Academic journal article Federal Reserve Bank of New York Economic Policy Review

Peas in a Pod? Comparing the U.S. and Danish Mortgage Finance Systems

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Peas in a Pod? Comparing the U.S. and Danish Mortgage Finance Systems

Article excerpt

The way mortgages are designed, financed, and regulated varies strikingly across countries.1 Although this variation reflects adaptation to international differences in social, economic, and legal conditions, it likely also stems from historical accidents and path dependence. As the United States considers further reform of its mortgage finance system, it is useful to examine what can be learned from the experiences of other countries and whether any international practices could be adapted to improve the institutional design of the U.S. mortgage market.

With that goal in mind, this article compares and contrasts the U.S. system with that of Denmark. The Danish mortgage finance system is a salient reference point because, in several respects, it is the international model most similar to the U.S. system. In particular, Denmark relies very heavily on capital markets for funding residential mortgages, transferring interest rate risk and prepayment risk to fixed-income investors in a way that is similar to U.S. mortgage securitization. Unlike the U.S. system, however, the Danish mortgage finance system remained stable and solvent during the 2007-09 financial crisis and did not require government funding or capital injections, despite experiencing a fall in home prices of similar magnitude to that in the United States during this period.

In the Danish model, mortgages are financed through the issuance of "covered bonds" (bonds collateralized by a cover pool of mortgages or other debt) by a small number of specialized mortgage banks. The system relies on the "balance principle"-the covered bonds match the maturity and cash flows of the underlying pool of mortgages funded by the bond, and payments by mortgage borrowers are passed directly through to covered bond investors. Thus, interest rate risk and prepayment risk are borne by investors rather than by the mortgage bank that issues the covered bond. However, ownership of the mortgages is retained by the mortgage bank throughout its life, and the bank bears any credit losses on the mortgages.

This approach shares many similarities with the structure of the agency mortgage-backed securities (MBS) market in the United States, where mortgage bonds carry a credit guarantee from the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), or the Government National Mortgage Association (Ginnie Mae). As in the Danish system, agency mortgages are funded by capital market investors who bear prepayment risk and interest rate risk but are not exposed to credit risk. Both agency MBS and Danish covered bonds are widely held and traded, and in both countries these bonds remained liquid throughout the 2007-09 crisis period and other market downturns (see Section 2 for more details).

This shared funding model explains why Denmark is also, to our knowledge, the only country aside from the United States where long-term (for example, thirty-year) prepayable fixed-rate mortgages (FRMs) are widely available to homeowners. Capital market financing is important for the availability of such loans because they embed significant interest rate and prepayment risk, which makes them less well suited for short-term bank deposit finance. Given the popularity and familiarity of FRMs in the United States, Denmark provides a useful case study because Danish homeowners2 have historically shared this same preference for FRMs. The Danish model may suggest ways to improve the efficiency of the U.S. mortgage finance system without restricting the types of contracts available to borrowers.

As we will describe, the Danish system includes several features that mitigate frictions in mortgage financing and could potentially be usefully adapted in some form in the United States. Prominent among these is the option for Danish homeowners to repurchase their own mortgages from the covered bond pool at the current market price. Mortgages are also assumable, meaning that a homeowner can transfer his or her mortgage to a buyer as part of a property sale. …

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