Danish mortgage regulations - structure, evolution, and crisis management.

• Published date: 22 March 2010
• Author: Chong, Jocelyn H.W.C
• Date: 22 March 2010

I. INTRODUCTION

The Danish mortgage system was hailed by the International Monetary Fund in late 2006 as "highly rated" and one of the "most sophisticated" mortgage systems in the world. (1) All mortgages granted by credit institutions to property purchasers ("Homebuyers") in Denmark must be supported by an "equivalent bond with a maturity and cashflow that matches those of the underlying loan almost perfectly." (2) This foundational principle, known as the "balance principle," balanceprincippet, is codified in Danish law (3) and has been the basis and hallmark of Denmark's mortgage market model since the market's inception in 1797. (4)

At first glance, the mortgage market system of a small Scandinavian country with a population of approximately 5.5 million and a land area of slightly under 43,000 square kilometers (slightly less than twice the size of Massachusetts), (5) may seem insignificant. However, in contrast to the country's land size and population, the Danish mortgage market, relative to its gross domestic product ("GDP"), is the largest in the world. (6) Further, in terms of sheer monetary value, it is the second-largest mortgage market in Europe. (7) This "tiny" country has an immense value in its real estate.

Mortgage bonds comprise just over seventy percent of the Danish bond market: Financial organizations call Danish mortgage bonds "very strong and very low-risk financial instruments." (9) In the over two hundred years since the inception of the mortgage bond market, "there has never been an incidence of default on a Danish mortgage bond." (10) Largely due to this stable regime, emerging mortgage markets, such as Mexico's, are now attempting to emulate the Danish system. (11) Billionaire financier George Soros has also called for an adoption of the Danish system in the United States as well as in other countries. (12)

Given this global high esteem and regard, the Danish system appears to be the "best possible" (13) mortgage system yet to be conceived. As such, given the current unstable global financial climate, if any housing finance system were to retain integrity through these tough times, it ought to be the Danish version. This Note traces the history, development, and recent crises of the Danish mortgage system. It also examines how the amount of insularity the system has protects it from the global market while continuing to court global investors to its product.

The strength of the Danish mortgage system was recently called into question when Denmark's eighth-largest bank went bankrupt in July 2008. (14) At that time, Roskilde Bank no longer met solvency requirements in the face of increasing "write downs" (15) of real estate loans. (16) Most of these real estate loans do not equate with mortgages regulated under the mortgage system, but are instead related to "property development projects." (17) Thus, Roskilde's demise was premised not on mortgage defaults or other problems with the mortgage bond system, but rather with Roskilde's other loans which failed due to the bank's "'slipshod' credit policy and a collapse in the local property market." (18)

However, much of Roskilde's holdings were also nested in the mortgage credit market: (19)

 In common with most regional and local Danish banks, Roskilde Bank
                 continues to finance its mortgage loans via mortgage providers
                 Totalkredit/Nykredit and DLR Kredit. Since 2007, Roskilde Bank has
                 not provided guarantees against losses in connection with the
                 arrangement of mortgages to Totalkredit. Therefore, the guarantees
                 against losses on mortgage loans will decrease. Going forward
                 losses on Totalkredit mortgages arranged by Roskilde Bank will be
                 offset against the current commission to the bank for its current
                 service to Totalkredit's borrowers. (20)
                

Thus, even though its liquidity woes were linked to bad real estate loans and not the mortgage bond market, Roskilde Bank's financial failures affected its guarantees against Homebuyers' default on mortgages arranged by the bank on behalf of the mortgage credit institutions.

Later in July 2008, Roskilde Bank put itself up for sale. (21) With no takers, it was bailed out by the Danish Central Bank, Nationalbanken, in August 2008. (22) The bailout amounted to over 4.5 billion kroner, which was equivalent to approximately $897 million USD. (23) Nationalbankens Governor Nils Bernstein expressed "that other Danish banks' ability to access international capital could have been compromised if the central bank had not stepped in to guarantee Roskilde's debt." (24)

Roskilde's demise brought to light a chink in the armor of the Danish mortgage system despite its reputation as a "tightly regulated" market that traditionally "shielded mortgage bonds from default risk." (25) Since 2007, Roskilde Bank had not guaranteed any of its arranged mortgages with Totalkredit. (26) Thus, while "[m]ortgagors shall be liable for the loan [mortgage] personally and with the mortgaged property towards the series or the mortgage-credit institution in general," (27) in the event that Homebuyers default, mortgage credit institutions remain obliged to pay mortgage bond holders. (28) If a commercial bank originally services the loan, it must also provide a guarantee to the mortgage credit institution should Homebuyers default; the "link" between the lender and the risk-holder in cases of default prevents irresponsible lending. (29) Roskilde Bank's avoidance of guaranteeing mortgages to credit institutions shattered the payment-reinforcement mechanism that is central to Denmark's mortgage market system.

How was it possible for a bank, within a tightly regulated, highly regarded mortgage system, to face liquidity problems and ultimately insolvency? If the Danish mortgage system is considered the best in the world, what are its weaknesses? Understanding the weaknesses of the "best" mortgage system could help identify similar, latent weaknesses in other nations' mortgage systems. Analyzing the Danish government's solutions to those weaknesses, and determining whether such actions translate to viable long-term solutions, will allow other systems to take more intelligent steps in safeguarding themselves from system failure.

Answering these questions first requires an understanding of the history of the Danish mortgage system, including the evolution of its mortgage laws and regulations, and their operation on the mortgage system itself. The Danish mortgage system is largely financed by bonds, which are issued based on a "balance principle"--a 1:1 ratio of bonds to debt. (30) This system has been adjusted over time to accommodate the various needs of investors and the health of the Danish economy in times of recession.

Next, within this historical framework, this Note will analyze the current regulations. Further, this Note will discuss the significant areas of change and how these changes have affected the enviable stability of the Danish mortgage system relative to other investment options for global investors. Then, this Note will examine the burst of the Danish housing bubble through the lens of these new regulatory changes.

II. HISTORY OF THE DANISH MORTGAGE SYSTEM

The Danish mortgage system is traceable to 1795. (31) That year, a large fire engulfed "many ... districts in the old town" of Copenhagen, (32) the home of the Danish Parliament. (33) The fire consumed over nine hundred properties, (34) which was over one-fourth of the homes in Copenhagen. (35) The fire caused over 4.5 million rix-dollars (36) in damage, only half of which was recoverable from Kobenhavns Brandforsikring, the only fire insurance company in the city. (37) The tremendous amount of destruction was partly due to the fact that streets in the older part of town were too narrow to allow adequate access to firefighters. (38)

The vast destruction prompted a need for a massive increase in lending to fund new construction. Traditionally, lending had been given on an unsecured basis with interest capped at four percent. (39) Both of these factors limited the supply of credit because of limitations placed on incentives for lenders to offer loans. Because of the unsecured basis of loans, lenders were given no option to collect on an unpaid loan because no collateral had been exchanged in return for the loan. (40) In Copenhagen, with interest rates capped at four percent, the risk involved in lending was not adequately compensated for by interest returns, and therefore there was a limited supply of such loans offered on the market. (41)

Yet the devastation caused by the fire called for some kind of action. In this case, it was the general public who came up with a solution to the crisis. By 1797, a group of wealthy citizens created the first Danish mortgage institution: Kreditkassen for Husejerne i Kobenhavn ("Kreditkassen'). (42) These loans were secured by a mortgage on real property with joint and several liability. (43) Owners pooled their land assets to form "credit societies," (44) or "credit associations." (45) Against the combined collateral, loans were granted to the group instead of to individual borrowers. (46) This worked in favor of the owners because the association's loan rates were lower than rates obtained by owners individually. (47) Not only was more land mortgaged, thus increasing foreclosable assets in the event of default, but each owner-member of a credit association was also jointly and severally liable for the entirety of the mortgage. Thus, there was pressure by the association for an individual owner to keep up with his payments. (48) In addition, there was the guarantee that in the case of some defaulters, it did not mean that the entire association would default. Thus, the lenders had greater incentive to offer mortgages on an associational, rather than on an individual, basis.

All financing for the loans came in the form of bonds, or negotiable debt securities...