July 22, 2002, Revised September 3, 2009

"A Danish friend was amazed when I told her of my ordeal in getting a mortgage. She said that in Denmark it was extremely easy and no one is ever taken advantage of. Can she possibly be right?"

Yes, the strength of the system is its low origination cost, the absence of sharp practices by loan originators, and complete transparency. It does not serve as large a segment of the population as the US system, and partial prepayments are too costly to be practical.  

Mortgage Banks

The core of the Danish system is 7 mortgage banks that specialize in making mortgage loans. They fund their loans by selling bonds in the capital markets. The bonds are in all major respects identical to the mortgage loans they fund.

For example, if I borrow $200,000 for 30 years at a fixed rate, the loan would be placed in a large pool of 30-year fixed-rate loans that serve as collateral for an equal amount of mortgage bonds held by investors. The mortgage bank on my behalf would sell an additional $200,000 of these bonds in the capital market and credit the proceeds to me. As I repay the loan, the mortgage bank passes along the payments to the bondholders in proportion to the amount of the total pool that they own.

Mortgage banks are not exposed to interest rate risk from funding long-term assets with short-term liabilities. The Danish system is built on the principle of “match-funding”, meaning that mortgages are funded with bond issues that have the same characteristics as the mortgages. 5-year ARMs, for example, are funded by  bonds on which the rate is reset every 5 years.

Shopping by Consumers

Shopping for a loan in Denmark is easy. The interest rate is the bond yield on the day the terms are locked, plus the mortgage bank’s markup. Bonds are traded on the Copenhagen stock market. The yields are readily available to everyone through the media, including the internet. Price shopping thus focuses entirely on the banks’ markups, which are very low and subject to competition between the banks.  

On a given day, all borrowers pay the same rate on the same type of loan. (This is not true of commercial mortgages, on which rates are negotiated individually). Loans are either fixed-rate for 20 or 30 years, or adjustable for periods ranging from 1 to 10 years. Each loan type has its corresponding bond, which determines the rate for that type. For example, in early June, 2003 the one-year adjustable bond yield was 3.75%, and the rate on a one-year adjustable rate mortgage (ARM) was 3.75% plus a markup of 0.60%, or 4.35%. The 30-year fixed-rate bond yield was 6.50%, and the mortgage rate was 0.60% higher at 7.10%.

No Points in Denmark

Danish mortgage banks do not adjust the interest rate for points, as lenders do in the US. Nor do banks tack on a series of fixed-dollar charges to cover their expenses, as they do in the US. All borrowers in Denmark pay the same upfront fees: 1/10 of 1 percent of the loan amount plus a fixed charge equivalent (at current exchange rates) to about $350.

Refinancing

Borrowers in Denmark can refinance by buying back bonds in an amount equal to their mortgage balance, at par or market, whichever is lower. When market rates go down. they buy at par to take advantage of the new lower rate. When market rates go up, they can stay put as borrowers do in the US, or they can refinance by buying back bonds at the depressed market price. They realize a capital gain in exchange for accepting a new higher rate on their loan.

Weaknesses

The most important weakness of the Danish system, relative to the US system, is its limited reach. Loans are not priced for risk, so borrowers with poor credit are not served. Borrowers must also put 20% down. Second mortgages are available for 15%, but not through the bond system. The mortgage bank acts as agent for non-bank investors in placing second mortgages at rates well above the first mortgage rate.

A second weakness is that partial prepayments on fixed-rate mortgages are not practical. Many borrowers in the US pay a little more each month to pay their loans off sooner, but this doesn’t work in Denmark. It would require a small bond purchase every month, which costs about $100 regardless of the amount of the purchase. On ARMs, borrowers can prepay at a small cost, but only when the rate is adjusted.

Impact of the Financial Crisis

The Danish system fared much better during the world-wide financial crisis that erupted in 2007 than the US system. A major reason was that the Danish system was much less caught up in the housing bubble during the years preceding the crisis than the US system. There were no toxic ARMs in Denmark to entice gullible borrowers to erode their equity in order get a temporary reduction in payment. There was no Danish equivalent of sub-prime loans to attract tenants into ownership who were not qualified to be owners. Denmark did not have alternative documentation rules that allowed borrowers to claim higher incomes than they actually had. And zero-down loans, which resulted in home buyers having negative equity in their homes the day they moved in, were unknown in Denmark.

While house prices declined in Denmark during the crisis, negative equity did not become a problem because the great majority of borrowers had substantial equity in their homes when the crisis struck. This was a major reason why the rise in defaults in Denmark was small and manageable.

The Danish financial system was impacted by the world-wide loss of confidence in financial institutions and the associated liquidity squeeze. In 2008 the Danish Government guaranteed the unsecured creditors of all banks including the mortgage banks. However, the 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 could continue to be written as before. This is in marked contrast to the US experience, where investors in mortgage-backed securities (MBSs) that were not guaranteed by a US Government entity (Fannie Mae, Freddie Mac or GNMA), were traumatized by the losses they incurred from the rising volume of defaults and foreclosures. These markets ceased functioning. Nothing like this happened in Denmark.