Matt Yglesias writes about the 30-year fixed rate mortgage in the United States and asks whether it would survive the end of government subsidies through Fannie Mae and Freddie Mac:
One is that if you look at other developed countries you generally don’t see the American-style 30-year fixed rate mortgage. Instead you either have short-term loans that need to be periodically refinanced at new interest rates, or else something more like an Adjustable Rate Mortgage.
From these two stylized facts you can draw two conclusions. One is that absent a specific government subsidy for the fixed rate mortgage it would vanish and we would become more like Canada. The other would be to say that the jumbo loan market shows that there’s enough path dependency in the marketplace than the fixed rate mortgage would persist, just at slightly higher cost.As it happens, I come from a country where 30-year fixed rate mortgages have a long history, so I will now abuse this platform to explain how they work at excruciating length. (The United States and Denmark also share the dubious distinction of being the only two countries with a debt ceiling.) Until recently most residential mortgages were 30-year fixed, and they are still very popular. In Denmark, the mortgages are issued through specialized mortgage banks (which are often part of larger financial conglomerates) that do not have any explicit government backing. There may be an implicit guarantee because some of these institutions are very large, but that guarantee probably isn’t stronger or less implicit than the one that any other systemically important financial institution gets in a small country.
The industry likes to say that there has been a default on a Danish mortgage bond. A careful study the history of the market, which dates back to 1797 and started because of the Copenhagen Fire of 1795, would probably add a few asterisks to that claim. Nevertheless, Danish mortgage bonds are generally considered very safe, and they can be used as collateral for monetary operations at Danmarks Nationalbank with very small haircuts.
Why are 30 year fixed rate mortgages so awesome for borrowers?
- The interest rate is fixed. This is an obvious benefit, but that doesn’t mean we shouldn’t take it seriously. Most people can pay off their mortgage in 30 years, and having a fixed rate means they know exactly how much they will pay every quarter (for Danish mortgages) for the term of the mortgage. A homeowner with a fixed rate mortgage could still lose his home if he loses his job, for example, and can’t make the payments, but he is much less likely to lose it solely because of movements in interest rates.
- Residential mortgages have a prepayment option. This is useful if the homeowner needs to sell the house and cancel the mortgage. It’s also useful if interest rates fall, so bond prices rise. By refinancing, the homeowner can reduce the mortgage payment, or keep the same payment and reduce the term, or benefit in some other way.
- Danish homeowners also have a delivery option. Suppose interest rates go up after the mortgage was originated, so bond prices fall, perhaps significantly below par. Because mortgages are tied directly to the mortgage bonds that finance them (more on this below), homeowners can buy up bonds at market prices, deliver them to the mortgage bank, and have the loan canceled. She would probably need a new mortgage to fund that bond purchase, but will end up owing less on the mortgage.
How does the Danish mortgage market pull this off without explicit government backing? I don’t really know. I can list the key features of the Danish mortgage market, but I can’t promise that 30 year fixed rate mortgages will be viable and common in any country that introduces them. The industry is actually in an effort to export the Danish mortgage model to Mexico, and we will see how that goes. In the end I would probably agree with Matt that there is a huge amount of path dependence in the consumer financial products that will exist in a country.
Some of the key features are:
- Mortgage loans are tied directly to bonds that are traded on the Copenhagen Stock Exchange—this is known as the “balance principle”. When a mortgage is originated, the mortgage bank will tap issue new bonds to fund it. Instead of having a different interest rate on mortgages that are originated on different days, the bonds generally have integer coupon rates such as 3% or 4%, and are then issued at a discount to par. Danish home buyers are actually expected to understand how all this works and the news media often reports on changes in prices of bonds with particular coupons, for example when a lower coupon bond starts trading below par and is therefore available for new issue. This structure standardizes the way mortgages are traded and eliminates any funding risk for the mortgage bank, because the loan is essentially securitized at the moment it is originated.
- The balance principle means that every borrower in a bond will have the same interest rate. Lenders can manage risk by reducing loan-to-value or refusing to lend in the first place. It also means that mortgage rates are more transparent because they are determined directly in a very liquid market, not just made up by the lender.
- The balance principle also means that borrowers can’t freely prepay at any time. It generally has to happen in connection with one of the quarterly payment dates.
- Mortgage bonds are claims on the issuing mortgage bank, not a separate trust set up for the purpose as is common in the US. Issuers are fully liable for the bonds, everything is on the balance sheet, and they have to satisfy Basel II capital requirements.
- For primary residences, loans can be issued up to 80% loan-to-value, and usually 60% for second homes. Borrowers who need additional financing will usually get a loan directly from a commercial bank that will keep the loan on its books.
- Mortgage banks make a profit by charging a spread over the coupon paid to bond investors, as well as through various fees. For example, many homeowners want to lock in their rate when they sign the contract for a home, so they will enter a forward contract for the bond they will use, and the mortgage bank charges a fee for this.
The Danish mortgage market is so obsessed with determining mortgage rates directly in the bond market that when residential adjustable rate mortgages were introduced, they were also based on market rates. A mortgage whose rate adjusts once a year, known as “F1”, is financed with 1-year bonds. Every December, the mortgage bank holds an auction to sell new 1-year bonds. Unlike the auction rate securities infamous from the US, there is no backstop or maximum interest rate, and it was never entirely clear to me what would happen if one of these auctions fail. Fortunately, they have never failed, even during the recent financial crisis. There is speculation that the central bank, Danmarks Nationalbank, would have intervened. (For commercial mortgages, it’s more common to have loans tied to a reference rate such as Libor or Cita.)