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The Danish mortgage model
The Danish model has another critical and innovative feature. Holders can retire their own mortgages by purchasing the same face amount of mortgage bonds at the prevailing market price. To prepay a mortgage by purchasing bonds, the home owner must give advance notice of several weeks to the MCI [mortgage credit institutions], which designates by lottery the specific bonds to be purchased. Thus, if rising interest rates or other factors cause mortgage bonds to trade at a discount, home owners can reduce the principal or retire the whole mortgage by purchasing an appropriate mortgage bond at a discount.
That passage is from Robert Pozen's new and notable Too Big to Save? How to Fix the U.S. Financial System.
You can't do this in the United States. You can pay off your mortgage but the "face value" of that transaction does not vary with market conditions. In essence the Danish system creates a new contingent claims market for homeowners who do not understand how to use interest rate futures and options. De facto, the homeowner receives some implicit insurance against the prospect of negative equity in the home.
Here is The Economist on the Danish model. Denmark also allows for speedy repossession of property, in case of default. Here is a more general discussion of the Danish model, which emphasizes transparency. Mortgage finance is conducted by explicitly designated institutions and originators retain a financial interest in the loan, even following securitization. The emphasis is on plain vanilla products. Here is Wikipedia on the Danish mortgage model. Here is a longer study.
Posted by Tyler Cowen on September 26, 2009 at 05:01 PM in Economics | Permalink
Comments
If we could only trade what we have for 300 million Danes...
Posted by: Vernunft at Sep 26, 2009 6:08:30 PM
It should also be noted that a small but significant number of Danes working in Copenhagen choose to live 'across the bridge' in Sweden & commute (and that some Swedes living in Sweden choose to work in Copenhagen). There's some tax/incentive arbitrage going on here.
And Denmark has a very 'progressive' property tax that could be said to discourage increasing the perceived value of ones house. Together with the norm of renting, these factors do colour the data somewhat.
Posted by: nick at Sep 26, 2009 6:32:27 PM
Per the link, Danish mortgages require 20% down. This, with the speedy repossession of property you mentioned mean risks are very low. Both are politically impossible in the US.
Posted by: tomhynes at Sep 26, 2009 7:46:48 PM
And why should 20% down, once the norm in the US (as recently as when I bought my house in 1981), not become the norm again? Not all at once, of course, but point by point.
Posted by: zbicyclist at Sep 26, 2009 10:16:28 PM
I've always wanted to pay off my mortgage by buying out the underlying bonds. I got 100% financing for my house in 2007, and given those facts, could probably have paid it off for 50% of face value late last year or early this year.
Posted by: Aric at Sep 26, 2009 10:44:01 PM
The 20% down rule is not as strict as it is in the US where you have to show the money in your bank account (I had issues because I did not move the money to US quickly enough). My last house buying experience in Denmark is rather old (1994) but it was accepted that the 20% could be financed with other means. This of course still mean that you have to find someone who will lend you that extra money.
This sounds difficult, but it quite common that you give seller an IOU (pantebrev) for something like 10%. Seller will typically sell this on the market that exists on what effectively is secondary mortgages. These do of course have higher yields and shorter maturities, they are commonly held by pension funds. These are of course riskier investments just like high yield bonds, but there is a solid market for them.
So it is in reality not harder to buy if we discount the absurdities that happened here in the last 5-10 years (and also happened in the UK when I was there in the late 80s). It is tricky enough to give people 95% mortgages, but going above 100% financing is silly.
I have been involved in house purchases in Denmark, UK and US (moved a lot for work). The former was also by far the most pleasant experience. Denmark didn't have the elaborate credit score system that we have here, so the mortgage company is mostly interested in your income (I am guessing that is why they care less about how you came up with your 20%).
Posted by: Jon at Sep 26, 2009 10:48:13 PM
"And why should 20% down, once the norm in the US (as recently as when I bought my house in 1981), not become the norm again?"
How will we increase homeownership among discriminated-against groups with that kind of thinking?
:shakes head:
Posted by: Vernunft at Sep 26, 2009 11:45:03 PM
This of course still mean that you have to find someone who will lend you that extra money.
Posted by: Moris at Sep 27, 2009 2:22:03 AM
The less down payment required, the more people can buy houses. The more homeownership at the end of your presidency, the more empowered a society you have left. The better job you've done. Prices of houses rise, those who already own, gain. Everyone wins. Right?
Posted by: Alex Conconi at Sep 27, 2009 4:17:00 AM
Doesn't this create an adverse selection problem? If the general risk of default causes mortgage bonds to drop in price while an individual's risk of default doesn't increase he can arb the difference...
Posted by: MattM at Sep 27, 2009 4:24:30 AM
MattM - don't think of it as adverse selection, think of it as a bonus payment rewarding the individual for being a better credit risk than society as a whole.
Efficient markets theory suggests that arbitrage would soon make excess profits disappear as mortgage bond prices rose. In essence, the Danish system provides a negative feedback loop which stabilizes the market. Nice.
More broadly, I think economists would benefit from a semester of Electronics 101, the old-fashioned kind that used to be taught at vocational institutions. Having a mental map of resistors, capacitors, and transistors along with knowledge of positive and negative feedback would enlighten and simplify economist's models of market behavior.
Posted by: Bob Knaus at Sep 27, 2009 6:35:12 AM
In the US the standard mortgage is fixed rate with the option to refinance. Of course, most of the savings from refinancings disappear in the cost of refinancing. Refinance five times and you're not saving much money. Bill Gross wrote a great article about how the American homeowner pays an enormous (in the aggregate) premium for the right to refinance, and how mortgage bond buyers can make a fortune by simply buying mortgage bonds and hedging that risk away. If anybody knows the article I'm talking about, or knows how this is done, please post a link. If you could do this yourself, by buying futures that payout if interest rates go down, then you could avoid the cost of refinancing.
Posted by: bjk at Sep 27, 2009 9:40:00 AM
Alan Boyce have been touring DC for about a year, to emphasize the point that the US can easily now introduce a "buy your debt back" option in the US system. George Soros wrote about it in the FT almost a year ago. This is simple to implement, as the GSEs are now effectually government owned. All it takes is a "total balance principle" forcing the GSEs to match all loans with securities with the same features. This neatly also reduces the balance sheet risk of the GSEs.
Read more here:
http://www.realkreditraadet.dk/Admin/Public/DWSDownload.aspx?File=%2FFiles%2FFiler%2FAarsmoede%2F2009%2FPrinciple_of_Balance_Lending_a_Better_Approach_Boyce_april09.pdf
Posted by: Carsten Valgreen at Sep 27, 2009 9:58:33 AM
Sounds exactly like what in the corporate bond world is called "defeasance". We could literally retire a bond issue by placing sufficient treasuries in an escrow account to cover the bond payments. One would note that this is a value destroying strategy as the bondholder is getting treasury risk substituted for corporate credit risk and this value musty come at the issuer's expense. However, such a strategy might still make sense to satisfy a rating agency concern or maintain some sort of balance sheet cosmetics.
Of course, you can effectively defease your mortgage without the contractual right to do so. Just by a portfolio of bonds with similar cash payout profile to your mortgage (at a discount) and use the bond proceeds to make your mortgage payments.
While this approach has the disadvantage that you still have your mortgage on your personal balance sheet (along with additional bond assets), it has the advantage that you can liquidate the bond portfolio if your financial strategies change. AKA, "option value". And, you don't give up your mortgage put of your house to the bank.
Indeed, one might struggle to justify reasons why a binding defeasance might be preferable to a non-binding self-administered one.
Posted by: diz at Sep 27, 2009 10:38:17 AM
Indeed, one might struggle to justify reasons why a binding defeasance might be preferable to a non-binding self-administered one.
One big problem is taxes. Your bond interest is taxable, and your mortgage interest payments are generally tax deductible, so they offset--but only if you earn enough to itemize but not enough to be hit by the AMT (at which point you'll start losing the value of your mortgage interest deductions but still be paying your highest marginal tax rate on your bond interest. Ooops).
Posted by: Slocum at Sep 27, 2009 11:40:20 AM
"Efficient markets theory suggests that arbitrage would soon make excess profits disappear as mortgage bond prices rose. In essence, the Danish system provides a negative feedback loop which stabilizes the market. Nice"
You should check your signs. It's a positive feedback loop. The more "good" borrowers who buy out their mortgages the worse the pool of borrowers left backing the mortgage bonds would be, thus the lower the prices would go and the more borrowers would engage in credit risk arbitrage.
Posted by: MattM at Sep 27, 2009 4:28:18 PM
Couldn't you effectively achieve the same thing in the US market, at least through an intermediary, by buying up the bonds that make up your own mortgage, or failing that bonds with the same overall risk profile? You can't formally redeem the mortgage, of course, but if the bonds are trading below par, you'd get back the interest part of your own mortgage payments, which would be worth more than the cost of the bonds.
Posted by: Simon Kinahan at Sep 27, 2009 4:36:09 PM
Hi all
I think I have some unique experience to offer here. I know the US mortgage system pretty well and have been working analyzing the US economy for a couple of years. I have also been the Chief Economist of Denmarks biggest bank and the happy borrower in the Danish mortgage market for more than a decade.
So here are my 5 cents:
It is absolutely feasible and desirable for the US to adopt some aspects of the Danish mortgage system. Most importantly would be to enforce a "total balance principle" on all securitizers of US mortgage bonds. Another would be to start issuing US mortgage bonds below par.
Why?
A "total balance principle" implies that mortgage bonds issuers have to match any loan given 100% with a bond series issued. From the households perspective this means that it appears as if the household has issued a bond itself, although in a liquid series. Households have different series to chose from (ARM, FRM, different coupons, maturity etc. etc).
This effectively changes the functioning of the mortgage bond issuer (Fannie & Freddie) to being a "credit insurer". They earn a margin which serves as an insurance premium. This premium covers credit risk. Moreover a neat little side effect is that if a borrower defaults the GSE only have to buy back the market value of bonds, which in a distressed market (like late last year) is low due to wide credit spreads.
One consequence is that the GSE have much less risk on their balance sheets (no duration risk, convexity risk, interest risk!), and that their balance sheets become transparent.
A second consequence is that the opaque US mortgage securitization market would become simpler and much more transparent for investors. No CDOs.
A third consequence is that homeowners can buy back their own loans when interest rates are high (and credit spreads wide) and cancel the loan. This is interesting as you can move from a 30 year fixed rate into ARMs and reduce your debt significantly (10-15% on two occasions for me personally). It also implies a partial hedge for homeowners with FRMs against rising interest rates killing their home equity through falling home prices.
It is not a panacea though. Non-recouse loans makes it optimal for borrowers to default when home prices fall. So no surprise that the US has a foreclosure crisis and that foreclosure relief will continue not to work. A Danish style mortgage bond market would be in as much trouble and the mortgage credit insurers (GSEs) would go down in any event, total balance principle or not. The US has to tighten protection of creditors - and not debtors - to improve and fix mortgage system fundamentally. Sadly few in the US seems to recognize this.
Posted by: Carsten Valgreen at Sep 27, 2009 5:15:31 PM
The less down payment required, the more people can buy houses.... Right?
Wrong.
The higher the down payment, the lower the price must be and the market will meet the demand with lower priced houses.
Reducing to 10% down, increases the price of allowed purchases, reduces the amount at risk to the buyer, and shortens the time required to save the down payment. Going to 5% or lower is absurd.
The GSE low income programs not only reduced the down payment, but also reduced the interest rate in exchange for two things:
- borrower/buyer time demonstrating the ability to budget and save
- the lender retaining an equity interest in the property which will capture 100% of the subsidy on property sale
Those with low incomes have no interest in higher property prices.
Posted by: mulp at Sep 27, 2009 6:56:59 PM
@mulp
You make some good points.
But all other things held even, the less down payment required, the more people can buy houses. Its not wrong. But all things aren't held even. There are multiple effects on affordability when changing the minimum loan-to-value, but I do think there is a good argument that lowering the loan-to-value would actually make housing less affordable in the long run, as housing prices rise to accomodate demand, re-increasing the down payment required, as well as increasing monthly principal and interest payments. My point was that I'm not sure those who influence policy have the same incentives. But, if you missed my sarcasm you missed my point.
Posted by: Alex Conconi at Sep 28, 2009 12:57:28 AM
*maximum loan-to-value; ie: minimum down-payment
Posted by: Alex Conconi at Sep 28, 2009 12:59:50 AM
*and raising the ltv, not lowering. man, really got that one backwards. all other things held even, my comment stands. ;)
(Really wishing these things were editable...)
Posted by: Alex Conconi at Sep 28, 2009 1:02:53 AM
personal bankruptcy law is much different. It is not easy to walk away from debt in Denmark. There is also the welfare safety net that it makes it feasible to collect from people that have earnings shocks..
So it would seem that property rights are better protected in Denmark and that this might translate into attitudes about responsibility, etc.
Posted by: jk at Sep 28, 2009 3:32:08 AM
Interesting related piece on Bloomberg.
http://www.bloomberg.com/apps/news?pid=20601039&sid=aeT_Yj3eanc4
Posted by: outsider at Sep 29, 2009 1:01:00 PM
Foreclosure in Denmark may be speedy by European standards (years to foreclose in France!?), but the 6 months it takes is about average in the US. In most states it takes 4-6 months to foreclose.
Another thing is that with the mandatory fees and taxes, it's actually rather expensive to buy and finance property in Denmark. 1.5 points just for legal fees? Yikes!
Posted by: Bob Smith at Sep 29, 2009 4:59:35 PM
