Should we do mortgages like the Danes do?

This blog has been falling down lately on its pledge to be America’s Leading Source of News About the Danish Economy™. I failed to link to Bryan Walsh’s excellent TIME article on Danish energy policy. I failed to bring to your attention an Economist story that ranks Denmark as one of the world’s top countries for entrepreneurs. I failed to report promptly this morning’s exciting news that there are now 12 (up from 10) restaurants in the Copenhagen area with Michelin stars.

But then I got an e-mail in my inbox this afternoon inviting me to an upcoming American Enterprise Institute discussion on the topic “Can Elements of the Danish Mortgage System Fix Mortgage Securitization?” I had to post on that, pronto. Even the conservatives want to be like the Danes now! Although some lefty named George Soros had the idea (of imitating the Danish mortgage system) first.

Here’s Soros’s accounting of the strong points of the 214-year-old Danish set-up:

First, it is an open system in which all mortgage originators can participate on equal terms as long as they meet the rigorous regulatory requirements. There are no GSEs enjoying a quasimonopolistic position.

Second, mortgage originators are required to retain credit risk and to perform the servicing functions, thereby properly aligning the incentives. Third, the mortgage is funded by the issuance of standardized bonds, creating a large and liquid market. Indeed, the spread on Danish mortgage bonds is similar to the option-adjusted spread on bonds issued by the GSEs, although they carry no implicit government guarantees.

Finally, the asymmetric nature of American mortgages is replaced by what the Danes call the Principle of Balance. Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes. To state it more clearly, as home prices decline, the amount that a homeowner must spend to retire his mortgage decreases because he can buy the bonds at lower prices.

Wow, that sounds really smart. And extremely Danish.

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mbirchmeier

Finally, the asymmetric nature of American mortgages is replaced by what the Danes call the Principle of Balance. Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes. To state it more clearly, as home prices decline, the amount that a homeowner must spend to retire his mortgage decreases because he can buy the bonds at lower prices.
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I’m somewhat unclear on this.
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So say I buy a house for 100,000 and a security is established for $100,000 broken into say 1000 bonds ($100 each). Each bond then pays a fixed amount every year say $6 (6% interest). The value of the bonds when property values go down, what causes the bond value to go down. So if I pay off $10,000 of my mortgage, the security value is now worth $90,000, so now the bond price is about $90 (thus returning 5.40 a year).
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Now I don’t understand how the value of the house affects the bond prices. If the home value is now ‘worth’ $80,000, how does this affect the $90,000 security? Does the value of the bond decrease because the risk of foreclosure is now increased? Or is this guided by some other force? If it’s another force does this also affect things if the price of the home goes up or is it capped at the original amount?
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-MBirchmeier
Justin Fox

@mbirchmeier: Ummm, that’s an excellent point. It would work as Soros describes if the fall in house prices were caused by a rise in interest rates, which would automatically drive down the prices of the bonds. But that’s not what’s going on in the U.S. housing market right now.
jzhang87

Higher interest rates means lower bond prices. But bad credit increases the risk premium that investors will demand, and hence higher interest rates. If the mortgage is non-recourse, as most first mortgages are in the US, then the loan is secured only by the property. If the value of the property goes down, then the bond is secured by a less valuable collateral, and hence becomes riskier to hold. It’s like the gold standard, if a country loses half their gold, their outstanding currency needs to be discounted since it’s backed by less gold and the chance that not everyone can redeem their money is increased. These countries then need to offer higher interest rates to entice people to hold their currency.