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

Transactions-Oriented Loan Originators: In the U.S., the incomes of the mortgage brokers and loan officers with whom borrowers deal depend almost entirely on the number and size of the loans they write. They were not responsible for the liberalized underwriting rules, interest-only loans and option ARMs that emerged during the housing bubble, but they took advantage of these changes to do more deals, stretching the bubble.

In contrast, prospective borrowers in Denmark who contact a mortgage bank deal with a salaried employee. While interest-only loans and new types of ARMs were introduced by mortgage banks during the bubble period, the initiative for seeking these instruments remained largely with consumers.

Personal Liability: In the U.S., some states such as California do not allow lenders who do not fully recover what they are owed through foreclosure to obtain deficiency judgments against borrowers for the balance, provided the loan was used to purchase a home. Even in states where deficiency judgments are allowed, few lenders actively pursue them. In Denmark, however, mortgage borrowers retain full personal liability, and it is actively enforced by lenders.

Government-Sponsored Enterprises and the Affordability Lobby: The U.S. had a particularly toxic combination of features that Denmark lacked: a pair of partly private/partly public secondary market agencies — Fannie Mae and Freddie Mac — and a political/social movement aimed at increasing the homeownership rate. This unholy alliance was by far the most important cause of the excessive liberalization of mortgage terms during the bubble. For readers interested in the details, I recommend "Cause and Effect: Government Policies and the Financial Crisis" by Peter J. Wallison, which is available at www.aei.org.

The two agencies were stockholder-owned but received an enormously valuable subsidy from the federal government in the form of an implicit guarantee of their liabilities. The quid pro quo was their active participation in programs to help low-income and minority households to become homeowners. In 1992, Congress authorized the Department of Housing and Urban Development (HUD) to set annual quotas for agency purchases of "affordable loans," expressed as a percentage of their total purchases. Initially 30 percent, these quotas rose over time, through both the Clinton and Bush administrations, reaching 55 percent in 2007.

Acquisitions of nonprime mortgages by the agencies increased rapidly beginning in 2004 and peaked in 2007 with the onset of the crisis. Wallison estimates their holdings in 2008 at $1.5 trillion — this total included purchases of private securities in the market, which HUD allowed the agencies to count toward their quotas of affordable loans. The horrendous default rates and losses on these loans sealed the fate of the agencies, which in 2008 were placed in a government-administered conservatorship.

Historically, most economists were skeptical or hostile to Fannie Mae and Freddie Mac. Usually, the reason was that only about half of the taxpayer-funded subsidy provided to the agencies was realized as a benefit by borrowers. We now see that that was the least of it. The more compelling argument against the mixed private/public model is that it corrupted the political process and destabilized the system. Not having any equivalent is one important reason why Denmark has weathered the crisis much better than the U.S.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


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