Reforming Housing Finance: Perspectives from Denmark

Journal of Real Estate Research, The, Apr-Jun 2006 by Svenstrup, Mikkel, Willemann, Søren

Abstract

This paper investigates the effect of adding a distinct feature of the Danish mortgage market to the market in the United States. This feature, a buyback option, enables mortgagors to buy back their share of the mortgage-backed security at market price. Extending a standard referenced pricing model, the findings indicate that the introduction of the buyback option reduces the credit spread required by the financial intermediary by 23%, potentially reducing the contingent liability of the U.S. government. Furthermore, the buyback option protects households against the risk of being locked in after an increase in interest rates. This could be of particular benefit to low-to-middle income households.

This paper received the award for the best paper on Real Estate Finance (sponsored by the Fannie Mae Foundation) presented at the 2004 ARES Annual Meeting.

Introduction

There is an ongoing controversy regarding the costs and benefits of Fannie Mae and Freddie Mac. The controversy has many aspects, but it mainly evolves around the fact that, in spite of any legal basis, investors treat debt and mortgage-backed securities issued by Fannie Mae and Freddie Mac (F&F) as if the United States government guarantees them. It is a fact, however, that they enjoy certain benefits and have certain restrictions due to their close relationship with the federal government, a summary for this relationship being that they are "government sponsored enterprises" or GSEs.

The controversy concerns a range of aspects of the GSEs of which two are of particular interest in this paper. First, it is argued in the literature that the GSEs pose a contingent liability for the U.S. government (e.g., White, 2003; and Frame and White, 2004. According to Frame and White (2004), the liability constitutes approximately USD 288 billion over a 25-year period. On the other hand, Roll (2003) argues that the retained mortgage portfolios of F&F provide a range of benefits to the homeowners in general. Second, some critics argue that in spite of their charters, the GSEs do not improve home ownership for low-to-middle income (LMI) households. This is, for example, the case in White (2003) and Passmore (2003), while Blinder, Flannery and Kamihachi (2004) criticize the approach in Passmore (2003) and generally find larger benefits of the implicit subsidy. Further, Bostic and Surette (2001) find that from 1989 to 1998, home ownership increased from 63% to 66.2%. The increase occurs while there is a general decline in disparity between different groups. The authors attribute this to a change in the mortgage markets, and see this as an indication that regulation works. In short, there is considerable disagreement concerning the risks posed by the GSEs to the taxpayers and how good a job the GSEs have done at promoting home ownership for the LMI households.

This paper contributes to the literature by addressing the possibility of a contingent liability of the U.S. government and the benefit to LMI households. It examines the effects of introducing a distinct feature from the Danish mortgage market into the U.S. mortgage market, which serves to reduce the contingent liability of the U.S. government and improve the conditions of LMI households. The distinct feature that will be introduced is the buyback option. This option enables the mortgagor, in addition to the standard prepayment option, to buy back the mortgage at the prevailing bond price. This will have a number of positive effects. First, the paper argues and supports with calculations that the credit risk of the GSEs could be decreased if mortgagors could buy back their loans at the market price. second, having a buyback option protects the mortgagor from the lock-in effect and could thereby encourage LMI households, which are particularly exposed to lock-in effects, to become homeowners. Third, from a macro economic perspective, introducing the buyback option could increase the mobility of the labor force in general, as it would make it easier for people to move if their the loan could be terminated at its current value.

This paper highlights a particular difference between the U.S. and the Danish mortgage markets, which are generally very similar. As is the case for the U.S., the Danish market for mortgage-backed bonds is very large. The total volume of outstanding mortgage debt totaled 101% of GDP in 2003, compared to 81% in the U.S. In Europe, the Danish market is the second largest, which is exceeded only by Germany.

Four large mortgage credit institutions (MCIs) who originate, securitize and service the loans dominate the Danish mortgage market. Founded as a cooperative system, the institutions are today private but highly regulated. For example, the MCIs are not allowed to retain any prepayment risk themselves. Despite being private companies, there is, like in the U.S., a widespread belief that the government will never allow the MCIs to default. As in the U.S., the Danish MCIs guarantee the loans such that in the event of default by mortgagors, the investor receives face value. The MCIs are required by law to follow the so-called 'balance principle,' which requires that all lending activities must be funded by issuing bonds with exactly matching cash flows. In that sense, Danish mortgage-backed bonds are genuine pass-through securities where the payments from an individual mortgagor can be traced into a pool and on to the bond for which the mortgage serves as collateral.