Jack M. Guttentag The Mortgage Professor

In 2002 I wrote a column contrasting the housing finance systems of Denmark and the U.S. Recently, both systems have been stressed by the worldwide 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 core of the Danish system is eight specialized mortgage banks which originate all home mortgages, as well as 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 consists of 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 percent are not served. In a financial crisis, however, this "weakness" is a source of strength, as we have recently learned.

A Worldwide Loss of Confidence

Both countries were afflicted by the worldwide 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 U..S, 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.

A Higher Default Rate

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 U.S. In addition, investors incurred larger losses on defaulted mortgages because defaulting borrowers in the U.S. had less equity.

Home prices have declined in Denmark since the crisis began, though not quite as much as in the U.S. Single-family home prices were down 15 percent in the second quarter from their previous peak, while "owner-occupied flats" were down 28 percent. As in the U.S., 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 U.S., down payments of less than 20 percent 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 two to three years had no equity.

In contrast, the down payment requirement in Denmark was 20 percent well before the bubble and remained 20 percent 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 U.S.

Erosion of down payment requirements was only one of the ways that the U.S. housing finance system was weakened much more than the Danish system during the bubble period. 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 U.S. There was no Danish equivalent of subprime 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.