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MODERN MORTGAGE MARKETS AND THE ANCIENT SCANDINAVIAN MODEL

In 1795 Copenhagen was devastated by the great fire. Virtually everything in its winding streets and curved waterways was destroyed by fire. Underneath the city’s rouble, and in an effort to rebuild, a new mortgage model was developed. Basically, this model lies in issuing mortgages and selling bonds.

It works thus. When a lender approves a mortgage loan, it is required operationally to sell a security (bond) that has the same maturity and cash flow as the mortgage loan. While this appears not to be different from the ‘originate –to-distribute’ securitisation models that are common place in North America and many parts of Europe, the Danish model has two distinctive characteristics.

In the Danish model, the issuer of mortgage security (bond) is obligated to make payments on them. This is different from the American and other European models in which there is no link between those who offer mortgages and those who bear the underlying risk of default. This flaw was most evident and painfully so in America where lax lending was thought to have been encouraged by the absence of this vital link.

The Danish model also is characterised by the fact that mortgage holders can and do buy the securities (bonds) in the market and use them to redeem their mortgages. This is advantageous if rise in interest rate (or conversely a fall in property prices) causes mortgage backed securities (bonds) to trade at a discount. The redemption of the securities (bonds) offers property owners the opportunity to reduce their indebtedness to the lender.

In European and American markets, mortgage-backed securities (bonds) have fallen very much below their fundamental value due in large part because there is no mechanism for those who will benefit most from them to acquire them – the property owner. Whereas in the Danish model, a fall in the value of mortgage securities (bonds) typically encourages property owners to buy them quickly to redeem their mortgages.

Ordinarily, this may give the impression that those securities (bonds) are less attractive to investors. In practice the result is the opposite. Danish investors see their country’s mortgage securities (bonds) as no more risky than their government’s debt instruments. Additionally, regulation allows property owners to borrow only 80% of the value while lenders are officially authorised to seize the properties of defaulters.

There is no numeric certainty that the Danish model would work this well in countries that property markets are less homogenous. The property market in the UK needs a systemic change. This model may be the way forward for mortgage markets in America and Europe.

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Tacklewild Financial Services is authorised and regulated by the Financial Services Authority and is entered on the FSA register (www.fsa.gov.uk) under reference 310816

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