the cash in progress were frozen or delayed. The rating trigger for the bank account provider is 'A-1' and, if we downgrade the bank account provider below this, DnB NOR will open a bank account with a bank that has a rating of at least 'A-1' within 30 days of the downgrade. The borrower payments will be swept on a daily basis to this account. If we downgrade DnB NOR below 'BBB-', it will notify the borrowers to make their payments directly to a collection account that is held with a suitably rated bank. If DnB NOR fails to give this notification within 30 days DnBB has the right to notify the borrowers. Cover pool at the date of the transaction update As of Aug. 31, 2010, the cover pool comprises a pool of prime Norwegian residential mortgage loans secured on residential properties (98.5% of the cover pool, backed either by single or multiple properties), and some loans to 9

10 housing associations (1.5% of the cover pool). The cover pool has grown substantially since the inception of the program the total outstanding balance of the loans in the cover pool as of July 2007 was NOK36.8 billion, and this had increased to NOK367.7 billion as of Aug. 31, The cover pool is granular and well diversified: It comprises 362,452 mortgage loans and shows a diversified geographical distribution in the Kingdom of Norway. The Standard & Poor's-adjusted weighted-average loan-to-value (WA LTV) ratio of approximately 55% is relatively low compared with the similar assets in the cover pool of other Nordic issuers (based on loan-level data reported to us). Another distinctive feature of the cover pool is that majority of the loans (approximately 93%) are floating-rate loans, which is a common feature in Norway. As of Aug. 31, 2010, the cover pool has the following characteristics: The weighted-average seasoning of the pool is 23 months. All loans are residential mortgages (about 98.5%) or housing association mortgages (about 1.5%). All of the properties are located in the Kingdom of Norway and all loans are denominated in Norwegian kroner. All loans are either repayment (62%) or loans with an interest-only period that revert to repayment loans (38%) loans. On an aggregated basis, the borrowers have a relatively low leverage with a WA LTV ratio of approximately 55% based on market values. The initial loan pool is well diversified geographically and in terms of loan size. Cover pool distribution by LTV ratios There is a broad distribution of LTV ratios in the cover pool with a WA LTV ratio of approximately 55%. We have calculated the LTV ratios in the cover pool as the ratio of the total amount of outstanding mortgage loans in relation to the reported market values of the properties as of August 2010, which are subject to valuation haircuts to ensure that a conservative view in relation to the recent house price development in Norway is maintained. We do this solely for analytical purposes, and this is why chart 2 displays some LTV ratios that are above the legal limit set in the Norwegian covered bond law. Some of the cover pool assets comprise multiple loan parts made by the DNBB to one borrower, secured on the same property; and in calculating the LTV ratios, we aggregated the total amount of loans secured on each property. In addition, the cover pool contains loans that have security over multiple properties (approximately 6% of the cover pool). In calculating the LTV ratios for these loans in our analysis, we have aggregated the amount of available collateral for each loan compared with the total balance outstanding against these properties. Chart 2 shows the LTV ratio distribution for the loans in the cover pool (after applying valuation haircuts in our credit analysis) from August

11 Chart 2 Product types in the cover pool Loans with an interest-only period are normally underwritten with a maximum interest-only period of 10 years, after which the terms and conditions require the borrower to amortize the loan. However, in rare cases DnB provides this condition up to more than 50 years for some housing association loans, but in combination with lower LTV ratios than the average. In the cover pool that we analyzed, approximately 62% are amortizing loans, while loans with an interest-only period account for approximately 38%. According to our experience, interest-only loans with maturities of less than 10 years may bear a higher credit risk, which we also address in our credit analysis. However, the cover pool as of August 2010 included less than 4% of interest-only loans belonging to that category. Most of the interest-only loans reported have a final maturity of above 20 years, which has been the case since the inception of the program. Traditional mortgages with a fixed loan amount from origination represent about 68% of the mortgages, and the mortgage loans which are characterized as overdraft facilities where the borrowers could increase the drawn amount up to a pre-decided limit represent approximately 32% of the cover pool. When calculating the foreclosure frequency for borrowers with loans including further drawdown possibilities, we took the maximum drawable amount into account in our credit analysis. Distribution by loan size The cover pool is fairly granular and the average aggregated loan per property in the cover pool amounts to approximately NOK1,194,538 (equivalent to approximately 149,000 or $189,000). Mortgages in the cover pool which exceed NOK1,000,000 (approximately 125,000 or $158,000) represent approximately 78.5% of the pool, and mortgages exceeding NOK2,500,000 (approximately 312,000 or $395,000) represent about 23% of the pool 11

12 (see chart 3). Chart 3 Maturities of the assets The maximum maturity term offered to borrowers in the residential mortgage market has increased in recent years and a mortgage loan may be taken out with a final maturity of above 50 years. The weighted-average original maturity of the mortgages in the cover pool is approximately 22 years. However, the average economic life is normally expected to be much lower due to the competition among banks lending in the Norwegian residential market, which can lead to continuous remortgaging among borrowers. Further, even if the borrowers remortgage, most Norwegian borrowers usually remain with the same bank. The latter means that a mortgage will be registered as a new mortgage, even if the bank has had a relationship with the borrower for many years. Prepayment rates All mortgage borrowers with floating interest rates in Norway could prepay their mortgages without any penalties, which means that the prepayment risk could be somewhat higher than in some other European countries, since almost all of the borrowers have floating interest rates. Furthermore, the increased competition seen in the Norwegian market during recent years, apart from the slowdown during the financial crisis, has also increased the prepayment rates. Although this is in line with conditions applied by other mortgage banks in Norway, in our analysis we model higher prepayment scenarios than in most other jurisdictions, to ensure that high prepayments do not put pressure on the rating. For a prepayment, the applicable legislation does not permit any penalty fees and the borrower pays only for the economic cost of the mortgage loan to the bank. All mortgage borrowers with floating interest rates may repay their mortgage at any date without a penalty. Only the fixed-interest mortgage borrowers need to pay a penalty to DnBB 12

13 in case of prepayment, to compensate DnBB for any mark-to-market losses. Cover pool seasoning The weighted-average seasoning is fairly low and amounts to 22 months (based on the loan-level data reported to us), which might not be fully representative of the credit risk in the pool, since the frequent remortgaging in the Norwegian market obviously will reduce the reported seasoning in the pool. This is due to the fact that, when a loan is refinanced in the loan-level data reported to us, the origination date refers to the refinancing date of the loan, and hence the seasoning and the weighted-average seasoning underestimate the true seasoning of the loans. This should be noted when examining the seasoning distribution (see chart 4). Chart 4 Geographic concentration The mortgages are well distributed throughout the country, mirroring the typical population density in Norway. The largest geographic concentrations are found in the areas of Oslo (southeast), representing almost a quarter of the mortgages. The areas including the three larger cities Trondheim (northwest), Stavanger (southwest), and Bergen (west) represent approximately 10% of the pool; and the remainder of the pool, approximately 65%, is well distributed in the other regions. Payment methods Mortgage payments from most borrowers are due monthly and almost all borrowers make their payments through direct debit, which ensures timely payment of interest and principal. All mortgage payments are received into a collection account for DnBB held at DnB NOR as bank account provider, and this bank account is registered in the cover pool register. 13

14 Market, Liquidity Risk, And Hedging Structure As at the date of this transaction update, DnBB has only one covered bond outstanding under the U.S. program. However, as these bonds rank pari passu with the covered bonds issued under the euro program, the covered bonds outstanding under both programs are presented below. The maturity profile of assets and the liabilities issued under the program is uneven, in our view. The weighted-average maturity of the cover pool assets is approximately 13.5 years, whereas the weighted-average maturity of the liabilities is approximately 6.5 years. This increases the pressure on the cover pool assets to provide sufficient cash flows to meet the timely interest and ultimate principal payments on the covered bonds under stressed market conditions if DnBB becomes insolvent. In a run-down scenario, the amortization of the cover pool ends with the maturity of the last asset in 2051 and all covered bonds having repaid by 2031 (see chart 5). Chart 5 Although the ALMM percentage is currently zero, there are substantial peaks in the liability profile (based on extended maturity dates where applicable), as can be seen in chart 6. The ALMM percentage is zero because it is a time-weighted calculation where more recent mismatches receive more weight, and because we give benefit to 5% prepayments in the ALMM calculation. In addition, the calculation is based on the current cover pool, so the amount of overcollateralization will affect the ALMM percentage. As DnBB has a considerable amount of overcollateralization in the cover pool and the mismatches occur in the relatively distant future, the ALMM percentage is zero. 14

15 Chart 6 A substantial portion of the liabilities (22.9% of outstanding covered bonds), based on the extended maturity dates, are concentrated in The next large concentration of maturities is in 2018, when 19.6% of the covered bonds outstanding come due. As these concentrations come closer, the ALMM and the TCE may increase if the issuer decides not to mitigate this and if other factors, such as the amortization profile of assets, remain constant. However, it should be noted that these mismatches are still relatively distant and the issuer has indicated that it will manage the ALMM on an ongoing basis. Another aspect to consider is that although the cover assets are currently only denominated in Norwegian kroner, the majority of covered bonds issued under the euro program are denominated in euros, and the future issuances under the U.S. program are expected to be denominated in U.S. dollars. Both programs provide the ability to issue in other currencies too, and the issuer has indicated that any foreign exchange risk arising will be hedged. In addition to the legal requirements in the Norwegian covered bond law, DnBB's hedging strategy foresees having a fully matched book, to be established by the use of derivatives. The hedges to be applied are either to address hedging mismatches on the asset side or mismatches on the liability side. Under the Norwegian covered bond law, derivatives enjoy preferential rights and are included in the cover pool and its register. Derivatives registered in the cover pool will not terminate upon the insolvency of DnBB. There will be two types of hedging used in the covered bond program, i.e., asset swaps and liability swaps. The asset swaps will cover the mismatches between the received interest rates on the fixed mortgages compared with floating-rate NIBOR (Norwegian interbank offered rate). The swap notional is the balance of the residential mortgages. Any fixed-rate substitute assets (there are none in the cover pool at the moment) will also be hedged into 15

16 floating-rate NIBOR and the swap notional will be the nominal amount of the substitute assets. The liability swaps will cover any mismatches between the issued covered bonds in respect of currency or interest risk. Any issued covered bonds with fixed euro rates under the euro program will be hedged into floating EURIBOR (European interbank offered rate), and any covered bonds issued under the U.S. program will be hedged into floating U.S. dollar LIBOR. The cross-currency element will be hedged from floating EURIBOR or U.S. dollar LIBOR, to NIBOR. Currently, DnBB has contracted all derivatives with its parent DnB NOR. The contracted derivative agreements have a downgrade provision that ensures that upon the loss of the 'A-1' short-term counterparty credit rating, the counterparty needs to post collateral, and upon losing its 'A-2' rating, the swap counterparty needs to be replaced by another eligible entity. Derivatives registered in the cover pool comply with Standard & Poor's criteria (see "Revised Framework For Applying Counterparty And Supporting Party Criteria," published May 8, 2007). Credit Analysis For Standard & Poor's to be able to assign a rating to the covered bonds, the transaction must be strong enough to withstand 'AAA' credit losses in the cover pool. Also, the cash flows from the assets must be sufficient to meet the debt service requirements on the liabilities so that timely interest and full principal are repaid on the scheduled maturity of the covered bonds. We analyze the collateral quality to determine the expected loss in a stressed situation. Cash flow shortfalls in the collateral would mainly result from asset quality problems, i.e., credit losses on the respective mortgage loans that would reduce the amounts available to service the secured debt. The typical form of credit enhancement for covered bonds that is provided to address potential risks, including credit risk, is overcollateralization. The credit analysis of the residential mortgage loans involves assessing the individual credit quality of the cover pool by estimating the credit risk associated with each mortgage loan. We then calculate the aggregated risk to assess the overall credit quality of the cover pool. We quantify the credit risk associated with each mortgage loan in the pool by estimating each loan's probability of default leading to a portfolio-wide weighted-average foreclosure frequency (WAFF) and its corresponding weighted loss severity (WALS), which is expected be realized if foreclosure occurs. The potential loss associated with a loan can be calculated by multiplying the foreclosure frequency with the loss severity. To quantify the potential losses associated with the entire cover pool, each mortgage loan's foreclosure frequency and loss severity is weighted by its percentage of the total cover pool. The probability of default (WAFF) and the stressed expected recovery (the inverse of the WALS), are input into the cash flow model to determine the required level of overcollateralization commensurate with a preliminary 'AAA' rating. We believe the current 'AAA' target credit enhancement to cover the asset default risk, according our analysis, is 3.8%. Cash Flow Analysis We evaluate a pool of covered bonds on a cash flow basis to determine whether, under conditions of severe economic stress, the cash flow generated by the assets would be sufficient to meet the debt service payments due on the liabilities in a timely manner. The aim of the cash flow analysis is to assess the pools for: 16

17 Credit risk, as described above; Market risk, in the form of interest rate and currency risk; ALMM risk, as a result of cash flow mismatches between assets and liabilities in terms of maturity (ALMM), and market value risk in case the program has to liquidate assets; Prepayment risks and servicing costs; and An appropriate stress-testing of these risks using the Covered Bond Monitor (CBM). CBM is a Monte Carlo model, which simulates approximately 100,000 different economic scenarios, or more if required, to establish an accurate default distribution. Each scenario produces a different path for interest rates and exchange rates for each currency included in the issuer's cover pool. Using these input parameters, it computes a corresponding set of cash flows to determine whether, under these stressed assumptions, the pool exhibits sufficient strength to pass the target rating eligibility test. The average maturity of outstanding covered bonds defines the target rating default probability against which the cash flows are benchmarked. If the respective cover pool cash flows exhibit fewer defaults than accepted under the threshold, the cover pool passes the rating eligibility test from a quantitative point of view. A more detailed explanation of the Covered Bond Monitor can be found in "Covered Bond Monitor, Technical Note" (see "Related Criteria And Research"). In the 'AAA' scenario, we assume the insolvency of DnBB and look to the cover pool to redeem existing covered bonds. The cash flow analysis is based on the assumption of a static pool, i.e., no active pool management or new issues other than servicing the liabilities and, if necessary, selling or securitizing loan portfolios to cover temporary liquidity needs. This assumption stems from our central rating assumption, where the issuer is insolvent and the cover pool is managed to its conclusion. The aim of the cash flow analysis is to stress the cover pool for credit risk, market risk in the form of interest and currency risk, and liquidity risk as a result of cash flow excesses or deficits. If there is an excess, we assume that the administrator of the cover pool is able to reinvest the proceeds in a conservative manner. However, if there is a liquidity deficit, we must conclude that the cover pool always has recourse to liquidity by selling the mortgage assets. The cash flow analysis determines the TCE level commensurate with the program's maximum potential rating. Table 2 Main Cash Flow Inputs Probability of default (WAFF) (%) Recovery rate (1 WALS) (%) Time to recovery (months) 18 Prepayment assumptions Low (0.5%) and high (24%; 35% for scenario analysis) Interest rates Simulated interest rate curves between 0% and 12% Servicing costs (%) 0.20 Spread shock (bps) 425 Step 1: Calculation and classification of the asset-liability mismatch To determine the maximum potential rating uplift for a covered bond program over the issuing bank's ICR, we first need to calculate the ALMM. Here we consider mismatches between the asset and liability cash flows, and we multiply mismatches that occur in 17

18 the distant future with a decreasing scaling factor. In our opinion, programs that are exposed to large funding needs within the next 12 months are typically riskier than those with mismatches throughout the tenor of the covered bonds. We apply our standard interest rate and default stresses and assume a constant prepayment rate of 5% on the mortgage assets when calculating the ALMM. Following the calculation, we categorize ALMM risk according to table 3. Table 3 ALMM Classifications And Maximum Potential Uplift Ranges ALMM classification ALMM percentage (%) Maximum potential number of notches uplift Zero N/A Unrestricted Low 0 <= 15 5 to 7 Moderate 15 <= 30 4 to 6 High > 30 3 to 5 N/A Not applicable. DnBB's covered bond currently has an ALMM percentage of 0%, which translates into a "low" ALMM classification. Step 2: Program categorization In this step, we categorize programs based on our ability to obtain third-party liquidity or to sell assets to fund any mismatch after the issuing bank fails. We believe the range of funding options and the strength of funding sources for Norwegian covered bonds are flexible, and there is a broad range of banks that are able to lend. Although the banking market in Norway is not as sizeable as in some other European jurisdictions, it should be noted that in the Nordic region the banking market is fairly diverse to the effect that the majority of the Nordic banks have operations in most Nordic countries. In addition, DnBB's cover pool does not exhibit characteristics that are uncommon in Norway. Therefore, we classify DnBB's covered bond program to Category 2. Step 3: The maximum potential covered bond rating We assess the maximum potential covered bond rating by combining the ALMM classification and the program categorization (see table 4). Table 4 Maximum Potential Ratings Uplift From The Issuer's ICR ALMM classification Category Zero Unrestricted Unrestricted Unrestricted Low Moderate High Combining the ALMM classification of "low" and the program category of 2, the maximum uplift that we can assign to covered bonds issued under DnBB's covered bond program is six notches. It should be noted that the ratings on DnB NOR Boligkreditt AS's covered bond program factor in the ICR on DnB NOR Bank ASA (A+/Stable/A-1), to which DnB NOR Boligkreditt is a core subsidiary. We have used this ICR as a basis for the 18

19 elevation of the ratings assigned to DnB NOR Boligkreditt AS's covered bond program. As the ICR of DnB NOR Bank is A+/Stable/A-1, it only needs four notches to reach the maximum achievable rating (AAA). In this case, the maximum uplift above the ICR is four notches. Step 4: Cash flow and market value analysis In step 4, we analyze the cash flows by taking into account credit risks, structural risks, and ALMMs. We model the market value risk (ALMM) by discounting the stressed cash flows of the cover pool assets with a modeled interest rate curve plus a "spread shock". We calculate the net present value of the projected cash flows of the assets using a discount rate, which we base on the pool-specific asset spreads over the relevant funding rates. The current stressed target asset spread used for DnBB's covered bond program based on the pool characteristics is 425 basis points (bps). Step 5: Covered bond rating In this last step of our rating analysis, we assign the rating to a covered bond program by assessing whether the available credit enhancement is at least equal to the target credit enhancement commensurate with the target rating. In order to calculate the target credit enhancement, we usually stress the cash flows for credit defaults and recoveries, trustee and servicer expenses, interest and currencies exposures, and stressed refinancing spreads. By applying these stresses to DnBB's covered bonds using Standard & Poor's Covered Bond Monitor, we are of the opinion that the TCE commensurate with the maximum achievable rating is 16.3%, which is less than the available credit enhancement of 25.7%. Hence, the DnBB has sufficient credit enhancement to reach the maximum achievable rating. Consequently, we assign four notches' uplift above DnB NOR Bank's issuer long-term credit rating of 'A+', which results in a 'AAA' rating on the covered bonds issued under both programs. In addition, we assigned a stable outlook to the covered bonds issued under the euro program and the new $2.0 billion covered bond issued under the U.S. program. The stable outlook reflects that adverse movements of the ICR or the ALMM measure would not automatically result in a change to the covered bond rating. The issuer could suffer either a two-notch downgrade to 'A-' or the ALMM category could deteriorate to "high", and the issuer would be still be able to maintain the 'AAA' rating, provided that the available credit enhancement is greater than the TCE. We believe the current 'AAA' target credit enhancement to cover ALMM risks, according our analysis, is 16.30%. Issuer DnBB is a subsidiary of DnB NOR Bank (A+/Stable/A-1) and its operation is specifically set up for mortgage lending and to issue covered bonds. DnBB is a limited company incorporated under the laws of the Kingdom of Norway and it was originally established as a finance company on June 14, The Norwegian FSA granted the issuer license to operate as a finance company on Aug. 11, 2005, and license to become a mortgage credit institution on May 9, DnB NOR Bank is a subsidiary of DnB NOR ASA (i.e., the DnB NOR Group). DnB NOR was formed in January 2004 through the merger of Norway's two leading financial institutions Den norske Bank ASA (DnB) and Union Bank of Norway ASA. The DnB NOR Group has total assets of NOK1.82 trillion ( 227 billion) at Dec. 31, 2009, and this banking group is Norway's undisputed leading financial services provider. It is the world leader in shipping finance and the 19

20 Norwegian market leader in corporate and retail banking services, life insurance and pension products, and asset management. Market shares in Norway are about 30% or more in household lending, life insurance, and customer deposits. For further credit details on DnB NOR Bank and the DnB NOR Group, see our most recent credit analysis on the bank in "Related Criteria And Research". Norwegian Housing Market The Norwegian residential mortgage market has experienced a prolonged period of fast expansion over the past decade. The market peaked in mid-2008, when the growth in property prices turned negative due to the financial crisis; but this trend quickly turned and property prices have continued on an upward trend since the beginning of The property prices have already recovered from the slump at the end of 2008 and have now surpassed the peak levels reached in mid In fact, in the past 12 months alone, the house prices in Norway have increased by 8.4%. The continued increase in house prices is helped by the current historically low level of interest rates, which has improved affordability for borrowers. The Norwegian Central Bank was very vocal in signaling interest hikes in the beginning of 2010, and in fact raised interest rates by 0.25% on May 5, However, weaker-than-expected production numbers have kept the current interest rates at 2%. The Norwegian FSA is also attempting to stem house price growth: In March 2010, it proposed that an LTV ratio cap of 90% should apply to all new mortgage loans. We would expect this, combined with market expectations of increasing interest rates, and the fact that lenders have generally tightened lending conditions, to lead to more stable development in house prices. Chart

21 Legal Framework The Norwegian covered bond law and secondary legislation provide a legal framework for the issuance of covered bonds. Based on our review of this framework and on legal experts' opinions, we believe the legislation provides the appropriate framework to allow us to look through the insolvency of the issuer in accordance with our criteria. Our covered bond ratings methodology links the rating on the covered bonds to the issuer's credit rating if we see mismatches between the cash flows from the assets and liabilities. As the issuer's credit rating decreases, the credit rating on the covered bonds will, ceteris paribus, also decrease. If the issuer becomes insolvent, the covered bond holders have to rely on the cash flows generated by the cover pool in order to receive timely payment of interest and ultimate payment on the maturity date as per the final terms and conditions of the covered bonds. To assess whether the legal framework supports this, we considered the following features: The isolation of, and priority to, the assets in the cover pool in an insolvency of the issuer; No acceleration or forced restructuring of debt on the insolvency of the issuer; The survival of the hedging agreements on the insolvency of the issuer; The ability for a manager to generate liquidity, to mitigate any maturity mismatch risk between the assets and the liabilities; and The ability to provide and maintain overcollateralization above the regulatory minimum requirements in the insolvency of the issuer. The Norwegian covered bond law defines eligibility criteria for the type of assets that may and may not be included in the cover pool. Mixed pools are allowed under the Norwegian law. An independent inspector has been appointed by the Norwegian FSA and it should regularly review compliance, oversee the register for the cover pool, and ensure that the value of the cover pool always exceeds the issued covered bonds. The issuer needs to be a specialized credit institution and also to obtain a license from the Norwegian FSA. A mortgage credit institution can include mortgage credit assets secured on residential and commercial property within the European Economic Area (EEA) or the Organisation for Economic Co-operation and Development (OECD), as well as public-sector credit assets granted to or guaranteed by a public body within the EEA or OECD. It may also include supplementary assets, such as government bonds, treasury bills, and securities issued by eligible financial institutions within the EEA or the OECD. However, there are further restrictions on these categories, as presented below: Maximum LTV ratios are 75% for residential mortgages and 60% for commercial mortgages, based on the prudent market value for each property. Substitution assets are limited to a maximum of 20% of the value of the cover pool. The Norwegian FSA may authorize this limit to be increased to 30% for a limited period. Nonperforming assets cannot be included. All derivatives used for hedging mismatches need to be registered in the cover pool. The net present value of the cover pool cash flows must always exceed the net present value of the cash flows of the covered bonds. Cash flows generated from the cover pool must exceed the payments on the covered bonds. A decrease in the house prices will affect the property valuations used. The loans with LTV ratios exceeding the LTV restrictions, described in the Norwegian covered bond law, will not be considered when calculating available 21