Securitization of Home Mortgages

By Steve Bergman

The securitization of home mortgages or the transformation of pools of mortgages into investment instruments with bond-like characteristics has been a useful way to keep the mortgage markets liquid. Instead of carrying the home loans on balance sheets, banks could sell them, and with revenue from the sales re-circulate the capital for new mortgages.

Everybody seems to be a winner. Investors receive bonds trenched to their investment needs, banks could loan more money, more people get more loans, and Wall Street, which packages the pools of loans, creates the tranches and markets them around the world making fabulous profits.

However, there is a problem. Like HAL in the film 2001, securitization started to take on a life of its own.

As a self-perpetuating monster, the securitization market had only one demand: feed me. And the banks and Wall Street complied, throwing everything into the maw, subprime loans, loans without due diligence, loans without interest rates, loans by citizens with no credit. After a half decade of living on a steady diet of junk food, the securitization market exploded in the summer of 2007, when the subprime segment of the market collapsed. The world hasn’t been the same since.

All that beggars the question: is securitization bad or was the model wrong. The good citizens of tiny Denmark would gladly explain, if someone here in the States would take the time to listen, that it was the model that was imperfect and securitization with the proper regulations in place can function smoothly over a long period of time. The Danes can make this claim because they boast a residential securitization market for 200 years and it all that time not one mortgage bank nor one mortgage bond has defaulted. If we could only make that claim here in the States!

In 1793, the Danish capital of Copenhagen suffered a catastrophic fire and the city needed to put in place an inexpensive means to finance rebuilding. What the city fathers came up with then is a simple, transparent, securitization system. Borrowers could go to a mortgage bank and get a loan. The mortgage bank, acting as an intermediary, would take the loans and package them into a bond, which would then be sold on the local stock exchange. At the time, the buyer of the bonds was the Royal treasury, essentially the Danish state. In 1850, the first regulations on mortgages were put into place, and over the years the Danish state has been replaced by a different group of institutional capital sources such as pension plans, insurance companies and foreign investors.

Over the years, the core of the Danish securitization process has not changed. The key structural factors remain: mortgage banks have a limited structure, granting loans and financing the loans by issuing bonds (commercial banks, some of which own mortgage banks, do all the other financing activities); the mortgage bonds are sold on the stock exchange and the monies from the sale are funneled back to the borrowers so they can purchase a house; a borrower is responsible for paying back the mortgage and not even bankruptcy lifts that demand; and most importantly, the loans remain on the balance sheet of the mortgage bank. They can never be sold away as in the United States.

The concept behind the Danish mortgage banking system is called The Balance Principal: payments on the debtor side and creditor side of the mortgage bank must balance as a whole. This balance is achieved by issuing a bond or portfolio of bonds each time a loan is granted. “One can say that all loans today are match-funded on a loan-to-bond basis,” says Carsten Madsen, a director and senior executive vice president at BRFkredit in Lyngby, Denmark. “It’s a simple pass-through system.” In principal, the biggest risk to the mortgage bank is the credit risk, i.e., that the borrower fails to meet contractual obligations. Again, it should be noted, that over the past 200 years a Danish mortgage bank has never failed. (Mortgage banks are obliged to fulfill a solvency requirement, maintaining a capital base equal to 8% of their weighted assets.)

The mortgage bank makes money on the “margin.” In essence, the borrower pays to the mortgage banks an installment that consists of principal and interest payment on the loan, fees and commissions, and margin, which covers the expense of the loan including the cost to hold the loan on the balance sheet. That margin is not necessarily fixed, explains Niels Torslev, group managing director for Nykredit mortgage bank in Copenhagen. “If we were in a climate where the value of homes in Denmark was going down and loan losses started to occur, we have the potential to raise margins, which would affect all Danish citizens. It’s a semi-access to tax the Danish population.”

Although the economy is slowing in Denmark, there hasn’t been a need yet to raise margins. The last time that happened was in the early 1990s, when Danish mortgage banks doubled margins. There are no independent mortgage brokers in Denmark, although commercial banks can act as an agent of the mortgage banks. And this is another key difference between the U.S. and Danish systems. If a commercial bank acts as a mortgage broker, it maintains a loan-loss guarantee typically for eight years at an L-T-V of 60%. That’s very important in the value chain of the borrower to ultimate investor.

When mortgage banks invite entities, such as commercial banks, to introduce customers, they have to maintain a presence until the maturity of the loan. Also, when the mortgage banks pay the commercial banks for doing the loan, it is not done on net present value, but on an annual basis – the banks get a portion of the margin every year.

Finally, the loan process in Denmark is very strict. Danish mortgage banks will only grant a loan when a credit assessment has shown the borrower is at minimum, able to service a 30-year, fixed-interest loan, even if the borrower chooses an adjustable-rate mortgage loan. If a situation occurs where the borrower does default, the mortgage bank will auction off the home. Then, if the proceeds from the auction are less than the value of the mortgage, the borrower remains responsible for the difference.

In Denmark, it’s almost impossible to escape the responsibility of the mortgage. Twenty years after a bankruptcy, a Danish citizen would still be responsible to pay back the mortgage bank.

Steve Bergsman's most recent book, AFTER THE FALL: OPPORTUNITIES AND STRATEGIES FOR REAL ESTATE INVESTING IN THE COMING DECADE, was published in March by John Wiley

& Sons