EVENTS

Date:	Thursday, March 26, 2009
Time:	10:00 AM -- 12:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

WASHINGTON, APRIL 3, 2009--Although members of Congress and the Obama administration have sweeping ideas for how to regulate the U.S. economy in the future, few of them seem to have thought very deeply about how we finance mortgages, AEI's Peter J. Wallison said at a conference on March 26. "Yet, at the root of the country's current financial crisis is a dysfunctional mortgage system," he added. Although Congress's attention is focused on other economic issues now, Wallison convened a panel of experts to discuss structural reforms that might improve the broken U.S. housing market. Panelists discussed the relative merits of the Danish mortgage system, which, Wallison explained, "is attractive because it does not involve any explicit or implicit taxpayer liability, permits homeowners to take advantage of declines in the housing values . . . and appropriately separates interest rate and credit risk."

This separation of risk is a key aspect of the Danish system, explained Alan Boyce, the CEO of Absalon, because it properly aligns the incentives of the lender and the borrower. In Denmark, the credit risk of a loan is required to remain with the brokers or mortgage bankers who originated the debt. Unlike the current U.S. model, Danish mortgage originators are now invested in the credit worthiness of the loan; their interests become "perpetually aligned" with the borrowers, and they become de facto "liability advisers." The interest-rate risk in the loan is sold to bond holders.

When house prices fall, the Danish system's rules for refinancing--known as the Principle of Balance (POB)--have helped to mitigate the problem of negative equity. In the United States, Boyce explained, "even though the [market] value of the mortgage has dropped, the homeowner still owes the face value of the mortgage"--the value when the borrower bought the house, less any principal paid to that point. In contrast, in Denmark, a creditworthy homeowner can refinance his mortgage at the current market price, which can be lower than the unpaid principal value of the mortgage. This system helps the borrower maintain equity in his home. Boyce observed that although Denmark experienced the same housing bubble as the United States, "it did not lead to the [same] wave of foreclosures and defaults." A final benefit of the Danish system is its extreme transparency--all details of the mortgage system are published daily by the national exchanges, as well as by NASDAQ, so their market does not suffer from informational advantages like those of the United States.

To implement this system in the United States, Boyce detailed several of the changes that would have to be made to the current structure:

• Fannie Mae and Freddie Mac should only function as POB guarantors
• Credit risk allocation must be shared between the originator and the federal guarantor
• Borrowers could refinance their loan based on the market value of the mortgage
• All new mortgage loans would have full recourse
• A single prudential regulator would govern the entire system and would have the power to remove bad loans, bad brokers, and bad borrowers from the system and to raise capital and reporting requirements as necessary

Panelists' reactions to Boyce's proposal were mixed. Bert Ely of Ely & Co. noted that "negative equity [is] less of a problem in a mortgage system which does not produce bubbles and busts." He worried that the plan did not address the underlying instabilities of the U.S. housing market. Ely also observed an asymmetry in the POB system that favors the borrower. When interest rates rise and house prices fall, the borrower benefits from refinancing, but when interest rates fall and house prices rise, the lender cannot reap any similar benefits. An additional criticism was that the system encourages "serial refinancing," which would lead to higher transaction costs. Ely was also concerned that "the mortgage credit risk will be [too] highly concentrated in the mortgage credit intermediaries."

Another consideration, highlighted by AEI's Alex J. Pollock, is that many banks may be too small to function in this system and would be put out of business. Pollock pointed out that the Danish system is not perfect--Denmark suffered a housing bust in the early 1990s and is in the midst of a severe recession. A final problem, cited by the World Bank's Olivier Hassler, is that "there is a problem of introducing new financial instruments into this market. . . . Market acceptance is dependent on what the benefits and incentives will be for all of the market players." Hassler questioned whether the regulatory and legal frameworks in the United States could be sufficiently altered for the Danish system to work here.

Despite the panelists' many concerns, they had strong praise for certain aspects of the Danish system. Ely applauded the requirement of high down payments, since such a condition forces borrowers to have more skin in the game than many U.S. borrowers. Both he and Pollock cited the obligatory full-recourse loans as a particular strength. In the United States, mortgage loans are typically nonrecourse, meaning that defaulting borrowers are not responsible for paying the difference between the market value of their home and the principal amount of their mortgage loan. This difference in value is known as a "deficiency," and in Denmark, Pollock explained, "the deficiency is pursued until it is paid"--even if the payment can't be made for a decade or more. "The best element of the Danish mortgage system," he continued, "is that the mortgage originator is responsible for credit risk for the life of the loan. . . . With statistical regularity, mortgages that are produced by depository institutions, such as banks and S&Ls, performed better than all others. . . [because] credit risk remained on their portfolios."

--KAREN DUBAS

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