Part 5: Preventing another crisis
Part 5: Preventing another crisis
Editor's note: This is Part 5 of a seven-part series.
The housing finance system of the U.S., once viewed by many as a model, is now a shambles. The underwriting rules applicable to nine of every 10 mortgage loans, stipulating who is and who is not eligible for the loan, are dictated by an arm of the federal government: Fannie Mae, Freddie Mac, FHA, VA and USDA. The sliver of the market not touched by those agencies is dominated by a small group of too-large-to-fail bank holding companies.
Before the crisis, the nonfederalized part of the market was much larger because it was supported by a private secondary market. Lenders originating loans that did not meet the requirements of any of the federal agencies could sell them in the private secondary market. But that market collapsed in 2007 and has yet to reopen.
One result has been a sharp widening of the yield spread between conventional loans that can be sold to Fannie Mae and Freddie Mac, and those that can't. Today, the spread between a $417,000 loan purchasable by the agencies and a $418,000 loan that isn't purchasable by them, but which is otherwise identical, is almost 1 percent. Before the crisis, it was 1/4 percent to 3/8 percent.
The key to an effective redesign of the housing finance system is the development of an effective private secondary market, but not the kind of market we had before. That market was markedly inferior to the Danish model, which could easily be transplanted here.
Structural stability: The U.S. market had a structural defect that made it extremely vulnerable to a contagious loss of confidence. Every individual mortgage security was a standalone entity secured by whatever reserves or insurance protections were embedded in that security.
If these reserves turned out to be superfluous, as they always were before the crisis, they were paid out to investors who owned a residual claim to them. These were often the firms that had issued the security. While these firms had the right to remove unneeded reserves, they were under no obligation to provide additional reserves if this proved necessary.
Since the surpluses on one security were not available to meet deficiencies on others, and since no one was obliged to provide additional reserves if this became necessary, the entire market was a house of cards. When some securities did run into trouble and were downgraded by the credit rating agencies, fears about the status of others ran rampant and the entire house collapsed.
In the Danish model, in contrast, every mortgage security is a bond that is a liability of the firm issuing it. The Danish mortgage banks issue multiple bonds, and if one of them experiences a high loss rate, all the resources of the bank are available to deal with it. There has never been a default on a Danish mortgage bond in more than 200 years. During the very worst months of the financial crisis, it was business as usual in the Danish mortgage bond market.
Linkages to primary markets: In the U.S. model, the secondary market and the primary market where loans are made to borrowers are distinct, connected only through transfers of ownership over a period of time. For example, a loan closed by a small ("correspondent") lender is sold to a larger wholesale lender who sells it to an investment bank who places it in a new mortgage security. Months may pass between the date when the loan is closed and the date when the loan becomes collateral for a security.
In the Danish model, in contrast, there are no transfers of ownership, because each individual borrower is funded directly by the secondary market. The mortgage bank sells the mortgage to investors simply by adding it to an open bond issue covering the same type of mortgage. If the new loan is a 5 percent 30-year fixed-rate mortgage (FRM), for example, it is added to the outstanding bond secured by 5 percent 30-year FRMs.
Reflecting these differences in the relationship between primary and secondary markets, borrowers in the U.S. face far more challenges in shopping for mortgages than borrowers in Denmark. Borrowers in the U.S. don't have access to secondary market prices, and if they did, it would do them no good because there would be no way to use it. They are on their own in dealing with loan originators, many of which use a variety of tricks of the trade to extract as much from them as possible.
In Denmark, borrowers can price their loan by accessing secondary market prices online. They enter the type of mortgage they want and the interest rate, and find the corresponding bond selling for the highest price. The prices of all Danish mortgage bonds are shown on the NASDAQ website, http://www.nasdaqomxnordic.com/bonds/denmark.
(Alternatively, they can go to a broker or loan officer who is paid by the lender selected, who has access to the same bond data with consumer-friendly add-ons.)
The borrower pays the bond price plus a 0.5 percent rate add-on by the lending bank, plus some out-of-pocket fees that are set competitively.
Refinancing options: When market interest rates drop, borrowers in both the U.S. and Denmark can refinance at par to lower their interest rate. When market interest rates rise, however, only borrowers in Denmark can refinance at the lower market price. Borrowers in the U.S. must pay off their old loan at par.
For example, Doe has a $200,000 balance on his 5 percent mortgage, and he expects to sell his house for $250,000 in a market in which homebuyers pay 5 percent. But before he can sell, market rates jump from 5 percent to 7.5 percent and potential buyers can now afford to pay only $200,000, wiping out Doe's home equity. However, because of the rate increase, the market price of Doe's 5 percent mortgage has dropped from 100 to 90.
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