Why fewer Danes default on loans

Editor's note: This is Part 2 of a two-part series. Read Part 1.

My first column in this series pointed out that the Danish housing finance system, which is tightly regulated but completely private, has emerged from the financial crisis barely scratched. The Danish mortgage bond market where all new mortgage loans are funded has continued to function normally. In contrast, the private secondary market in the U.S. has shut down, leaving the system almost entirely dependent on the federally controlled secondary market agencies: Fannie Mae, Freddie Mac and Ginnie Mae.

The mortgage crisis that erupted in 2007 had its genesis in the prior bubble period, when home prices were rising rapidly. Price increases reduce the perceived riskiness of mortgages, encourage investors to accept mortgages that in a stable environment would be viewed as unacceptably risky, and induce lenders to increase loan volume by liberalizing their underwriting requirements.

While exact comparisons are not possible, the bubble in Denmark was roughly comparable to the bubble in the U.S. The average price of single-family homes in Denmark rose 60.4 percent between the beginning of 2004 and mid-2007 when prices peaked; that was an annual rate of increase of 13.6 percent. Yet the relaxation of lending standards in Denmark was far less than in the U.S., which was a major reason why the mortgage defaults arising from the crisis were much smaller in Denmark. Here are some possible reasons why:

Risk Shifting: In the U.S. system, lenders typically sell their loans, which may go through several hands before coming to rest in a security or a portfolio. If potential buyers are willing to accept loans subject to more liberal underwriting rules, the lenders originating loans will liberalize them because it expands their market and the increased default risk is transferred with the sale.

In contrast, the Danish mortgage bank that originates loans must hold them and retain the default risk. It is plausible to believe that not having the option of passing the default risk to a buyer dampens the impulse to liberalize terms.

Regulation: Regulators in the U.S. did not take any action to curb excessive mortgage liberalization during the bubble period. Regulatory responsibility for the thousands of mortgage lenders was divided among four federal agencies and 50 states. By the time the federal agencies got their act together in late 2006, the damage had already been done.

I don't know if the Danish regulator, DFSA, took any steps to restrain liberalization of lending standards during the bubble. The problem, if there was one, was much less severe than in the U.S. But DFSA could have done what needed to be done because it had sole authority over the eight firms that originate mortgage loans in Denmark. ...CONTINUED

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