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As we begin the last quarter of 2010, our housing finance system (as well as those of some other countries) is still struggling in the wake of the great housing bubble of 2000-06 and its collapse into the panic and serial crises of 2007-09.
Housing finance cannot be considered apart from its effects on house prices. When you push a lot of credit at an asset class, its price tends to rise. American housing finance practices and subsidies helped inflate house prices during the bubble. Then U.S. average house prices fell by more than 30% from peak to trough-something, we must remember, which was previously considered impossible. This brought them back to their long-term trend line and to the levels of 2003, with all of the losses and turmoil with which we are so familiar. A memorable decade! One of its lessons is to try to remember that things considered impossible can nonetheless happen.
As we develop other lessons for the next decade, there is no doubt that it is educational and useful to examine American housing finance in international perspective.
Comparing our housing finance system to other countries, we discover that one thing remarkable and indeed unique in the world about American housing finance was the dominant and disproportionate role played by government-sponsored enterprises, namely Fannie Mae and Freddie Mac, wielding their “implied” government guaranty. Based on this “implied” guaranty, massive amounts of their debt securities were sold around the world, so that foreign institutions could help inflate U.S. house prices without worrying about the risk and later be bailed out as creditors by American taxpayers. Of course the “implied” guaranty always was a real U.S. government guaranty, as events have amply demonstrated, but it did not have to be accounted for as one.
In the days of Fannie and Freddie’s pride, their representatives and political supporters used frequently to say, “American housing finance is the envy of the world.” It really wasn’t, at least based on my discussions with housing finance colleagues from other countries. But many Americans-including members of Congress-thought it was, just as they mistakenly thought and said that the U.S. had the highest homeownership rate in the world. We didn’t and don’t.
I think we can agree that we would like our society to have a property-owning democratic citizenry, which includes widespread homeownership. But the international perspective makes it clear that many countries achieve homeownership levels as high or higher than ours with no GSEs. It turns out that these levels can be achieved without tax deductions for the interest paid on home mortgages, without our very unusual practice of making mortgages into nonrecourse debt, without government mandates to make “creative” (that is, riskier) loans, without 30-year fixed-rate loans, and with prepayment fees on mortgages. Of course, as bubbles and busts in other countries show, you can also get in trouble with different systems.
At a minimum, we should never assume that the particular historical development so far of the U.S. housing finance system is definitive.
The better credit performance of Canadian housing finance over the last several years has become well known. The proportion of Canadian mortgage loans more than 90 days delinquent in the first quarter, 2010 was less than 0.5%. This is about one-tenth the ratio of U.S. mortgages over 90 days delinquent at that time, which was 4.9%. If we add to the U.S. number mortgage loans in foreclosure to look at serious delinquencies, it jumps to 9.5%. Quite a contrast, as many people have remarked.
Canada makes a pertinent comparison for the U.S. It is in population and economic size much smaller, of course-about one-tenth in both cases-but is in many ways very similar.
Both countries are rich, advanced, democratic and stable, have sophisticated financial systems and pioneer histories, and stretch from Atlantic to Pacific. But Canada has no housing GSEs; mortgage loan interest is not tax deductible; it does not have 30-year fixed-rate mortgages; it does have prepayment fees.
Mortgage lending is more conservative and creditor-friendly. Canadian mortgage lenders have full recourse to the borrower’s other assets and income, in addition to the security interest in the house. This means there is less incentive for underwater borrowers to “walk away” from their house and mortgage. No tax deduction for interest probably increases the incentive to pay down debt. Most Canadian mortgage payments are made through automatic debit of the borrower’s checking account and can be matched to paycheck frequency, a technical but important behavioral point. Canadian fixed-rate mortgages typically are fixed for only up to five years. Subprime mortgages were a much smaller part of the market.
This relative conservatism has meant that Canadian banks, the principal mortgage lenders, while experiencing some pressure, have come through the international financial crisis in much better shape than their U.S. counterparts, with mortgage delinquencies so far well behaved.
There does not appear to have been a homeownership price to pay for this relative credit conservatism. Canada’s homeownership rate is 68% vs. 67% for the U.S. Two very different housing finance systems, one, as it turned out, much riskier than the other, produced virtually the same homeownership rate.
It is important to recognize that Canada does have an important government body to promote housing finance, which has a substantial role: the Canada Mortgage and Housing Corp. Among its principal activities is insuring (guaranteeing) mortgage loans, another is securitizing some of the insured loans. So you could think of it in one sense as a combination of FHA and Ginnie Mae.
Whether or not you like the idea of such a scale of government financing, you have to say that, in contrast to the American GSEs, at least CMHC’s status is completely clear and honest. It is a 100% government-owned and controlled corporation. Its government guaranty is explicit, so it operates with the formal full faith and credit of the government of Canada. It also provides housing subsidies which are on budget and must be appropriated by Parliament.
Canada in this respect looks superior to the U.S. in candor, as well as credit performance.
The most perfect solution in theory, which also functions very well practically in its national setting in an admittedly small country, is that of the housing finance system of Denmark. It has been admired by many observers. Explicitly governed by what it calls the “matching principle,” the interest rate and prepayment characteristics of the mortgage loans being funded, which include long-term fixed rate loans, are passed entirely on to the investor in Danish mortgage bonds.
At the same time, there is a total “skin in the game” requirement for retention of credit risk by the mortgage lenders. The mortgage banks retain 100% of the credit risk of the loans, in exchange for an annual fee, thus insuring alignment of incentives for credit performance. Deficiency judgments, if foreclosure on a house does not cover the mortgage debt, are actively pursued.
The fundamentals of the Danish mortgage system go back over 200 years. There are no GSEs or government housing banks. This is a private housing finance system built on what appear to be quite robust principles. It generates a homeownership rate of 54%, below that of Canada or the U.S.
Some years ago, when the proud hearts of Fannie and Freddie had not yet had their fall, I participated in an exchange with the Association of Danish Mortgage Banks. They explained their mortgage bond and skin in the game based system to me, then I explained the American GSE-centric mortgage system to them. When I was done, the CEO of one of the leading Danish mortgage banks said this: “In Denmark we always say that we are the socialists and America is the land of free enterprise. Now I see that when it comes to mortgage finance, it is the opposite!”
Alex J. Pollock is a resident fellow at AEI.
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