September 21, 2009
 

In 2002 I wrote a column contrasting the housing finance systems of Denmark and the US. Recently, both systems have been stressed by the world-wide financial crisis, prompting me to take another look. I was interested in whether the impact of the crisis on the two systems revealed anything further about their relative strengths and weaknesses?

The Danish System

The core of the Danish system is eight specialized mortgage banks which originate all home mortgages, and a mortgage bond market where the loans are funded. Each new loan is immediately sold in the market for the equivalent bond. If the new loan is a 30-year FRM, for example, it will be sold to investors as an increase in the balance of the 30-year fixed-rate bond. There are bonds with fixed and adjustable rates, and within each category there are separate bonds for different terms.

The Danish system makes it easy for borrowers to shop for a mortgage. On a given day, all borrowers pay the same interest rate on a given type of loan. (Borrowers either meet the credit and other requirements, or they don’t.). The interest rate on a new mortgage loan is the current market yield on the specific bond that will fund the loan, plus the mortgage bank’s markup. Bonds are traded on the Copenhagen stock market, and their yields are readily available.   
 
Danish mortgage banks do not adjust the interest rate for points, nor do they tack on a series of fixed-dollar charges to cover specific expenses, as is the practice in the U.S. Total upfront fees are modest and pretty much the same at all the mortgage banks.

The strength of the Danish system is its transparency and low origination costs. Its major weakness is that it does not serve as large a segment of the population as the U.S. system. Loans are not priced for risk, so borrowers who have poor credit or who cannot make a down payment of  20% are not served. In a financial crisis, however, this “weakness” is a source of strength, as we have recently learned.

Impact of Crisis on Secondary Markets

Both countries were afflicted by the world-wide loss of confidence in financial institutions. Both governments responded by guaranteeing the liabilities of banks and other financial firms, including mortgage banks in Denmark. However, in Denmark that guarantee did not include mortgage bonds, because it was not considered necessary. The Danish mortgage bond market continued to function normally during the crisis, which meant that new loans continued to be written as before.     

In the US, in contrast, markets in mortgage-backed securities (MBSs) not guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae ceased functioning. This is why “jumbo” loans – those too large for purchase or insurance by a Government entity -- which before the crisis were often placed in MBSs, are so costly in today’s market relative to conforming loans.

The market for private MBSs collapsed because investors incurred -- or anticipated that they might incur -- horrendous losses, whereas investors in Danish mortgage bonds did not suffer any losses at all! One reason is that the Danish mortgage bond system is inherently stronger than the MBS system. A Danish mortgage bond is a liability of the mortgage bank issuing it and is supported by the capital, reserves and income of the bank, as well as by the mortgage loans that collateralize that particular bond. If the collateral supporting one bond happens to suffer large losses, the bond holders are nonetheless protected by the entire resources of the bank.

In contrast, in the U.S. system each private MBS has “credit enhancements”, such as reserve accounts, excess cash flows, or insurance, designed so that each can stand on its own. If the credit enhancements on one issue out of 100 turn out to be insufficient, the investors in that issue will suffer loss, even though the enhancements in the other 99 are excessive. Further, any such failures can have a contagious effect on the confidence of investors in other issues, who may wonder whether the credit enhancements in their issues are adequate.

The second reason the private MBS market in the U.S. collapsed and the Danish bond market didn’t is the much higher default rate on mortgages in the US. In addition, investors incurred larger losses on defaulted mortgages because defaulting borrowers in the US had less equity.

More Equity in Denmark

Home prices have declined in Denmark since the crisis began, though not quite as much as in the US. Single-family home prices were down 15% in the second quarter from their previous peak, while “owner-occupied flats” were down 28%. As in the US, price declines have been much larger in some areas than in others. Despite the price declines, however, the great majority of Danish borrowers had substantial equity in their homes when the crisis struck. The widespread negative equity that emerged in the US – a major factor encouraging defaults and increasing losses when default occurs – had no counterpart in Denmark.

Why? A major reason is that, in the US, down payments of less than 20% were the norm well before the bubble began, and no-down payment loans became increasingly common during the bubble. When the bubble burst in 2007, therefore, a substantial proportion of the homes purchased in the prior 2-3 years had no equity.

In contrast, the down payment requirement in Denmark was 20% well before the bubble and remained 20% during the bubble. While second mortgages were available from commercial banks and may have increased in importance during the bubble period, all mortgage borrowers in Denmark have personal liability which is enforced by lenders. Losses on second mortgages have been very small compared to the US.

Erosion of down payment requirements was only one of the ways that the US housing finance system was weakened during the bubble period much more than the Danish system, The “quality” of new borrowers, meaning the array of financial and personal factors that affect the likelihood that they will default at some point, deteriorated much more in the US. There was no Danish equivalent of sub-prime loans to attract tenants into ownership who were not qualified to be owners. And Denmark did not have alternative documentation rules that allowed borrowers to claim higher incomes than they actually had.  

Erosion of Lending Standards During the Housing Bubble

The mortgage crisis that erupted in 2007 had its genesis in the prior bubble period, when home prices were rising rapidly. Price increases reduce the perceived riskiness of mortgages, encourage investors to accept mortgages that in a stable environment would be viewed as unacceptably risky, and induce lenders to increase loan volume by liberalizing their underwriting requirements.

While exact comparisons are not possible, the bubble in Denmark was roughly comparable to the bubble in the US. The average price of single-family homes in Denmark rose 60.4% between the beginning of 2004 and mid-2007 when prices peaked; that was an annual rate of increase of 13.6%.  Yet the relaxation of lending standards in Denmark was far less than in the US, which was a major reason why the mortgage defaults arising from the crisis were much smaller in Denmark. Here are some possible reasons why:

Risk Shifting:  In the US system, lenders typically sell their loans, which may go through several hands before coming to rest in a security or a portfolio. If potential buyers are willing to accept loans subject to more liberal underwriting rules, the lenders originating loans will liberalize them because it expands their market and the increased default risk is transferred with the sale.

In contrast, the Danish mortgage bank that originates loans must hold them and retain the default risk. It is plausible to believe that not having the option of passing the default risk to a buyer dampens the impulse to liberalize terms.

Regulation: Regulators in the US did not take any action to curb excessive mortgage liberalization during the bubble period. Regulatory responsibility for the thousands of mortgage lenders was divided among four Federal agencies and 50 states. By the time the Federal agencies got their act together in late 2006, the damage had already been done.

I don’t know if the Danish regulator DFSA took any steps to restrain liberalization of lending standards during the bubble. The problem, if there was one, was much less severe than in the US. But DFSA could have done what needed to be done because it had sole authority over the 8 firms that originate mortgage loans in Denmark.

Transactions-Oriented Loan Originators: In the US, the incomes of the mortgage brokers and loan officers with whom borrowers deal depend almost entirely on the number and size of the loans they write. They were not responsible for the liberalized underwriting rules, interest only loans and option ARMs that emerged during the housing bubble, but they took advantage of these changes to do more deals, stretching the bubble.

In contrast, prospective borrowers in Denmark who contact a mortgage bank deal with a salaried employee. While interest-only loans and new types of ARMs were introduced by mortgage banks during the bubble period, the initiative for seeking these instruments remained largely with consumers.

Personal Liability: In the US, some states such as California do not allow lenders who do not fully recover what they are owed through foreclosure, to obtain deficiency judgments against borrowers for the balance, provided the loan was used to purchase a home. Even in states where deficiency judgments are allowed, few lenders actively pursue them. In Denmark, however, mortgage borrowers retain full personal liability and it is actively enforced by lenders.

Government-Sponsored Enterprises and the Affordability Lobby: The US had a particularly toxic combination of features that Denmark lacked: a pair of partly-private/partly-public secondary market agencies -- Fannie Mae and Freddie Mac -- and a political/social movement aimed at increasing the homeownership rate. This unholy alliance was by far the most important cause of the excessive liberalization of mortgage terms during the bubble. For readers interested in the details, I recommend Cause and Effect: Government Policies and the Financial Crisis by Peter J. Wallison, which is available at www.aei.org.

The two agencies were stockholder-owned but received an enormously valuable subsidy from the Federal Government in the form of an implicit guarantee of their liabilities. The quid pro quo was their active participation in programs to help low-income and minority households to become homeowners. In 1992, Congress authorized the Department of Housing and Urban Development (HUD) to set annual quotas for agency purchases of “affordable loans,” expressed as a percentage of their total purchases. Initially 30%, these quotas rose over time, through both the Clinton and Bush administrations, reaching 55% in 2007.

Acquisitions of non-prime mortgage by the agencies increased rapidly beginning in 2004 and peaked in 2007 with the onset of the crisis. Wallison estimates their holdings in 2008 at $1.5 trillion, This total included purchases of private securities in the market, which HUD allowed the agencies to count toward their quotas of affordable loans. The horrendous default rates and losses on these loans sealed the fate of the agencies, which in 2008 were placed in a Government-administered conservatorship. 

Historically, most economists were skeptical or hostile to Fannie Mae and Freddie Mac. Usually, the reason was that only about half of the taxpayer-funded subsidy provided to the agencies was realized as a benefit by borrowers. We now see that that was the least of it. The more compelling argument against the mixed private/public model is that it corrupted the political process and destabilized the system. Not having any equivalent is one important reason why Denmark has weathered the crisis much better than the US.