Hi! I’m Aziz. My newsletter contextualizes economic news using data visualization. These days I’m focusing on housing—hit reply and let me know what you think.

American homeowners don’t want to move and lose their cheap mortgages. This “mortgage lock-in” effect has frozen the real estate market. Low inventory has prevented prices from falling. As a result, affordability has tanked, and there have been few transactions. People are staying put even if their homes no longer suit them.

There is a better model. Similar to the US—and otherwise unique in a global context—Danish banks finance their housing market by turning home loans into bonds and selling them to investors. Bond investors are willing to take on longer-horizon risk than banks. That’s why you can get a fixed-rate 30 year mortgage in the US and Denmark—and nowhere else.

But there is a twist to Denmark’s approach that prevents the kind of freeze we are seeing in the US today: Danish homeowners can sell their mortgages when they sell their homes, pocketing a profit that exactly compensates them for the additional cost of taking on a new, higher rate mortgage. As a result, higher interest rates don’t gunk up Denmark’s housing market—sellers are happy to sell, prices adjust downwards, and buyers jump in. Shouldn’t we do something similar here?

Let’s talk about how housing is funded is most countries, how the US and Danish systems are similar to each other but different from the rest of the world, and finally why the Danish model has some nuances that make it superior to the American approach. This is a 5-minute read.

Mortgage finance in most countries: banks do the lending

Typically, banks give home loans, and fund them with deposits. But loans are long term while depositors can ask for their money back at any time. This creates all kinds of risks (remember SVB?).

One of these risks is interest rate risk: for example, if interest rates rise, banks have to pay depositors more, but the long term mortgages they’ve extended continue to pay them the same (lower) interest rate. In order to avoid this loss-making situation, banks generally only lend at fixed rates for short periods of time—and over longer horizons but only at floating rates.

This is nice for banks, since they don’t expose themselves to too much risk, but it’s not great for homeowners, who have little visibility into their mortgage payments over the long run. In the UK, for example, about 90% of mortgages mature within 5 years—it’s a big headache for the Brits whose mortgages are coming up for renewal these days and are facing spiraling monthly payments.

The American and Danish system: bond investors do the lending

By contrast, the central idea underpinning the American and Danish systems is that bond investors are better placed than banks to make long term mortgage loans (a bond is just a small, tradable piece of a big loan or a pool of many small loans).

Compared to banks, bond investors use less leverage and are more diversified—this means they can suffer greater losses on their mortgage investments without going bankrupt. And unlike banks, bond investors usually want long term assets (to match their long term liabilities).

How does the sausage get made? Banks extend loans to homeowners. Then they package the loans into bonds (the formats are slightly different, Denmark uses “covered bonds” and the US uses “mortgage-backed securities”—but they’re broadly similar). Then the banks sell the bonds to investors, after sticking a guarantee on them (such that if a borrower defaults, the bond investor doesn’t take the hit—in the US, government agencies like Fannie Mae provide the guarantee, in Denmark the originating bank makes the guarantee). At the end of the day, the banks have acted merely as middlemen, connecting the borrowers and lenders for a fee.

The way the US and Denmark fund mortgages makes far more sense than how it’s done in the rest of the world.

But for one problem: when interest rates rise, homeowners sitting on long term mortgages fixed at a cheap rate don’t want to lose them. Since nobody want to lose their cheap mortgage, nobody wants to move, and the system freezes.

Not so in Denmark.

Why the Danes do it better

Say you live in Copenhagen. Say you got a mortgage for 1 million Danish Kroner (kr.) at 2%. And then say interest rates go up to 4%. Now, imagine you want to move—and to a home of equal value, for simplicity. In the American system, you’d have to give up your cheap 2% mortgage and get a new, expensive 4% mortgage.

But in Denmark, you can buy back your mortgage from the bond investor who owns it. And because your mortgage carries an interest rate lower than the going rate, it’s worth less than it was when you got it. If you borrowed kr.1 million, you can now buy your mortgage back for just kr.850,000, pocketing a kr.150,000 gain.

Where do you get the money to do that? From the bank: they will give you a new mortgage, for the kr. 850,000 you need to pay off the old mortgage, at the current 4% interest rate. The math works out perfectly such that your new mortgage is for a smaller amount, but at a higher rate, and it’s in every respect the same as if you had taken your mortgage with you.

Questions? Put them in the comment box below and I will answer them as best I can!

Further reading

Britain faces a deep freeze in living standards Aziz Sunderji · Mar 6 Read full story