I've written in the past about the loan origination underwriting failures that are at the heart of the current credit crisis. Market failures in Mortgage Backed Securities, Collateral Debt Obligations, and Credit Default-Swaps can all trace their lineage to high default and foreclosure rates resulting from those underwriting failures. In a piece I wrote in early 2008, I argued that simple changes in underwriting standards could have prevented the market meltdown.
I've also written about the relative efficiency of the Danish Mortgage Model and yesterday I heard an in-depth comparative presentation on that Model that I have to relate because it totally changed my point of view on the Danish Model. Up to know, I had seen the Danish Model as a business platform for mortgage processing. What I saw yesterday is a consumer solution with enormous political appeal.
The meeting was at the American Enterprise Institute in Washington, DC and the speaker was Alan Boyce, CEO of Absalon, the organization that exported the Danish Mortgage Model to Mexico. Alan presented the Danish Model in the context of what the Danes call "The Principle of Balance."
The Principal of Balance enables borrowers to refinance their mortgages when housing prices go up AND sell their mortgage bonds at current market prices when housing prices go down to preserve their equity. In the United States, borrowers can refinance when rates decline and housing prices rise, but they have to suffer negative equity when housing prices decline. Housing prices often decline in a recession, and negative equity restrains labor mobility by nailing home-owners to their existing homes until prices rise and they can sell without a loss.
In Denmark, when recessions hit and housing prices fall, borrowers can sell their straight securitized bonds in a secondary bond market and refinance their mortgage at the current market price for their home. This flexibility protects consumers from negative equity and empowers workers with greater labor mobility.
From Alan's charts, Here is how the current system in the US works:
If Interest Rates decline:
- Home prices go up
- Homeowner can prepay existing mortgage
by refinancing at new lower rate
- Allows for equity withdrawal
- Home prices go down
- Value of the mortgage (in a MBS) drops to
the holder of the mortgage
- Even though the value of the mortgage has
dropped, the homeowner still owes “par” –
the face value of the mortgage. He cannot
prepay existing mortgage at the price the
mortgage is selling for in the market
- ~$5 trillion is currently owed by
homeowners of non-agency mortgages.
These mortgages are valued by the market
at $3.5 trillion.
- In some of the hardest hit regions in the country home owners have lost their jobs and have negative equity in their homes, and they can't do anything about it.
If Interest rates decline:
- The system operates the same
- Home prices increase and people can refinance and take equity out
- Home prices go down
- Assuming credit worthiness, a homeowner
can prepay by purchasing back his or her
mortgage at the current discounted price
- This maintains equity in the home
- The key is new, standardized mortgage
This model doesn't perfectly preserve home equity as home owners will suffer some loss when housing prices decline, but the loss is substantially mitigated and this system offers individual freedom and choice. It is actually far more market oriented than the current US model.
In the US, we currently suffer 10% default and foreclosure rates, and there are an additional 15-20% who suffer negative equity in their homes but are not at risk of foreclosure. People in foreclosure can't take advantage of a new Principle of Balance Mortgage system, but the government can offer programs to restructure their mortgages at market value. Those with negative equity could be encouraged to migrate to a new Principle of Balance mortgage model.
This is an idea that has enormous benefits all around. It can help the Obama Administration reprice existing toxic assets. It can help provide more market-flexibility to home-owners. And it can repair confidence in the American mortgage market among investors world wide.
Who would have thought that market-oriented reforms would come from such a "socialistic" country like Denmark!?
I encourage everyone to read Alan Boyce's presentations and white papers. It is one of the most intelligent and easy to implement regulatory reforms I have seen in many years.
His full presentation: https://www.ibm.com/developerworks/blogs/resources/adler/20090325_1.pdf
His short white paper: https://www.ibm.com/developerworks/blogs/resources/adler/20090325_3.pdf