    [Senate Hearing 111-886]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 111-886

             A COMPARISON OF INTERNATIONAL HOUSING FINANCE SYSTEMS

    =======================================================================

                                    HEARING

                                   before the

                                SUBCOMMITTEE ON
                  SECURITY AND INTERNATIONAL TRADE AND FINANCE

                                     of the

                                  COMMITTEE ON
                       BANKING,HOUSING,AND URBAN AFFAIRS
                              UNITED STATES SENATE

                         ONE HUNDRED ELEVENTH CONGRESS

                                 SECOND SESSION

                                       ON

              COMPARING THE INTERNATIONAL HOUSING FINANCE SYSTEMS

                                   __________

                               SEPTEMBER 29, 2010

                                   __________

      Printed for the use of the Committee on Banking, Housing, and Urban
                                    Affairs

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                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                   CHRISTOPHER J. DODD, Connecticut, Chairman

    TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
    JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
    CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
    EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
    ROBERT MENENDEZ, New Jersey          MEL MARTINEZ, Florida
    DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
    SHERROD BROWN, Ohio                  JIM DeMINT, South Carolina
    JON TESTER, Montana                  DAVID VITTER, Louisiana
    HERB KOHL, Wisconsin                 MIKE JOHANNS, Nebraska
    MARK R. WARNER, Virginia             KAY BAILEY HUTCHISON, Texas
    JEFF MERKLEY, Oregon
    MICHAEL F. BENNET, Colorado

                        Edward Silverman, Staff Director

            William D. Duhnke, Republican Staff Director and Counsel

                           Dawn Ratliff, Chief Clerk

                         William Fields, Hearing Clerk

                          Shelvin Simmons, IT Director

                              Jim Crowell, Editor

                                     ______

          Subcommittee on Security and International Trade and Finance

                          EVAN BAYH, Indiana, Chairman

                BOB CORKER, Tennessee, Ranking Republican Member

    HERB KOHL, Wisconsin                 ROBERT F. BENNETT, Utah
    MARK R. WARNER, Virginia
    MICHAEL F. BENNET, Colorado
    CHRISTOPHER J. DODD, Connecticut

                          Ellen Chube, Staff Director

                  Courtney Geduldig, Republican Staff Director

                                      (ii)
    ?

                                C O N T E N T S

                                  ----------

                         WEDNESDAY, SEPTEMBER 29, 2010

                                                                       Page

    Opening statement of Chairman Bayh...............................     1
    Opening statements, comments, or prepared statement of:
        Senator Corker...............................................     3

                                   WITNESSES

    Michael J. Lea, Director, The Corky McMillin Center for Real
      Estate, San Diego State University.............................     4
        Prepared statement...........................................    26
    Susan M. Wachter, Richard B. Worley Professor of Financial
      Management, Professor of Real Estate, Finance, and City and
      Regional Planning, The Wharton School, University of
      Pennsylvania...................................................     7
        Prepared statement...........................................   108
    Alex J. Pollock, Resident Fellow, American Enterprise Institute..     9
        Prepared statement...........................................   110

                                     (iii)

             A COMPARISON OF INTERNATIONAL HOUSING FINANCE SYSTEMS

                                  ----------

                         WEDNESDAY, SEPTEMBER 29, 2010

                                           U.S. Senate,
          Subcommittee on Security and International Trade and
                                                       Finance,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.
        The Subcommittee met, pursuant to notice, at 2:36 p.m., in
    room SD-538, Dirksen Senate Office Building, Hon. Evan Bayh,
    Chairman of the Subcommittee, presiding.

                OPENING STATEMENT OF CHAIRMAN EVAN BAYH

        Chairman Bayh. If the Subcommittee would please come to
    order. Good afternoon. I am pleased to call to order this
    Subcommittee hearing entitled, ``A Comparison of International
    Housing Finance Systems.'' I want to thank and welcome my
    colleague in attendance, Senator Corker, and I am happy to say
    that we have had an excellent working relationship, to show
    that Democrats and Republicans can cooperate together when the
    spirit so moves us. So, Robert, it is great to be with you once
    again. As a matter of fact, if I have to absent myself later, I
    have such trust and confidence in my colleague, I will hand him
    the gavel.
        [Laughter.]
        Chairman Bayh. Which does not happen much here on Capitol
    Hill, but it will be in good hands when it is in his. He was,
    in fact, the impetus behind holding this hearing and having
    this important discussion today.
        To our three distinguished and learned witnesses that
    appear before us today, welcome and thank you for your
    testimony.
        All three of the academics on our panel have extensive
    research and practical experience in the area of housing
    finance, with a particular expertise in the systems of
    developed nations abroad. I understand that two of our
    witnesses have traveled to be with us here today, and so I want
    to thank you for your time and consideration with regard to the
    Subcommittee's deliberations. Thank you for literally going the
    extra mile.
        I look forward to our dialog today, but, unfortunately, due
    to some last-minute scheduling constraints, I may be unable to
    stay for the entirety of the hearing. I am confident, however,
    that given Senator Corker's keen interest in this issue and the
    appeal of the subject matter, we will still have a lively and
    informative discussion.
        If the witnesses will indulge me, I may have a few written
    follow-up questions for you to be submitted for the record on
    certain topics that are not covered in the question-and-answer
    portion of today's hearing. I promise they will not be too
    voluminous.
        Before we turn to the panel, I would like to give a few
    very brief remarks to provide some context for this hearing and
    what the Subcommittee would like to achieve today. And I invite
    Senator Corker to do the same when I am done.
        Today we convene as a Subcommittee to gain insight into the
    legislative challenge facing Congress as it considers reforms
    to our housing finance system. This is a critical economic
    policy issue that affects virtually all of those involved in
    the housing market: homeowners, potential borrowers, financial
    institutions, investors, realtors, construction, and I could go
    on and on.
        Many with an interest in reform are already hard at work.
    Last month, the Treasury Department held a conference on the
    future of housing finance. Some of our witnesses today
    participated in that conference, and it proved to be a
    worthwhile and substantive meeting.
        Just last week, Assistant Secretary Barr reiterated the
    Treasury Department's intention to release a plan that will
    call for fundamental change by January 2011. This debate has
    the potential to become political and polarizing, but that
    should not prevent us from addressing such a consequential
    issue in a pragmatic fashion.
        It is the responsibility of Congress to tackle how to build
    a more stable housing finance system, with an understanding of
    what went wrong with our current system and what we can do
    together, given the economic realities, to fix it.
        To assist in that endeavor, we hold today's hearing to
    explore the housing finance models of other developed nations,
    including, but not limited to, Canada, Denmark, the United
    Kingdom, Australia, and Germany. We will hear from the
    witnesses on how the housing finance systems of these countries
    differ from the United States', the strengths and weaknesses of
    their product approach, and whether any lessons may be learned
    from their experiences prior to enduring the global economic
    crisis. More importantly, we hope to learn whether any aspects
    of their systems and policies or regulatory frameworks may be
    adapted to our system here in the United States.
        As a lead-in to that discussion, I would note that some of
    the policy approaches of other nations are seemingly difficult
    to reconcile with the economic data. For instance, most
    developed countries experienced robust growth in their housing
    and mortgage markets during the first half of the decade. Some
    countries also experienced record levels of house price
    inflation, relaxed underwriting standards, and increased
    competition. Still, no other major developed nation has
    experienced the type of house price decline, the staggering
    default and foreclosure rates, and drastic change to their
    mortgage finance system that the U.S. went through. Why is
    that? What have they done differently?
        At the same time, Australia, Ireland, Spain, Canada, and
    the U.K. all have higher or comparable rates of home ownership
    to the U.S., but these countries provide far less government
    support. In fact, the U.S. is unique in that it provides
    preferable tax treatment for owner-occupied housing and it uses
    all three types of Government support: support of mortgage
    institutions or guarantee programs, mortgage insurance,
    mortgage guarantees, and Government-sponsored mortgage
    enterprises.
        How did they achieve those rates of home ownership without
    the Government subsidies or the types of programs that we offer
    here in the U.S.?
        In addition, some of those same jurisdictions have far
    stricter underwriting standards for loans and a limited number
    of mortgage products available to borrowers, with arguably less
    preferential terms, but still maintain high home ownership
    rates. How do we reconcile that paradox?
        These are just a subset of the issues we seek to explore
    with our witnesses today as we learn more about our
    counterparts to the north and abroad and how they deal with
    housing finance and confront the challenges and asset bubbles.
        I welcome our witnesses' insights and perspectives on this
    pressing issue and gathering what we can from other nations'
    experiences. Thank you all.
        Senator Corker.

                    STATEMENT OF SENATOR BOB CORKER

        Senator Corker. Well, thank you, Mr. Chairman. I very much
    appreciate your working to cause this meeting to take place.
        I want to thank our witnesses, who are outstanding. And,
    you know, the fact is that this year we are probably not going
    to do anything as it relates to housing finance, but next year
    we probably will, and I think understanding what has worked and
    what has not worked in other places will be helpful. I think a
    lot of times we have these myths or these built-in issues into
    the DNA here as it relates to housing finance, and sometimes
    looking in other places we can learn from that.
        So I very much appreciate you being here today. I know that
    we are at the wind-down and there is not a lot of activity as
    far as people thinking about policy. But this will be very,
    very helpful to us as we move ahead this next year, and I thank
    all of you for coming, and I certainly look forward to the
    Chairman introducing you.
        Chairman Bayh. Thank you, Senator Corker.
        I am going to ask that the introductions of our three
    witnesses be included in their entirety in the record. You all
    have such great experience and so many credentials, I am not
    going to take your time by reading them all. I will just kind
    of hit the highlights starting from our perspective with you,
    Dr. Lea, and then moving to the rest of the panel.
        Dr. Michael Lea is the director of the Corky McMillin
    Center for Real Estate at San Diego State University. I have
    already just mentioned that Dr. Lea is an international
    authority on housing and mortgage finance and has published
    over 75 articles and book chapters, including the editing and
    coauthoring of an influential World Bank publication on
    emerging market housing finance in 2009.
        I am sure your book went higher on the Amazon scale than
    mine did, Doctor.
        He has over 25 years of financial services industry
    experience, including more than 18 years of international
    advisory work in 28 countries spanning six continents. He has
    taught at Cornell University, San Diego State University, the
    University of California-San Diego, and the Wharton
    International Housing Finance Program at the University of
    Pennsylvania. Wharton is well represented here today. He
    receive his Ph.D. in economics from the University of North
    Carolina at Chapel Hill.
        Welcome, Dr. Lea.
        Next we have Dr. Susan Wachter--I hope I pronounced that
    correctly, Doctor--the Richard B. Worley Professor of Financial
    Management, Professor of Real Estate and Finance, codirector at
    the Institute for Urban Research, the Wharton School,
    University of Pennsylvania. Dr. Wachter is codirector and
    cofounder of the Penn Institute for Urban Research, has served
    as president of the American Real Estate and Urban Economics
    Association, and is coeditor of Real Estate Economics. She was
    appointed Assistant Secretary for Policy Development and
    Research at HUD and served from 1998 to 2001, where she was
    principal adviser to the Secretary, responsible for national
    housing and urban policy. Dr. Wachter received her B.A. from
    Harvard College, which in our part of the country, Doctor, we
    refer to as the Indiana University of the East.
        [Laughter.]
        Chairman Bayh. And her Ph.D. from Boston College. Welcome,
    Dr. Wachter.
        Next we have Alex Pollock, Resident Fellow of the American
    Enterprise Institute. Mr. Pollock joined AEI in 2004 after 35
    years in banking. He was president and chief executive officer
    of the Federal Home Loan Bank of Chicago from 1991 to 2004. He
    is also the author of numerous articles on financial systems
    and the organizer of the ``Deflating Bubble'' series of AEI
    conferences. He is a director of the Chicago Mercantile
    Exchange--you employ many people in my State, which we
    appreciate, Mr. Pollock--the Great Lakes Higher Education
    Corporation, the International Housing Union for Housing
    Finance, and the Chairman of the Board of the Great Books
    Foundation. Mr. Pollock is a graduate of Williams College, the
    University of Chicago, and Princeton University. Welcome, Mr.
    Pollock.
        Dr. Lea, why don't we begin with you. Just as a rule of
    thumb--and I do not intend to enforce this strictly, but if you
    have got a lengthy statement, if you could kind of summarize it
    in 5 minutes or so, give or take, and then we could submit the
    rest to the record. And as I said, if you go over a little bit,
    that is not a big deal. But if you can kind of keep it in that
    ball park, that would be great. And then we will go to a round
    of questions after all three of you have finished your
    statements.

       STATEMENT OF MICHAEL J. LEA, DIRECTOR, THE CORKY MCMILLIN
           CENTER FOR REAL ESTATE, SAN DIEGO STATE UNIVERSITY

        Mr. Lea. Great. Thank you, Mr. Chairman and Ranking Member
    Corker and Members of the Subcommittee, who will see it in the
    record, I guess. As you said, I am Michael Lea, and I am the
    director of the Corky McMillin Center for Real Estate at San
    Diego State, and as Mr. Chairman's introduction, I have had
    extensive experience in working and doing research in
    international mortgage markets now for more than 20 years.
        I recently completed a comparative study of developed
    country housing finance systems that is going to be published
    by the Brookings Institution later this fall as well as a
    comparative study of mortgage instrument design which was
    released this week by the Research Institute for Housing
    America. And I would ask that both of these papers be entered
    into the record.
        Chairman Bayh. Without objection.
        Mr. Lea. Thank you.
        I would like to start by looking at the U.S. owner-occupied
    mortgage markets in an international context. Our market is
    internationally unusual in several respects. First, the U.S.
    has a more extensive role of Government in our mortgage market
    than other countries. The U.S. Government backs over 50 percent
    of the stock of mortgage debt and over 95 percent of the new
    flow. Only Canada comes close, with approximately 50 percent of
    its loans directly or indirectly insured by the government, and
    about 25 percent of Canadian mortgage-backed securities have a
    government guarantee. Japan is the only other major developed
    market with a government security guarantee program, and the
    Netherlands is the only other market with a government-backed
    insurer. I did a study of about 11 or 12 major developed
    markets for this work.
        No other developed market has a Government-sponsored
    enterprise, as you said earlier. No other market has
    quantitative housing goals or CRA-type legislation.
        The U.S. is also unusual in the preponderance of the long-
    term fixed-rate mortgage and funding through securitization.
    Currently over 90 percent of U.S. new originations are fixed-
    rate mortgages, and in most years, they have a 70-percent
    market share. The only other countries with predominant market
    share in long-term fixed-rate mortgages are Denmark and France.
    The dominant instrument in other countries is either an
    adjustable-rate mortgage, such as Australia, Spain, or the
    U.K., or a short- to medium-term fixed-rate, sometimes called a
    rollover, mortgage with a longer amortization period, such as
    in Canada, Germany, and the Netherlands.
        Over 60 percent of U.S. mortgages have been securitized and
    over 90 percent of current originations are funded through
    securitization. Internationally, Canada, Spain, and the U.K.
    have funded approximately 25 percent of the mortgages through
    securitization. In other countries, that markets share is quite
    less.
        The predominance of fixed-rate mortgages and securitization
    in the U.S. is causally linked. Experience has shown that
    capital market financing is necessary to manage the risk of
    such mortgages. Their dominance is both a function of and a
    rational for Government involvement. The Government effectively
    subsidizes fixed-rate mortgages through the Government-
    sponsored enterprises and Ginnie Mae, the guarantees for which
    reduce the relative cost of this instrument. Investors in
    fixed-rate mortgages like Government guarantees so they do not
    have to worry about credit risk, only the underlying cash-flow
    risk caused by long amortization and frequent prepayment.
        Thus, supporters of Government-sponsored enterprises argue
    that Government guarantees are needed to continue offering the
    fixed-rate mortgage. Without such guarantees, fixed-rate
    mortgages, in my opinion, would still exist but they would be
    more expensive and there would be a smaller market share.
        What has been the result of these policies? The U.S. does
    not have a higher home ownership rate than in many other
    countries, as you indicated in your introduction. In my survey
    of 11 major developed markets, the U.S. was in the middle. The
    U.S. does not have a deeper mortgage market, either. A number
    of countries have higher ratios of mortgage debt outstanding to
    GDP. The U.S. market was unequivocally the worst-performing
    market during the crisis, with significantly higher rates of
    default and foreclosure.
        There are many factors contributing to its poor
    performance, but the role of Government lending incentives and
    the crowding out of lower-risk lending by Government entities
    are significant contributors.
        So what can we learn from the experience in other
    countries? The role of Government in fostering home ownership
    through tax incentives and lending programs has not resulted in
    higher rates of home ownership, rather contributed to a
    pronounced boom and bust that continues to plague the economy.
    International experience suggests that sustainable home
    ownership and mortgage indebtedness can be achieved without
    such a large role of the Government.
        What can replace the Government-dominated funding model
    that now characterizes the U.S.? The Danish model offers
    several areas for improvement. The Principle of Balance results
    in a one-to-one correspondence between a mortgage loan and a
    bond that finances it. If mortgage rates fall, the borrower can
    refinance, as in the U.S. today. If interest rates rise, the
    borrower, through their mortgage lender, can repurchase the
    bond at a discount and cancel the mortgage. In this way the
    borrower can reduce debt and, therefore, the likelihood of
    negative equity in a rising interest rate environment.
        This feature could also reduce the significant extension
    risk that mortgage-backed security investors face in the U.S.
    today. With rising rates, the effective maturity of mortgages
    is going to be rising over time.
        The highly efficient Danish mortgage market is funded
    through corporate bonds in which the credit risk stays on the
    balance sheet of the lender, thus aligning incentives. The
    Danish model could be implemented initially by Fannie Mae and
    Freddie Mac, ultimately transitioning to a private model.
        The Canadian-European combination of the rollover mortgage
    and covered bond financing has desirable characteristics as
    well. For example, a 5-year fixed-rate mortgages with a 30-year
    amortization provides significant, though not complete,
    insulation of the borrower from interest rate risk,
    particularly given the fact that the average homeowner moves
    every 5 to 7 years here in the U.S. A shorter fixed-rate period
    reduces the risk for the lender and investor and will result in
    lower relative mortgage rates.
        A key characteristic of this model is the ability of
    lenders to charge prepayment penalties during the fixed-rate
    period. The penalties allow lenders to issue very simple bullet
    bonds or fund the loans through swap deposits. While prepayment
    penalties got a bad reputation during the subprime lending
    crisis here, they do serve a valuable function and are common
    outside the U.S.
        In conclusion, I believe there is much the U.S. could learn
    from international experience, and I look forward to your
    questions. Thank you.
        Chairman Bayh. Thank you very much, Dr. Lea.
        Dr. Wachter.

     STATEMENT OF SUSAN M. WACHTER, RICHARD B. WORLEY PROFESSOR OF
     FINANCIAL MANAGEMENT, PROFESSOR OF REAL ESTATE, FINANCE, AND
     CITY AND REGIONAL PLANNING, THE WHARTON SCHOOL, UNIVERSITY OF
                              PENNSYLVANIA

        Ms. Wachter. Chairman Bayh, Ranking Member Corker, thank
    you for the invitation to testify.
        The United States belongs to a group of countries that
    suffered particularly severe recessions driven by sharp housing
    price crashes. Other countries in this category include the
    United Kingdom and Spain. On the other end of the spectrum are
    countries where home prices merely leveled from 2007 to the
    present, resulting in no or mild recessions. This category
    encompasses Canada, Australia, and Germany. Denmark lies
    somewhere in the middle, with a late bubble and current
    downturn. By comparing these two groups, we can investigate
    what causes and what prevents housing bubbles and financial
    crises. In a forthcoming paper with colleagues, cited in my
    written testimony, we conduct just such an investigation, and
    we find that two institutional differences separate these
    groups: the role of mortgage insurance and the strictness of
    regulations countering the market's tendency toward procyclical
    behavior.
        No country better exemplifies this procyclicality in
    housing and mortgage markets than the United States. With
    economic growth and low interest rates coming out of the
    recession of 2000-2001, mortgage lenders and securitizers
    increased lending and competed for market share among
    borrowers. When the available market was satiated, they
    expanded the market by lowering their standards. Eventually,
    borrowers found themselves with too much debt to repay, and the
    downward spiral of foreclosures, defaults, and home price
    declines resulted in the crisis we have today.
        While lending standards deteriorated, the extent to which
    this was occurring was unknown due to information opacity. I go
    through a short description of what happened in the United
    States to compare it to other countries.
        Contrast this experience to that of Canada, where
    regulators mandate that all high loan-to-value mortgages must
    be covered by mortgage insurance. This practice has not
    inhibited Canada from achieving levels of home ownership on par
    with those of the U.S. at their peak in 2004. Canada and in
    this period Australia, which also shows a high rate of home
    ownership, relied on mortgage insurers as a ``third-party
    regulator'' with the result that mortgage lending standards did
    not deteriorate and housing prices did not collapse. Mortgages
    in Australia and Canada were and are typically short-term
    variable rate, or in the case of Canada, rollover, and were
    originated and to a large extent held in portfolio by banks.
    Both countries avoided recessions, home ownership, as I said,
    has been maintained at high levels, and their banking systems
    have been able to continue lending as the crisis has caused
    financial systems in other countries to stop functioning.
        The structure of the dominant mortgage product is also
    critical to preventing procyclicality. Most countries rely on
    adjustable-rate mortgages or rollover mortgages provided by
    banks and held in bank portfolios. The U.S., Denmark, and to a
    lesser extent Germany are the three notable exceptions,
    favoring fixed-rate mortgages or relatively long-term fixed-
    rate mortgages. ARMs place the interest rate risk on the
    borrower, who is not well suited to bear this risk. When
    interest rates rise, borrowers have difficulty making payments
    and may be forced to default. ARMs are also less conducive to
    systemic stability, as exhibited during the current economic
    crisis here and elsewhere. During the housing bubble,
    securitizers' appetite for market share drove them to
    underwrite riskier adjustable-rate mortgages from less
    creditworthy borrowers. The U.K. and Spain also relied on ARMs
    with deteriorating lending standards. All countries with ARMs
    saw their lending dry up during the credit crunch with
    borrowers not able to refinance even though it was assumed that
    refinancing would always be possible. With ARMs that need to be
    repaid or refinanced, the illiquidity of the system may be
    transformed as in these countries into a solvency or
    foreclosure crisis.
        Building a system around the fixed-rate mortgage requires a
    secondary market. In my written testimony, I go into more
    detail as to why.
        Unlike the private label securities of ARMs, securitization
    allows a fixed-rate mortgage that would otherwise not exist. In
    Germany, a secondary market exists in the former of covered
    bonds, identified as ``Pfandbriefe,'' that are secured by
    standardized mortgage loans, which the quality of the
    standardized mortgage loans was not allowed to be undermined
    over time.
        But without proper regulation, covered bonds can get a
    country into trouble. German regulators ensure that investors
    get periodic updates on the state of the collateral securing
    their covered bond, and they do not allow covered bonds to be
    secured by loans with an LTV ratio above 60 percent. Unlike in
    the U.S., these regulations were not eroded during the housing
    bubble. Denmark also relied on covered bonds and had similarly
    stringent regulations until recently. When Danish legislation
    moved the system toward interest-only mortgages, the market
    joined the housing mania and developed a late bubble that
    subsequently deflated, causing the current recession in
    Denmark. Similarly, Spain used covered bonds extensively, yet
    they did not have fixed-rate mortgages; they used covered bonds
    to finance adjustable-rate mortgages. The Spanish banks, the
    savings banks, cajas, securitized ARMs through cedulas in an
    effort to generate fees and gain market share, generating a
    bubble and crisis that is severe, with Spain now suffering 20
    percent unemployment. In the face of rising prices, it is
    tempting to lower lending standards, as occurred in these
    countries, contributing to procyclicality.
        Most countries do have significant involvement of
    governments in housing and mortgage markets. Now, Canada, as we
    have just heard, provides catastrophic mortgage insurance to
    most of its mortgage market. In other countries, when the
    housing market is in crisis, when the entire system is in
    danger, there is a rescue. The British rescue of Northern Rock
    preceded the American bailouts; the Spanish government has
    intervened to protect the cajas and their covered bonds. To
    prevent a foreclosure crisis from driving an economy into a
    severe recession or depression, governments will intervene;
    thus, it is necessary to regulate the housing market before it
    reaches the crisis stage. The taxpayer owns the tail risk.
    Rather than raise lending standards after the fact, we can
    prevent the problems of moral hazard, shrinking equity, and
    bailouts by maintaining standards and transparency.
        In closing, the clearest difference between the U.S., the
    U.K., and Spain on the one side and Australia, Canada, and
    Germany on the other side is the stability of regulation. The
    first group allowed lending standards and capital requirements
    to decline, stoking the procyclical behavior that created a
    housing bubble and economic crisis, while the latter group
    maintained rules in the face of market pressure.
        Thank you.
        Senator Corker [presiding]. Go ahead, Mr. Pollock.

        STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW, AMERICAN
                          ENTERPRISE INSTITUTE

        Mr. Pollock. Thank you, Mr. Chairman.
        As you mentioned in your opening comment, it is without
    doubt the case that it is very useful to examine American
    housing finance in an international perspective. When we do, we
    discover one thing unique in the world about American housing
    finance, and that was the dominant and disproportionate role
    played by Government-sponsored enterprises--that is, Fannie Mae
    and Freddie Mac.
        With Fannie and Freddie so prominent, many Americans,
    including Members of Congress, including the two gentlemen I
    had lunch with today, thought that America had the highest home
    ownership rate in the world. As you have pointed out, we did
    not and we do not.
        In my written testimony, there is a table of comparative
    home ownership rates. Michael has 11; I have 26 advanced
    countries in my table, and I think it is about as up to date as
    it can be. The U.S. ranks 17th in this list among advanced
    countries, or about two-thirds of the way down the list, in
    home ownership. And as I say, that table is in my written
    testimony.
        Many countries achieve home ownership levels as high or
    higher than ours with no GSEs. Various housing finance systems
    operate without tax deductions for the interest on home
    mortgages, without our highly unusual practice of making
    mortgages into nonrecourse debt, and without government CRA-
    like mandates to make riskier loans, without 30-year fixed-rate
    loans, and with prepayment fees on mortgages.
        Of course, as bubbles and busts in these other countries
    show, you can also get in trouble with different systems. That
    is a general rule, I take it, of finance. You can always get
    into trouble in finance.
        The better credit performance of Canada and Canadian
    housing finance has been well known, and, indeed, Canada has
    mortgage delinquencies which are a small fraction of ours.
    Canadian mortgage lenders have full recourse to the borrower's
    other assets and income, in addition to the security interest
    in the house. The fact that there is no tax deduction for
    interest probably increases the incentive to pay down the debt
    over time. Most Canadian mortgage payments are made through
    automatic debit of the borrower's checking account and can be
    matched to the frequency and timing of the paycheck. It is a
    technical but I think very important point in terms of the
    behavior of borrowers.
        With this relative credit conservatism, as has been pointed
    out, Canada's home ownership rate is 68 percent compared to 67
    percent for us, and Canada does have a government body to
    promote housing finance, which has a very substantial role, as
    my colleagues on the panel have said, the Canada Mortgage and
    Housing Corporation, or CMHC. But at least CMHC's status,
    unlike the American GSEs, is completely clear and honest. It is
    a 100-percent government-controlled corporation. Its government
    guarantee is completely explicit. It provides housing subsidies
    which are on budget and have to be appropriated by the
    Parliament.
        Canada in this respect, therefore, looks superior to the
    U.S. in candor, as well as credit performance. It has, however,
    had a big run-up in its house prices over the last decade, and
    this is shown in my written testimony. In response to this,
    Canadian regulators have taken actions to decrease the maximum
    loan-to-value ratios on some classes of mortgages, and such
    countercyclical movements in LTV limits, in my opinion, are an
    excellent idea and are, indeed, necessary to moderate the
    inevitable cycles in real estate credit.
        As has been discussed, the most perfect housing finance
    solution in theory, which also functions very well in practice
    in an admittedly small country, is the housing finance system
    of Denmark, which has been admired by many observers. The
    interest rate and prepayment characteristics of long-term
    fixed-rate loans in the system are passed entirely on to
    investors in Danish mortgage bonds. But at the same time, there
    is a total ``skin in the game'' requirement for credit risk.
    The lending mortgage banks retain 100 percent of the credit
    risk of the loans. Deficiency judgments, if foreclosure on a
    house does not cover the mortgage debt, are actively pursued.
        Some years ago, before the fall of Fannie and Freddie, I
    participated in an exchange with the Association of Danish
    Mortgage Banks. The idea was that they explained their bond-
    based and skin-in-the-game-based system to me, and I explained
    the American GSE-centric system to them.
        When I had finished my presentation, the CEO of one of the
    leading Danish mortgage banks said this: ``In Denmark we always
    say that we are the socialists and America is the land of free
    enterprise,'' he said. ``Now I see that when it comes to
    mortgage finance, it is the opposite!'' And, indeed, I think
    that is an insightful statement.
        In my written testimony, I also discuss some other
    countries, including two ideas from Germany worth pursuing, one
    being covered bonds and the other being an emphasis on savings
    as part of housing finance, which has not been mentioned yet,
    Mr. Chairman. We need to rediscover the idea of savings as part
    of what we are doing in housing finance, as the old name
    savings and loan would indicate.
        Well, America's GSE-centric housing finance system has
    collapsed, with massive taxpayer expense, as did the former
    thrift-based system which preceded it.
        The international perspective suggests that there is every
    reason to think broadly about how to develop a better, post-GSE
    U.S. housing finance system for the future.
        Senator Corker. Thank you all for your testimony, and I
    think, to sort of shorten the chase here, if you will, Mr.
    Pollock, why do we not just start with that and have each of
    you, if you will, describe without the built-in DNA that exists
    around what we have in our own country, based on what each of
    you know about other countries and what you have seen here, if
    we were--because that, I think, is where we are going to try to
    go this next year--if we were going to design a housing finance
    system that worked in this country, taking into account the
    cultural aspects over the last 50 years that have developed
    around housing, what would it be?
        Mr. Pollock. Do you want me to start, Mr. Chairman?
        Senator Corker. Yes.
        Mr. Pollock. In my opinion, it would have a much bigger
    role for a truly private market. That is to say, the vast bulk
    of the residential market, which is the middle-class what we
    call conforming or prime mortgage market of the size that the
    vast bulk of the population borrows to buy houses that are in
    the middle of the distribution, would be a fully private
    market.
        I have the notion that among the participants in this
    market would be the privatized parts of Fannie Mae and Freddie
    Mac in the future, when they leave behind their bankrupt old
    business. But that needs to be a private market, and I think on
    that basis it would work well and it would succeed in
    delivering a better resource allocation that is not warped and
    distorted by all kinds of government subsidies and guarantees.
        For that part of the system which we would choose to
    subsidize or to do credits which a market would not do, I think
    that should be a purely and explicitly government activity, as
    it is in Canada, where the subsidies, instead of being hidden
    in GSEs and be able to allow those GSEs to exert significant
    political clout, those subsidies and nonmarket financings
    should all be explicitly in the government, have to be approved
    and appropriated by the U.S. Congress. So in that way, I think
    we would look more like other countries and we would have a
    superior economic model.
        Just two other points. I think that it does make sense to
    think about covered bonds as an alternative financing. As my
    colleagues have pointed out, if you want to have fixed-rate
    mortgage loans, you have to have a bond market financing. You
    cannot finance long-term fixed-rate mortgage loans on a deposit
    basis, and in this country the banks are not big enough to
    finance the whole mortgage market anyway. And covered bonds, I
    think, make an alternative which should be explored. That
    alternative needs to have a statutory basis so the bond holders
    are truly given certainty about their collateral. And I agree
    with Dr. Wachter that the loans in such covered bonds should be
    conservatively underwritten loans.
        And then finally, as I said, we need to rediscover savings
    and an emphasis on saving to enter into the housing market and
    paying down the mortgage as a source of long-term savings, so
    that in the very old fashioned but correct idea you actually
    end up owning the house as you get older.
        Senator Corker. What would the government subsidy that you
    are talking about that would be transparent, that subsidy would
    be directed at what?
        Mr. Pollock. Well, Mr. Chairman, of course, it would be
    directed at whatever the Congress decided it would be directed
    at, but typically----
        Senator Corker. But you are developing this----
        Mr. Pollock. ----but typically low-income households who
    are trying to enter into home ownership but still have a very
    good chance of performing successfully on the debt which they
    undertake. Certainly, this system has to have, or should have
    as part of what we do in the future, very clear, simple, and
    transparent information provided to borrowers about the credit
    commitments they are making so they really understand the
    commitments they are signing up for and they can underwrite
    themselves, as I like to say. It is much more important to
    underwrite yourself as a borrower, can I do this, than for
    somebody else to underwrite you.
        And you, of course, never do anybody a favor by making them
    a loan they cannot afford, whether you are the government or
    whether you are a private factor, and we want to avoid that.
        Senator Corker. Generally speaking, do other countries--are
    there a lot of other countries around the world that have
    subsidies for----
        Mr. Pollock. Yes.
        Senator Corker. ----for lower-income citizens?
        Mr. Pollock. Yes, in advanced countries.
        Senator Corker. And they are interest rate subsidies, is
    that what you are talking about?
        Mr. Pollock. I think they are typically--actually, Michael
    would know this better than I, but I think they are typically
    credit availability programs or--and there are often rental
    subsidies, as well. A lot of countries use these subsidies,
    including Canada, as a rental program, government program for
    low-income housing.
        Senator Corker. And for the middle- and upper-income
    citizens, would there still be--would you, if you could design
    it, still focus on long-term fixed-rate mortgages, or would you
    just let the market determine that----
        Mr. Pollock. I would definitely have long-term fixed-rate
    mortgages in a system, because I think they would naturally
    evolve. But I think Dr. Lea is right. They would be a smaller
    part. They would probably be somewhat higher priced. And houses
    would be less expensive because you know that the most
    fundamental proposition in all economics is that not only
    lunches, but nothing is free, and all of the subsidies we put
    into housing finance merely go to make houses more expensive.
    So the home buyers do not win in the end.
        Senator Corker. Dr. Wachter.
        Ms. Wachter. I agree with much of what Dr. Pollock has
    said. I do want to take a small exception to the last comment.
    While it is true that housing subsidies do raise prices some
    places in the United States, not all throughout the U.S.
    Housing is elastically supplied in much of the U.S., and in
    that case, it does not have that impact.
        But I specifically do agree with the need for subsidies and
    the need for them to be explicit. I also, as you know from my
    comments, I do think it is extremely important, particularly at
    this time, for there to be the necessary institutions to
    support the long-term fixed-rate mortgage. We are at a point of
    historically low interest rates. If interest rates were to
    rise, let us say, 20 percent, 30 percent, in a world with an
    adjusted-rate mortgage, that would be equivalent to a 20, 30
    percent rise in mortgage payments, which could create a crisis
    of similar dimensions of the crisis that we had if across the
    board mortgages went up that much, and perhaps in some cases
    doubled. If rates doubled, this would basically take people
    from, let us say, 30 percent of their income to 60 percent of
    the income. It is for this reason that countries that have
    reliance on adjusted-rate mortgage are attempting to create
    fixed-rate mortgage and move away from adjusted-rate mortgages.
        Also, there is a problem that the U.K. has spoken of, and
    it is in the Miles report, of some hesitancy to use monetary
    policy when necessary because of the fear of rising interest
    rates and what it would do to destabilize not only individual
    homeowners, but indeed the entire economy.
        So we are fortunate in having a fixed-rate mortgage. What
    we are not fortunate, obviously, what cratered our system was
    the deregulated private-label securitization that undermined
    lending standards. That happened nowhere else. In fact, Canada
    was considering a subprime mortgage market. They came to me,
    among others, to write a report to advise on that. This was in
    2004. Many people submitted a report--I did--and advised
    against their moving to allowing a subprime mortgage market.
        Canada, as we have heard, does have great involvement in
    the mortgage market. Specifically, it has also recourse
    mortgages. Recourse mortgages really could not work in the
    United States. Because of our bankruptcy law, that is not
    really an option for us.
        And so we have for every reason, then, to be even more
    determined and careful in our regulation of our mortgage system
    so that we do not have crises which end up being taxpayer
    funded.
        So let me go back to your question of what, then, would we
    take from other systems. Systems of both Denmark and Germany
    have much in them for us to model, particularly, as Dr. Pollack
    has said, they have in their securitized--and they use covered
    bonds, but, in fact, covered bonds when regulated well are not
    so dissimilar from mortgage-backed securitization that is
    regulated well. These securities that go into the covered bonds
    are, indeed, transparent. They are standardized. They are--
    information on them is maintained over time.
        This is significantly monitored, and it is key if we are to
    have securitization that we monitor, from my perspective, what
    goes into the securitized entities for housing finance, because
    capital markets will always be subject to shocks. There is no
    way of stopping that. The shocks will then be transferred
    through the securitization to the housing market. If at the
    same time in a procyclical way the securitization standards are
    undermined, then we will, of course, have what we have today
    and it will be recurrent.
        So to avoid both of these problems, I absolutely am in
    favor of a fixed-rate mortgage. By the way, if you just have
    adjusted-rate mortgages, you are basically reliant on your
    banking system and banking systems across the world have
    cratered, as we are well aware. Japan has had, through a kind
    of savings and loan crisis which got even larger, a basic real
    estate crisis beyond that, two decades of slow to no growth.
        So a banking system mortgage-based finance does not prevent
    crises, either. In both cases, transparency, risk monitoring by
    the private sector as well as the public sector, is necessary.
        Senator Corker. So Mr. Pollock mentioned, I think, that the
    only involvement government had in his model would be on the
    subsidizing lower-income portion. As it relates to fixed-rate
    mortgages from your viewpoint, would that also--would you have
    government involvement, and middle- and upper-income loans
    also?
        Ms. Wachter. Absolutely, as there is in Canada. There would
    be, as in Canada, a provision of catastrophic mortgage
    insurance that would be priced. It would be explicitly priced.
        Senator Corker. And how does the insurance work in Canada?
        Ms. Wachter. I think perhaps Dr. Lea might be able to give
    us more details on how it works, but my understanding is that
    both the private insurers, of which there are two, do have a
    backstop of catastrophic insurance if there is a crisis, as
    well, of course, as the mortgages that are insured through
    CMHC.
        Senator Corker. And they are insuring the mortgage, but not
    the entity that actually----
        Ms. Wachter. And that is exactly where I would go. I would
    go to issuers of mortgages that are securitized that have a
    wrap on the mortgage-backed securities, but the first loss
    would be the private equity which would be at the risk and the
    companies themselves would be absolutely at risk.
        It would seem to me you could also have, although you are
    never going to get away from the risk of catastrophic
    insurance, you would also potentially have companies which are
    issuing mortgages, securitized, without a wrap. But that would
    require, from my perspective, that the mortgages in these
    securities be well understood, well vetted, tracked real time
    for their potential risk.
        Senator Corker. Why do you not go ahead and jump in, Dr.
    Lea.
        Mr. Lea. OK. Several comments and responses. In my view, an
    ideal housing finance system should have diversity in both
    instruments and in funding sources. I think a model that has
    almost all of its loans being fixed rate has problems and
    issues because of the risks associated with that to investors.
    I would also point out, in a rising interest rate environment,
    affordability problems are going to be exacerbated by the
    inflation premium that is built into long-term fixed-rate
    mortgages.
        Likewise, as Dr. Wachter says, I do not think it is wise to
    have an entirely adjustable rate system where you have
    potentially significant payment shock for a wide part of the
    population. Rather, I would like to see some of both, where
    borrowers and lenders self-select with regard to the interest
    rate risk carrying capacities of the different borrowers.
        For example, in Canada, they have this rollover mortgage.
    While the typical fixed-rate term is 5 years, so this would be
    a 30-year amortization mortgage but typically fixed for 5
    years, the borrower can select between a 1-year, a 3-year, a 5-
    year, or in some cases even a 10-year fixed rate period. So
    that does allow the borrower to manage interest rate risk to a
    degree, because if they think rates are high and going to fall,
    then they can go into a shorter-term fixed rate. If they think
    rates are low and going to rise, they would pick a longer-term
    fixed rate.
        I would also point out in the adjustable rate world, such
    as in the U.K., talking to the Council of Mortgage Lenders, for
    example, they credit the adjustable-rate mortgage for actually
    reducing defaults during the crisis because interest rates and
    payments have come down quite a bit. This is also the case of
    Australia. Though I fully agree with Dr. Wachter that we are
    now at historic lows and we are going to see significant
    increases going forward.
        A couple other comments. With regard to subsidy, I just do
    not think it is generally a good idea to subsidize interest
    rates or to push the market toward particular products. I think
    from the subsidy kind of standpoint, what we should do is focus
    on affordability. I would note that both Australia and Canada
    have first-time homebuyer tax credit programs. They do not have
    the mortgage interest tax deduction. The mortgage interest tax
    deduction does very little to stimulate home ownership. In
    fact, most of its effect is as a regressive subsidy to higher-
    income people as well as being capitalized in the house prices.
        And so if we are talking about an ideal world, I would
    gradually phaseout home mortgage interest deduction, but I
    would put in its place some form of first-time homebuyer tax
    credit which is targeted toward first-time buyers. It could
    also be targeted toward lower-income.
        I also point out that other countries do subsidize rental
    housing more extensively than we do. In most countries that I
    looked at, the types of voucher programs that assist lower-
    income renters are entitlements. You qualify, you get it, as
    opposed to the U.S. where they are still effectively rationed
    and there is excess demand for those kinds of subsidies.
        I agree with Dr. Wachter on the efficacy of the mortgage
    insurance. I think that using mortgage insurance initially
    through private mortgage insurers and having the government
    insurance backstop is a good idea. In Canada, the government
    provides a 90 percent backstop, catastrophic backstop, to
    private insurers. That was done primarily to try to level the
    playing field between the government insurer and the private
    insurers.
        I would disagree with one thing with Dr. Wachter, though I
    have not looked at this from a legal standpoint, but the
    contention that recourse is impossible in the U.S. Recourse is
    practiced in a number of States in the U.S. Some lenders are
    more aggressively going after deficiency judgments. And it is
    an important, I think, incentive mechanism for avoiding things
    like strategic default. And every other developed country has
    recourse mortgages and lenders do routinely go after deficiency
    judgments, and I think that also curbs over-indebtedness and
    speculative behavior on the part of borrowers. And so I would
    submit that in the future, we should not rule that out. I think
    that that is an important part of any legal system underlying
    the mortgage market.
        Senator Corker. What is it about the--and just 1 second,
    Mr. Pollock, but what is it about the bankruptcy laws that make
    the recourse issue not practical? I thought it was more the
    State Constitutions----
        Ms. Wachter. State Constitutions are actually the big----
        Senator Corker. So it is really not the bankruptcy laws?
        Ms. Wachter. Well, the biggest--yes, the bankruptcy adds to
    it in the sense that if the borrower has an option to go into
    bankruptcy, then repaying through income, for example, may not
    be viable. In Denmark, actually, wages are garnished, and I do
    not think that that would be viable if the borrower was in
    bankruptcy, at least in that period.
        Senator Corker. Mr. Pollock, you wanted to say something?
        Mr. Pollock. Thank you, Mr. Chairman. I just wanted to add
    three quick things. I hope it was clear in my comments, but in
    my ideal mortgage system for the U.S. going forward, there
    would be no GSEs.
        Senator Corker. I kind of gathered that.
        Mr. Pollock. I just wanted to make that explicit.
        Senator Corker. Yes.
        Mr. Pollock. You would either be private or you would be
    the government, but you could never be both at the same time. I
    think that is an important principle.
        A second comment is that there is also a risk for the
    borrower with fixed-rate mortgages, and that is you have a
    fixed-rate mortgage at some rate and rates go way down because
    we are having a recession, unemployment is high, and you cannot
    refinance for credit reasons, which is the situation of many
    people now. And the fixed-rate mortgage, in fact, puts you in a
    terrible place in that situation. So we need--there is nothing
    you can do that takes away all risks from everybody, and there
    are risks in that, as well.
        Finally, just on the fact of how Canada works, one of the
    things I would not copy is the Canadian mortgage insurance. The
    overwhelming amount of Canadian mortgage insurance, and there
    is about 470 billion Canadian dollars of mortgages insured out
    of a total market of about 950 billion Canadian dollars or so,
    so that is half of the market, is provided directly by the
    Canada Mortgage and Housing Association, which is the
    government and it, in effect, guarantees 100 percent of the
    mortgage. There is no private capital there. There is just the
    taxpayer guaranteeing it. In my judgment, that is a bad idea. I
    would not do it.
        There are Canadian critics who think that that pushing of
    credit, of mortgage credit, is contributing to the rise, which
    is quite dramatic if you have a chance to look at the graph in
    my testimony, in my written testimony, and they think that they
    may have a bubble. They say--some people in Canada say they
    have a bubble and attribute this very heavy intervention as
    part of the cause. That is obviously debatable. But it is clear
    that in the Canadian system, for about half of the market,
    there is a direct taxpayer guarantee with no private equity in
    there, and the banks who then hold these insured mortgages get
    extremely low capital requirements for the mortgage. So the
    capital is not in the bank, either, when they are holding the
    mortgages. And, as I say, that is a part of what our Northern
    neighbors do that I would definitely not copy.
        Senator Corker. Dr. Lea, what is required in Canada to
    receive that insurance, meaning what type of oversight and
    standardization has to exist for those originating these loans
    to be able to secure this government insurance guarantee?
        Mr. Lea. Well, first, if you are a bank or regulated
    lender, you have to have insurance if the loan is over 80
    percent loan-to-value ratio. So that then brings a mortgage
    insurer, either government or private, into the picture and
    they will set the standards for what they will insure.
        Senator Corker. And in a collapse, I mean, one like we have
    had here in our country, very quickly, those entities would be
    out of business, is that correct? I mean, in a crisis like we
    have had. That is an interesting thing for episodic-type, just
    episodes of people failing, but when you have a systemic crisis
    like we have had, basically, those are wiped out pretty
    quickly, right?
        Mr. Lea. Well, not necessarily. I would point to the fact
    that our private mortgage insurers still exist and they have
    basically survived. We have had one that has ceased writing new
    business, but they are still in business and several have
    raised new capital.
        They, I think, benefited from the fact that a lot of the
    riskier mortgages, A, they did not insure them, did not meet
    their standards, and B, a lot of lenders tried to circumvent
    the insurance by creating the so-called ``piggyback loans,''
    80/20 type of loans so that they could avoid charging borrowers
    mortgage insurance, and that also was where a lot of the
    riskier loans went.
        And the third thing I would say is that if you had the
    universal, everything over 80 percent, then you are spreading
    your risk out, and one of the principles of insurance is to try
    to get more and more diversification. And absent a true
    systemic collapse--now, certainly you can come up with
    scenarios in which the insurance capital will not be
    sufficient, but insurance capital is different than banking
    capital in the sense that it is much more risk-based and you
    cannot pay out dividends as long as your risk ratios are at
    particular levels. So I think that, actually, from a capital
    adequacy standpoint, insurance models may be somewhat better
    than bank capital models.
        Senator Corker. So then back to this sort of standard
    issues, other than the mortgage insurance, what is it that
    happens in Canada to be able to get, if you will, that
    government insurance? What kind of standardization? What kind
    of oversight?
        Mr. Lea. Well, again, the mortgage insurers are regulated--
    --
        Senator Corker. So it is really the mortgage insurer that
    is making that determination.
        Mr. Lea. Absolutely.
        Senator Corker. OK.
        Mr. Lea. Absolutely. The bank----
        Mr. Pollock. But Michael, you would have to say the
    overwhelmingly dominant mortgage insurer is the government of
    Canada----
        Mr. Lea. Correct----
        Mr. Pollock. ----through CMHC.
        Ms. Wachter. And two other companies----
        Mr. Pollock. Yes, but they have----
        Ms. Wachter. ----smaller, I agree----
        Mr. Pollock. ----they have a very minor share of the
    market. We are really talking about a government program.
        Mr. Lea. So the government set the standards and----
        Senator Corker. And are those standards stringently
    enforced and----
        Mr. Lea. As far as I know, yes.
        Ms. Wachter. Absolutely.
        Mr. Lea. They started to relax them a little bit during the
    mid-2000s, kind of a boom period, and as they saw the markets
    starting to weaken, they lowered the maximum LTV. They also
    lowered the maximum term. They had been insuring out to 40
    years. They moved that back to a maximum of 35. So they
    definitely tightened as they saw the downturn coming.
        Senator Corker. Dr. Wachter and Mr. Pollock, do you all
    agree that the interest rate deduction does not stimulate, as
    Dr. Lea has said, does not stimulate home ownership?
        Ms. Wachter. I agree. I would like to go back to the--but
    today, if you did withdraw the interest rate deduction, it
    would be a problem in the state of today's market.
        Senator Corker. Well, other than the rebellion that would
    take place, you are saying--but expand. Tell me, in your
    opinion, why it does not aid in home ownership or the
    desirability of home ownership.
        Ms. Wachter. The way we--at this stage, the way it is
    structured, because many people take the standard deduction,
    lower-income, middle-income households take a standard
    deduction, we only have----
        Senator Corker. So they never bump up against the actual--
    --
        Ms. Wachter. They never bump--almost 49 percent do not pay
    taxes at all, so that you can see that the deduction is more
    important for higher-income households----
        Senator Corker. Mr. Pollock----
        Ms. Wachter. ----who would own, also, and----
        Senator Corker. And on that same note?
        Mr. Pollock. Everything we do in housing finance, Mr.
    Chairman, you have to think about the interaction of finance
    and prices of the houses. Certainly, in an upper part of the
    market, upper half or so, the prices reflect the deduction, and
    I suspect if you took it away, you would not like the price
    reaction, and in a situation when a lot of people are
    underwater on their mortgages already, that gives you a real
    transition problem to work on if you wanted to get to a state
    of no interest deduction. We all know about politically how
    hard that is, but there is also a price problem especially now.
        Senator Corker. So, I mean, but from a standpoint of making
    that transition, is that something that if one were to make
    that transition over a decade, would that be so distortive that
    it would hurt prices immediately?
        Ms. Wachter. Yes. This is not the decade to do it. Housing
    markets are too fragile. Perhaps 5 years from now, we could
    reconsider, or 2 or 3 years. But at this moment in time,
    housing markets are sufficiently fragile, they may start
    declining again and setting up a spiral of declining prices,
    increasing foreclosures, decreasing prices. We are not out of
    those woods yet.
        Mr. Lea. I would point out that the U.K. did, over a decade
    time period, get rid of the mortgage interest deduction. They
    started as the market was coming out of the early 1990s
    downturn, which was a very severe downturn in the U.K. So I
    agree fully with Dr. Wachter that this is not the time to do
    it, but if we think 2, 3 years out of something like a decade-
    long policy, what they did in the U.K. was starting to lower
    the cap. We have a million-dollar loan cap now on deducting
    interest. You start lowering that. You also can lower the
    maximum marginal tax rate that you can take the deduction
    against, so you shrink the absolute size of the deduction then
    eventually have it go away. But it would have to be in a
    recovered market before you would want to start eliminating
    that.
        Senator Corker. How do the three of you feel about
    prepayment penalties?
        Mr. Lea. How do what?
        Senator Corker. How do the three of you feel about
    prepayment penalties? In other words, in a normal, functioning
    commercial market, if you have a 10- or 15- or 20-year fixed-
    rate mortgage and you want to pay it off, you pay a penalty.
    That accounts for the losses that the investor would have
    because of the rate adjustment that would take place on the new
    mortgage they might have to replace it with. How would the
    prepayment penalty, should it come back, how would that affect
    the housing market and people's mentalities as it relates to
    longer-term mortgages?
        Mr. Lea. Well, the countries where you have prepayment
    penalties, you would not have it for a full 20-, 30-year term.
    So typically, in countries like Canada and the Netherlands, it
    is predominately with a 5-year or shorter fixed-rate period.
    And so at the end of that period, then the loan rate is
    renegotiated and you are free to pay it off in entirety at that
    time. In Germany, you can go up to 10 years with a prepayment
    penalty, but the law caps it at that, even if the actual
    interest rate may be fixed for a longer time period. So it is
    not for 20- to 30-year type times.
        The second thing, I think that the market is a place for
    both loans with and without prepayment penalties, and I think
    borrowers can self-select based on the pricing of the loans,
    because remember, if we do not have a prepayment penalty, as we
    have in the U.S., there is a fee that all borrowers pay. It is
    incorporated into the mortgage rate. There is an option premium
    for the option the borrower has to have early repayment that
    has mortgage rates to be higher than if you did not have that
    option. So everybody is, in effect, paying it, whereas the
    European view is that you benefit, you pay. So it is not a
    socialized type of model.
        I think there is a market for both and that allows
    borrowers to self-select based on the initial rate in the
    mortgage, what their expectations are, both for interest rates
    and moving. And again, I think more choice is better. We should
    not have a market that is all one or all of another.
        Ms. Wachter. I agree. I think there should be a choice in
    the prepayment penalty or not, and absolutely agree with Dr.
    Lea that it is priced in. If there is no prepayment penalty,
    then that is going to affect the payment.
        I do also want to underline, however, that there is an
    advantage for the overall economic and systemic stability to
    having a preponderance of no prepayment penalty, and that goes
    just to the point of Dr. Pollock. Today, if we had a
    significant prepayment penalty, that would create an even more
    severe problem for those who wish to refinance out of fixed-
    rate mortgages into lower interest rate fixed-rate mortgages
    today, helping out the overall economy. That is, there is an
    automatic stabilizer in the ability to refinance when the
    economy declines and interest rates decline if there is an
    ability to refinance. Nonetheless, it should be priced. It is
    priced and there should be both options.
        Mr. Pollock. There is an economist at the World Bank who
    has pointed out that in America, we have very high transaction
    fees for refinances which function in a way like a prepayment
    penalty. And another of the things we should think about in a
    future housing finance system is instruments that reduce those
    very high transaction costs as we churn fixed-rate mortgages.
    That is a very high cost to consumers.
        I agree, in a private system, which I would favor, you
    would evolve mortgages with prepayment fees and mortgages
    without. The ones with prepayment fees would have lower
    interest, just like you have mortgages with up-front points you
    pay and mortgages that are no-point mortgages. If you pay
    points, you get a lower rate. It would work the same way and
    the market would work out the balance. We have to make sure
    only that the parties to the transaction understand what the
    deal really is and then the market will sort out the
    preferences of the various borrowers and lenders.
        Senator Corker. What has been your experience over the last
    20 or 30 years looking at markets where most borrowers have a
    floating rate as opposed to a fixed rate? Over the course of
    time, has the amount of interest that they have paid, how does
    that compare to a fixed-rate market like the U.S.?
        Ms. Wachter. Well, the dramatic issue is that over the 20
    years, interest rates have fallen across the world. They have
    fallen dramatically, seeing they were on average, in the study
    that we have done of 15 countries over 1980 through 2000, they
    fell from about 15 percent to 6, 7 percent. So in this scenario
    of declining interest rates, an adjustable-rate mortgage is
    perfectly safe. There have been very few countries that have
    had adjustable-rate mortgages a large share of their system
    that have faced a situation with rising interest rates. There
    is one exception to that that I know of, and that is the U.K.
    in the early 1990s.
        Many, actually, developed housing markets have only, as Dr.
    Lea has extensively written about, have only developed since
    1980. So we do not really have a huge experience of a well
    developed mortgage system, by that I mean a system where many--
    where the preponderance of people do have mortgages and have
    adjustable-rate mortgages in a world where there is a sharp
    rise in interest rates. We simply have not seen that. As I
    said, there was this exception in the 1990s in the U.K. The
    U.K. did have a very well developed mortgage market and
    entirely adjustable-rate mortgages and their banking system was
    imperiled, as was the mortgage insurance system, at that point
    in time as interest rates rose coming out of 1990.
        Senator Corker. Any other comments here?
        Mr. Pollock. I would comment on that, Mr. Chairman. There
    was a time in the 1990s when I was refinancing my loan once a
    year and it was much cheaper--U.S. specifically--how much
    interest you pay on an adjustable rate versus a fixed rate.
    That was much cheaper in that setting. And Chairman Greenspan
    at the time got himself in trouble once for talking about how
    much cheaper it would be for people to finance on adjustable
    rates. But there are times when it is cheaper. In a market
    where you have choices, it allows consumer borrowers to make a
    risk-reward choice. As in other normal financial markets, you
    have got purveyors of funds and takers of funds and they are
    negotiating where they think the risks and rewards are.
        For a long time, starting off, let us say, around 1950
    until 1980, interest rates were rising. People who had
    mortgages they took in the 1950s, if they were long-term
    mortgages, or 1960s, did very well relative to floating rates.
    Of course, the result of that was the failure of the entire
    savings and loan industry and the difference got to be paid by
    the taxpayers.
        There is no way you can mechanically set up systems to
    assure that they will not fail and get you in trouble, but I
    think the more choices people can make in informed ways, the
    better overall it will function, including the question of
    trying to manage their total interest rate bill.
        Ms. Wachter. If I could just quickly follow up, the fact
    that we did have, of course, this major crisis, we were not the
    only country, and many countries had similar crises, which has
    led to the fact that banks do not make fixed-rate mortgages and
    hold them in their portfolio going forward.
        Senator Corker. In my previous life, I borrowed a lot of
    money and it was just part of what we did in business. I can
    tell you, there was no question a built-in mentality that if
    you had a floating-rate loan, especially one that was recourse,
    you know, most fixed-rate mortgages in the commercial sector
    are nonrecourse, but usually floating-rate loans are not. They
    are recourse. And so the mentality of having a recourse loan
    and also knowing that that rate could change caused you to pay
    that loan off as quickly as possible, and every cent, every
    dollar you had that was extra was used to pay down that
    mortgage. And so it is easy to see, certainly with the mortgage
    deduction component that goes with it, that--I mean, we
    basically incent people not to do that.
        As you look at these other countries that have variable-
    rate mortgages mostly, that have not gotten into the kind of
    troubles we have, you know that part of the mentality in that
    household is that if there is an extra dollar or two that
    month, they are going to use it to pay the mortgage down
    because it, in effect, is savings, right? I mean, that is the
    same as savings and it is also deferring costs that are going
    to occur down the road due to interest payments.
        Ms. Wachter. I am certainly not disagreeing that in the
    commercial sector, in your experience of the commercial sector,
    but it is absolutely not the case that adjustable-rate
    mortgages have stopped borrowers from not taking on new debt.
    Of course, in the United States, the entire subprime market was
    an adjustable-rate market. So the increasing debt over time in
    this period from the late 1990s to 2006, at its height, was
    refinancing in the adjustable-rate product.
        Senator Corker. Yes?
        Mr. Lea. In both Australia and the U.K., you did have very
    high LTV lending, where people took on a lot of debt even with
    the adjustable-rate mortgages. The one thing, though, that
    exists is people, as you suggest, do tend to pay down their
    debt more rapidly. I think that is in part due to the fact that
    interest, again, is not tax deductible, so it pays to
    essentially pay off that higher rate mortgage, for one thing.
        The second thing is that, historically, both Australia and
    the U.K. have kind of an administered rate system, so unlike
    the U.S. adjustables, which are indexed to something like LIBOR
    or a money market rate or 1-year Treasury rate, you have what
    is called a discretionary ARM where the rate is set by the
    lender for all borrowers at the same time. Now, the positive of
    that is that lenders do tend to lag the interest rate changes,
    both on the up and the down cycle, which means that if rates do
    start sharply rising, it is not a guarantee that lenders are
    going to follow that up in lock step with whatever short-term
    index is going, but rather they have the discretion of
    spreading that out and lagging that, and statistically, that
    has been the case over the last couple of decades.
        Senator Corker. Yes, sir?
        Mr. Pollock. An interesting difference between commercial
    credit markets, which you referenced, Mr. Chairman, and
    residential markets is commercial markets invariably have loan
    covenants, so with either private placement investors or banks
    or bond indentures, as a borrower, you are committing to
    maintaining certain levels of capitalization or earnings or
    inventory coverage or what not, whereas we do not have such
    things in residential loans.
        I was in a discussion recently, and I think it is an idea
    worth thinking about, where there might not be covenants added,
    and these might develop if we really had a private market, to
    residential mortgages, for example, prohibiting the taking on
    of second lien borrowings without the agreement of the first
    lienholder so that you get a more commercial-like contract and
    you are not allowed as a borrower to run your leverage of the
    household up to foolish levels. It is something worth thinking
    about, anyway. But it is a clear, interesting distinction
    between the two markets.
        Senator Corker. And I might add, and I certainly look
    forward to hearing from you, but I might add that especially in
    an environment where basically the servicers of these first
    mortgages are usually the ones that have the locks on the
    second mortgage, so they are looking after their interest
    naturally more so than the prime lender is.
        Dr. Wachter.
        Ms. Wachter. Yes, and this is an interesting idea, and
    other countries have other ways of getting to the same
    conclusion. For example, in Canada, you cannot refinance your
    mortgage if it is over 80 percent without the mortgage
    insurance agreement to that.
        Senator Corker. So it sounds like, looking at the body
    language, all three of you would support loan covenants as a
    part of whatever we might propose. It is certainly on any kind
    of Government support system, is that correct?
        [Panel nodding heads.]
        Senator Corker. Is there anything demographically about our
    country that is different than others as it relates to how our
    whole loan system has evolved and why it is so different than
    most other countries?
        Mr. Pollock. Well, one reason we could say that Canada is
    an interesting comparison is that demographically we are both
    nations of immigrants and frontiers and pioneers and
    settlement, which gave us a land holding population. We still
    have heavy immigration, which we keep assimilating and trying
    to assimilate into home ownership, which is an interesting
    issue to think of. We would think about it generationally as
    cohorts of the family or of the generations of the family
    establish themselves in American society and move to home
    ownership that they could not afford in the beginning.
        Ms. Wachter. There are countries with serious problems of
    renters versus owners, where renters are have-nots in the sense
    that they cannot become renters [sic]. Their families do not
    have the wealth. Their families have not been owners. And with
    development and price rises, it is possible that these sectors
    will be out of home ownership entirely, leading to real
    stresses.
        In our country, despite the fact that we have had these
    tremendous immigrants fueling our growth, we have also
    incorporated immigrants into home ownership so that they have a
    stake in our country. And as housing prices have risen, their
    wealth has risen with it, so that instead of being kept out of
    the potential of home ownership generation to generation, they
    have been able to buy into America's growth. I think this is
    extraordinarily important going forward.
        Senator Corker. Any comments?
        Mr. Lea. You know, I do not really know that there is a
    major demographic argument for a lot of the characteristics of
    our system. As Dr. Wachter said, we have historically had a
    bias or penchant for home ownership for good reasons. But if
    you look at the legislation and language of a lot of other
    countries, they will also say that home ownership is really
    good, but they do not necessarily think it is good for
    everybody, and then the question becomes do you have the kind
    of support systems for lower-income people, for rental or
    people that are doing that in order to save and in order to
    own.
        So I think that our system is actually--its characteristics
    are more defined by the very longstanding role that governments
    had, going all the way back to the 1930s, creation of FHA and
    Fannie Mae, prohibition of adjustable-rate mortgages until the
    early 1980s. That explains a lot more about why our system
    looks the way it does than any demographic feature.
        Senator Corker. And all three of you, I think, would
    support some type of legislation to deal with covered bonds but
    do not see it as a panacea to our housing, is that correct? All
    three of you think that----
        Mr. Pollock. Yes.
        Ms. Wachter. Yes.
        Mr. Lea. Yes for me.
        Ms. Wachter. Yes for me, but I do actually think it is, in
    fact, going the other direction. Covered bonds are not only not
    a panacea, but they can be a source of systemic risk, as we see
    in Spain.
        Senator Corker. So they can add risk to the system if you
    do not properly balance----
        Ms. Wachter. Absolutely.
        Senator Corker. ----off what the FDIC's rights are
    against----
        Ms. Wachter. Exactly.
        Senator Corker. Yes. In closing, we have been here almost
    an hour and a half now, and are there any closing thoughts? I
    know you all had opening comments. I have asked a few
    questions. Are there any other comments or thoughts you would
    like to share with us before we adjourn?
        Mr. Pollock. If I could, I would just repeat, Mr. Chairman,
    that looking at this in an international context where you see
    a lot of different evolved systems around the world is really a
    fruitful thing to do because we need to think anew about the
    way American housing finance, which is a huge market, hugely
    important economically and socially, but it needs to work quite
    a bit differently, in my judgment, than it has in the last
    generation, and, in fact, in the generation before that. So it
    is definitely time for these bigger, more open-ended thinking
    about what we might do.
        Ms. Wachter. I think it is also useful to look at the
    successes, but also to look at the failures, and the European
    regulators are looking at their failures at the same time. So
    cross-country examination and looking together at what works.
    We are not a nation alone. Our crisis helped bring down other
    markets. Other markets also affect us. I absolutely think it is
    important to have an international perspective and I do thank
    you for the opportunity to speak to it today.
        Senator Corker. Thank you.
        Mr. Lea. And I would just add that there is no perfect
    system. We cannot say that one that is totally adjustable rate,
    bank deposit funded, or one that is totally fixed rate,
    security funded, is ideal. In act, both have their strengths
    and weaknesses, and I think what we can draw from the
    international experience is there is a diverse set of ways,
    both instrument and institution, that you can provide
    sufficient credit for housing and for home ownership, and I
    think we should look at, again, having a diverse menu of
    products, funding types with essentially the interplay of
    investors and borrowers determining what that mix looks like.
        Senator Corker. You know, we have just gone through,
    obviously, a huge financial regulation bill and some tangible
    decisions were made and then some, in many cases appropriately
    so, regulators are making decisions. In the area of housing
    finance, because of the involvement we have had, which has
    been, let us face it, 90 percent of the market today, we are
    going to have to make some tangible, hard decisions as it
    relates to housing finance going ahead. As a matter of fact, I
    think it is going to be in many ways a far more difficult issue
    for us to come to terms with and solve because it affects so
    many people. And again, our involvement in it today is it is
    such a huge level--I am talking about our Government
    involvement.
        So I thank you for coming today. I know that there will be
    people here, staffers and others that represent folks that will
    want to ask additional questions, and so we will leave the
    record open, I am sure, for a couple of days and we look
    forward to calling on you.
        I know in our own office, we are trying to develop a sort
    of a thesis, if you will, about the direction that we think
    this ought to go. I know the New York Fed informally has come
    up with some ideas. I know others are doing the same. We thank
    you very much for traveling as far as many of you did today,
    for all of you being here, and look forward to your continued
    input. Thank you very much.
        Ms. Wachter. Thank you.
        Mr. Pollock. Thank you.
        Mr. Lea. Thank you.
        Senator Corker. The hearing is adjourned.
        [Whereupon, at 3:58 p.m., the hearing was adjourned.]
        [Prepared statements supplied for the record follow:]

                      PREPARED STATEMENT OF MICHAEL J. LEA
     Director, The Corky McMillin Center for Real Estate, San Diego State
                                   University
                               September 29, 2010

        Mr. Chairman, Ranking Member Corker, and Members of the
    Subcommittee thank you for the opportunity to be here today. I am
    Michael Lea, Director of The Corky McMillin Center for Real Estate and
    Professor of Finance at San Diego State University. I have an extensive
    background in housing finance including senior executive positions at
    major mortgage lenders and as Chief Economist of Freddie Mac. I have
    been actively involved in the study of international housing finance
    systems for more than 20 years having done consulting and business
    development work in 30 countries and serving as Director of Research
    for the International Union of Housing Finance. I recently completed a
    comparative study of developed country mortgage markets that will be
    published by the Brookings Institution later this fall as well as a
    comparative study of mortgage instrument design released by the
    Research Institute for Housing America. I would request that both
    studies be entered in the record as they provide data support for the
    points I will make today. (See, Attachments 1 and 2 following this
    statement.)
        In addressing the Subcommittee today you have asked me to compare
    the structure and performance of major developed housing finance
    systems with a focus on Australia, Canada, Denmark, Germany, and the
    United Kingdom. The three major issues you have asked me to emphasize
    are home ownership and affordability, the role of the Government in
    mortgage finance, and the dominant mortgage instrument, funding
    mechanism, and underwriting standards. I will address each in turn.

    Home Ownership and Affordability
        The United State has a relatively high home ownership rate of 67
    percent. This rate puts the U.S. in the middle of a group of 11
    countries. Australia, Canada, Ireland, Spain, and the U.K. have higher
    rates while Denmark, Germany, Japan, the Netherlands, and Switzerland
    have lower rates. Countries in Northern and Western Europe have lower
    rates of home ownership in part because of significant social rental
    programs. Such programs are less significant in Southern Europe with
    corresponding higher home ownership rates.
        Although many countries extol the virtues of home ownership there
    is far less intervention to support affordable owner-occupied mortgage
    lending in other developed countries. No other developed country has
    ``housing goals'' or Community Reinvestment Act legislation. Only
    Canada and the Netherlands have government-owned mortgage insurance
    agencies and in neither case is the insurance targeted to affordable
    housing.
        Many European countries provide greater rental housing assistance
    than the U.S. Subsidized social rental housing is a significant sector
    of the market in Western and Northern Europe and the U.K. The housing
    is owned by municipal governments or nonprofit groups. Subsidies take
    the form of rent assistance and financing assistance (e.g., municipal
    guarantees, State loans). Generally the assistance is available to all
    households who qualify (income targeting) and in some countries
    (Denmark, Netherlands) it is available to homeowners as well as
    renters. Australia and Canada have more limited assistance programs.
    They provide targeted rental assistance but do not support social
    housing to a significant extent.
        The recession has had limited impact on home ownership in other
    countries but a more significant effect on house prices. High house
    prices in some countries limited home ownership opportunity prior to
    the crisis. No other country has experienced the magnitude of mortgage
    defaults and foreclosures that force households out of home ownership.
    However, underwriting criteria have tightened worldwide which will
    ultimately have a negative influence on home ownership, particularly
    for first time homebuyers and self-employed borrowers.
        House prices declined in all countries except Australia in 2008 and
    remained depressed in most countries in 2009. House prices increased
    significantly in Australia and Canada in late 2009 and 2010 and have
    risen in several other countries including the U.K. Only Ireland has
    experienced an extent of decline comparable to the U.S.

    Extent of Government Involvement in Mortgage Finance
        The U.S. is internationally unusual in the extent of government
    involvement to support owner-occupied mortgage finance. No other
    developed country has a government-sponsored enterprise similar to
    Fannie Mae and Freddie Mac. Only Canada and Japan have government
    mortgage security guarantee programs equivalent to Ginnie Mae. Only
    Canada and the Netherlands have government-owned mortgage insurance
    companies. Australia sold its government mortgage insurer to the
    private sector in 1997.
        For countries with government mortgage market support the market
    share of government-supported entities is far less than the current
    U.S. situation in which over 90 percent of mortgage credit is coming
    from Government-backed institutions. In Canada approximately 50 percent
    of mortgages have government-backed mortgage insurance which is
    required for all loans over 80 percent loan-to-value (LTV).
    Approximately 25 percent of mortgages have been securitized with
    guarantees from the Canada Housing and Mortgage Corporation. A similar
    proportion of mortgages have been securitized in Japan with guarantees
    from the Japan Housing Finance Agency. Governments do not support
    mortgage securitization in other countries.
        A minority of countries allow a tax deduction of homeowner mortgage
    interest. Only the Netherlands and Switzerland have unlimited
    deductibility. Denmark, Ireland and Spain limit the deduction and
    interest is not tax deductible in the other countries including
    Australia, Canada, Germany, and the U.K. Households in these countries
    tend to pay down debt faster reducing mortgage risk. Tax-exempt bond
    financing programs for owner-occupied housing are also unique to the
    United States. Australia, Canada, and the U.K. have small first time
    homebuyer tax credit programs.
        Mortgage regulation has been tightened in many countries as a
    result of the crisis. Canada and U.K. now require ARM qualification at
    higher than initial rates. Canada lowered the maximum LTV and term on
    bank originated mortgages. Both Australia and the U.K. have introduced
    suitability standards for mortgage lenders. Both the European
    Commission and individual country regulators are contemplating tighter
    underwriting parameters.

    Mortgage Instruments, Funding, and Underwriting
        The U.S. is internationally unusual in the market share of a long-
    term, fixed rate mortgage (FRM). Only two other countries have a
    dominance of this instrument: Denmark and France. Like the U.S. FRM,
    borrowers in Denmark can prepay their loan without penalty if mortgage
    rates fall. In France borrowers who refinance must pay a penalty and
    the typical term is shorter, 15 to 20 years. The Danish instrument adds
    a unique and valuable feature to its fixed rate mortgages. The
    Principle of Balance results in a one-to-one correspondence between a
    mortgage loan and a bond that finances it. If interest rates rise the
    borrower, through their mortgage lender, can repurchase the bond at a
    discount and cancel the mortgage. In this way the borrower can reduce
    debt and the likelihood of negative equity.
        The dominant mortgage instruments in other countries correspond to
    one of two models--either adjustable rate mortgages (ARMs) or short to
    medium term fixed rate ``rollover'' mortgages. The dominant instrument
    in Australia, Spain and the U.K. is an adjustable rate mortgage.
    Reliance on this instrument has been credited with reducing the
    incidence of default during the crisis. However it is clear that there
    is significant credit risk in the system if and when rates rise.
        The dominant instrument in Canada and many European countries is
    the rollover mortgage. With this instrument the loan rate is fixed for
    a period of 1 to 10 years (typically 1-5) with a longer amortization
    period (25-35 years). Borrowers are subject to a prepayment penalty for
    refinance during the time the rate is fixed. The rate is renegotiated
    at the end of the fixed rate period, adjusting to the market rate.
    Borrowers can manage interest rate risk by shortening or lengthening
    the fixed rate period at adjustment depending on the level and trend in
    rates.
        The dominant mortgage instrument in individual countries reflects
    historical patterns, funding sources and government involvement. The
    U.S. is internationally unusual in its dependence on securitization for
    funding. Over 60 percent of the stock of mortgages has been securitized
    mostly through the government-backed entities. Today over 90 percent of
    U.S. mortgage funding comes through securitization. The highest
    proportion of loans securitized in other countries is approximately 25
    percent in Canada, Spain, and the U.K. The dependence on securitization
    in the U.S. is driven by two factors; the predominance of the FRM and
    the involvement of the government agencies. GSE and Ginnie Mae
    securities primarily fund FRMs. Government backing lowers the relative
    price of that instrument leading to a larger market share. Lenders
    depend on securitization to fund such loans because of the high degree
    of interest rate risk they entail (as evidenced by the savings and loan
    failures in the 1980s).
        Mortgage lending in adjustable-rate countries is dominated by
    commercial banks. They prefer this instrument because it minimizes
    interest rate risk for the bank--by passing it to the borrower. In
    Australia and the U.K. the rate is set for all borrowers at the
    discretion of the bank. Lenders typically lag the market in rate
    adjustment. In times of rising rates banks cushion the interest rate
    shock with gradual rate increases.
        Banks finance mortgage lending in rollover countries primarily
    through a combination of deposits and covered bonds. Covered bonds
    finance approximately 20 percent of mortgage lending in the European
    area. Outside of Denmark the bonds are bullet instruments of varying
    maturities. Mortgages have prepayment penalties that facilitate match
    funding by covered bonds or a combination of deposits and interest rate
    swaps.

    Mortgage Performance and Underwriting
        The default and foreclosure experience of the U.S. market has been
    far worse than in other countries. Serious default rates remain less
    than 3 percent in all other countries and less than 1 percent in
    Australia and Canada. Of the countries in this survey only Ireland,
    Spain, and the U.K. have seen a significant increase in mortgage
    default during the crisis.
        There are several factors responsible for this result. First
    subprime lending was rare or nonexistent outside of the U.S. The only
    country with a significant subprime share was the U.K. (a peak of 8
    percent of mortgages in 2006). Subprime accounted for 5 percent of
    mortgages in Canada, less than 2 percent in Australia and negligible
    proportions elsewhere.
        Second while some countries including Australia, Canada and the
    U.K. relaxed documentation requirements there was far less ``risk
    layering'' or offering limited documentation loans to subprime
    borrowers with little or no down payment. There was little ``no doc''
    lending.
        Third, there has been less prevalence of negative equity in other
    countries. Although many countries allowed high LTV loans, the
    proportion of loans with little or no down payment was less than the
    U.S. and the decline in house prices in most countries was also less.
        Fourth, loans in other developed countries are with recourse and
    lenders routinely do go after borrowers for deficiency judgments.
    Research in Europe and the U.S. has found that recourse reduces the
    incidence of default. With a much smaller proportion of loans that are
    securitized lenders are more apt to work with borrowers to restructure
    loans rather than go through a lengthy and costly foreclosure process.
        Lenders have moved to tighten underwriting guidelines since the
    onset of the crisis. Down payment requirements have increased, loan-to-
    income criteria have been tightened, there are fewer interest only
    loans available and in some countries the maximum mortgage term has
    been reduced. In most cases this has been at the volition of lenders
    and not imposed by regulators. To date there have been few government
    mandated minimum underwriting standards or product restrictions such as
    those in the Dodd-Frank legislation.

    Conclusions
        There is no ideal housing finance system. Individual country
    arrangements reflect history, market structure and government policy.
    However, almost all developed country housing finance systems performed
    better during the crisis than that of the U.S. What can the U.S. learn
    from other countries?
        First in no other country is there as much government involvement
    in the mortgage market. The combined effect of the various forms of
    government intervention undoubtedly contributed to the housing boom and
    bust in the U.S. Other countries have achieved comparable or higher
    rates of home ownership and well-developed, stable mortgage markets
    with much less government support.
        Second, features of the Danish system offer the prospect of real
    improvement in the U.S. housing finance system. It retains the core
    fixed rate mortgage product but makes it more consumer and investor
    friendly by adding the option to repay the loan through the bond market
    if rates rise. This feature would have reduced some of the negative
    equity build up in the U.S. system during the crisis and the
    significant extension risk faced by mortgage security investors today.
    The Danish model could be adopted by the GSEs to facilitate its
    introduction with a transition to a nongovernment guaranteed bond
    market such as the one that exists in Denmark today.
        Third, European style covered bonds can provide an alternative to
    funding through GSE securitization. The market is deep and liquid in
    Europe and has performed much better than the structured finance
    markets. The instruments are simple, bullet bond structures backed by a
    pool of conservatively underwritten mortgage assets and the capital of
    the issuer without government guarantees. Incentives are aligned as
    credit risk remains on the balance sheet of the issuer.
        However, the fixed rate mortgages funded by covered bonds have
    prepayment penalties allowing issuers to meet strict asset-liability
    matching requirements. The recently passed Dodd-Frank financial reform
    legislation reinforces long-standing restrictions on the use of
    prepayment penalties that will hamper the development of a European
    style covered bond market
        Fourth it should be recognized that the high proportion of FRMs
    funded through securitization in the U.S. is both the outcome of
    Government involvement and a justification for its continuation. The
    risks inherent in the FRM realistically require it to be funded in the
    capital markets. Investors require government guarantees against loan
    or issuer default to invest in mortgage-backed securities with volatile
    cash flows. Thus the argument is made that we need to continue
    Government support through the GSEs and/or Ginnie Mae to keep the
    mortgage market functioning. Their guarantees lower the relative cost
    of the FRM sustaining its dominance. The result is that the Government
    backs the majority of all mortgages in the U.S.
        If Government guarantees for mortgage-backed securities were
    reduced or withdrawn over time the U.S. market would most likely
    achieve a more balanced mix of products and funding sources. Adjustable
    rate mortgages, medium term fixed rate mortgages and long term fixed
    rate mortgages all have a place in a robust mortgage market. Likewise,
    funding through deposits, bank bonds, covered bonds, and securitization
    allows lenders to tap a variety of funding sources and manage the risks
    of the various instrument designs.
        The experience of other countries shows that high rates of home
    ownership and stable well-developed mortgage markets can be achieved
    without the degree of government intervention that exists in the U.S.
    today. In that respect the U.S. clearly can learn much for
    international housing finance systems.
        Thank you for the opportunity to appear before this Subcommittee.
    Attachment 1

    Attachment 2

                     PREPARED STATEMENT OF SUSAN M. WACHTER
    Richard B. Worley Professor of Financial Management, Professor of Real
     Estate, Finance, and City and Regional Planning, The Wharton School,
                           University of Pennsylvania
                               September 29, 2010

        Chairman Bayh, Ranking Member Corker, and other distinguished
    Members of the Committee, thank you for the invitation to testify at
    today's hearing on the ``Comparison of International Housing Finance
    Systems.'' It is my honor to be here today to discuss the strengths and
    weaknesses of various models, how they differ from the United States
    system and any lessons or themes that may be learned from their
    experiences prior to, and during, the global economic crisis.
        The United States belongs to a group of countries that suffered
    particularly severe recessions driven by sharp housing price crashes.
    Other countries in this category include the United Kingdom, Spain, and
    Ireland. On the other end of the spectrum are countries where home
    prices merely leveled from 2007 to the present, resulting in no or mild
    recessions. This category encompasses Canada, Australia, and Germany.
    (Denmark lies somewhere in the middle, with a late bubble and current
    downturn.) By comparing these two groups, we can investigate what
    causes and what prevents housing bubbles and financial crises. In a
    forthcoming paper with colleagues, we conduct just such an
    investigation and find that two institutional differences separate
    these groups: the role of mortgage insurance (MI) and the strictness of
    regulations countering the market's tendency toward procyclical
    behavior.
        No country better exemplifies this procyclicality in housing and
    mortgage markets than the U.S. With economic growth and low interest
    rates coming out of the recession of 2000-2001, mortgage lenders and
    securitizers increased lending and competed for market share among
    borrowers. When the available market was satiated, they expanded the
    market by lowering their standards to include less creditworthy
    borrowers. An expanding economy thus drove lax lending standards, the
    increase in nonstandard mortgages, and the proliferation of private-
    label securitization (PLS). It also encouraged regulators and bankers
    to increase leverage (i.e., lower capital requirements) to maximize
    profits. Eventually, borrowers found themselves with too much debt to
    repay, and the downward spiral of foreclosures, defaults, home price
    declines, and decreased aggregate demand ensued. Unfortunately, banks
    had too little capital--especially in liquid form--to cushion the blow,
    forcing them to curtail lending and even file for bankruptcy. The free
    market naturally motivates firms to lower lending standards and capital
    buffers in good times, thus adding momentum to the upswing, and to
    increase lending standards and capital buffers in bad times, thus
    reducing economic activity when the system needs it the most.
        While lending standards deteriorated, the extent to which this was
    occurring was unknown due to information opacity, the underlying
    mortgages were complex and difficulty to track, the extent of fake
    equity, in which the rise in house prices was due to unsustainable
    product growth was unknown.
        In the U.S., mortgage insurance and regulation declined as the
    housing bubble grew, thus magnifying this pro-cyclical behavior.
    Regulators who brought attention to declining lending standards, an
    increase in aggressive and predatory lending, and a rise in loan-to-
    value (LTV) ratios were ignored or overruled. Mortgage insurers could
    have served as a ``third party control,'' as they must pay the
    remaining value of the mortgage if the homeowner defaults, but
    originators came to rely less and less on MI because they could pass on
    the default risk to investors via securitization. To deal with low down
    payments that would have triggered the need for mortgage insurance,
    piggy back loans were originated and these too were securitized. When
    Fannie Mae and Freddie Mac securitized mortgages, they bore the default
    risk, making them the ``third party control.'' However, when Wall
    Street securitized mortgages, the default risk transferred to the
    buyers of the mortgage-backed securities (MBS). Because the mortgages
    and the MBS were becoming more complex and heterogeneous, investors
    could not assess the default risk, as evidenced by the fact that they
    were accepting lower interest rates (even in comparison to Treasuries)
    for riskier products.
        Contrast this experience to that of Canada, where regulators
    mandate that all high-LTV mortgages must be covered by MI. This
    practice has not inhibited Canada from achieving levels of home
    ownership on par with those of the U.S. in 2004, at their peak. Canada
    and Australia in this time period as well relied on mortgage insurers
    as a ``third party regulator'' with the result that mortgage lending
    standards did not deteriorate and housing prices did not collapse.
    Mortgages in Australia and Canada were and are typically short term
    variable rate, or in the case of Canada, rollover, and were originated
    and to a large extent held in portfolio by banks. Both countries
    avoided recessions, home ownership has been maintained at high levels,
    and their banking systems have been able to continue lending as the
    crisis has caused financial systems in other countries to stop
    functioning. Australia has a significant ARM share, but regulators
    prohibited lenders from issuing ARMs to borrowers who did not qualify
    for the highest projected rate over the life of the loan. Thus,
    Australia was spared the fate of the U.K., Denmark, and Spain.
        A system reliant on MI can only work, however, if the insurers
    maintain enough capital to cover defaults during economic downturns.
    The U.S. is an example of what can happen when this principle is
    ignored. Credit default swaps (CDS) acted like insurance on MBS, but
    CDS issuers like AIG did not have enough capital to cover the defaults
    and were not required to reserve for the risk they were holding. Thus,
    MI is only one half of the equation, with strict countercyclical
    capital regulation being the other half. Canada is an excellent example
    of maintaining both ends of the equation. Their adjustable rates were
    regulated to prevent predatory behavior; for example, originators were
    not allowed to use low ``teaser'' rates.
        The structure of the dominant mortgage product is also critical to
    preventing procyclicality. Most countries rely on adjustable-rate
    mortgages (ARMs). The U.S., Denmark, and Germany are the three notable
    exceptions, favoring fixed-rate mortgages (FRMs). ARMs place the
    interest rate risk on the borrower, who is not as well-suited to bear
    it as lenders and investors. When interest rates rise, borrowers may
    have difficulty making payments and may be forced to default. ARMs also
    subject the borrower to greater market risk because their interest
    rates may rise when defaults increase elsewhere in the economy. ARMs
    are less conducive to systemic stability, as exhibited during the
    recent economic crisis. During the housing bubble, securitizers'
    appetite for market share drove them to demand riskier mortgages from
    less creditworthy borrowers. Originators responded by favoring ARMs
    over FRMs, and it was these nonstandard mortgages that eventually
    exploded. The U.K. and Spain also relied on ARMs with similar
    consequences. All countries with ARMs saw their lending dry up during
    the credit crunch with borrowers unable to refinance at the high new
    rates. With ARMs that need to be repaid or refinanced the illiquidity
    of the system may be transformed as in these countries into a solvency
    or foreclosure crisis.
        Building a system around the FRM requires a secondary market. Banks
    do not want to bear the interest rate risk of ``borrowing short'' from
    depositors and ``lending long'' to homeowners. When interest rates
    rise, they will have to pay more to depositors but will be receiving
    the same low payments from homeowners that were established when the
    contract was signed. This mismatch was directly responsible for the
    U.S. savings and loan crisis two decades ago and similar crises
    elsewhere. While in practice they can hedge this risk with derivatives,
    in practice no country has a banking system reliant on FRMs without
    secondary market institutions that bear some of that risk and/or
    increase their profitability. In the U.S., Fannie Mae and Freddie Mac
    serve that role by purchasing FRMs and securitizing them. Unlike PLS of
    ARMs, this securitization yields a product that would not otherwise
    exist. In Germany, banks issue ``covered bonds'' (instead of MBS) that
    are secured by standardized mortgage loans through Pfandbrief
    institutions. While the investor who purchases a covered bond receives
    the cash flows from the homeowner, the issuer who sold the covered bond
    retains the default risk. If the homeowner defaults, the issuer owes
    the remaining balance to the investor. Unfortunately, the stringent
    loan to value requirements of the system in Germany has resulted in one
    of the lowest home ownership rates in the industrialized world, relying
    on renting for over half its population.
        But without the proper regulations, even covered bonds can get a
    country into trouble. German regulators ensure that investors get
    periodic updates on the state of the collateral securing their covered
    bond, and they do not allow covered bonds to be secured by loans with
    an LTV ratio above 60 percent. Unlike in the U.S., these regulations
    were not eroded during the housing bubble. Denmark also relies on
    covered bonds and had similarly stringent regulations until recently.
    When Danish legislation moved the system toward interest-only
    mortgages, the market joined the housing mania and developed a late
    bubble that subsequently deflated. Similarly, Spain used covered bonds
    extensively, yet they slid toward ARMs in recent years. The Spanish
    banks, cajas, securitized ARMs through cedulas in an effort to generate
    fees and gain market share, generating a bubble and crisis that is
    severe, with Spain suffering 20 percent unemployment. In the face of
    rising prices, it is very tempting to lower lending standards,
    contributing to procyclicality.
        All industrialized nations have significant government involvement.
    When the housing market is in crisis, it endangers the entire system.
    The British rescue of Northern Rock preceded the American bailouts and
    the Spanish government has intervened to protect the cajas and their
    covered bonds. To prevent a foreclosure crisis from driving an economy
    into a severe recession or depression, governments will intervene; thus
    it is necessary to regulate the housing finance market before it
    reaches the crisis stage. The taxpayer owns the tail risk. Rather than
    raise lending standards after the fact, we can prevent the problems of
    moral hazard, shrinking equity, and bailouts by maintaining standards
    and transparency.
        The clearest difference between the U.S., the U.K., and Spain, on
    one side, and Australia, Canada, and Germany, on the other, is the
    stability of regulation. The first group allowed lending standards and
    capital requirements to decline, stoking the pro-cyclical behavior that
    created a housing bubble and economic crisis, while the latter group
    maintained rules in the face of market pressure.

    Bibliography

    ``Housing Finance in Developed Countries--In a Time of Turmoil'',
        coauthored by Richard Green, Adam Levitan, and Susan Wachter,
        working paper, 2010.
    ``The American Mortgage in Historical and International Context'',
        coauthor Richard K. Green, Journal of Economic Perspectives, Vol.
        19, No. 4, Fall 2005, 93-114. http://papers.ssrn.com/sol3/
        papers.cfm?abstract_id=908976
    ``The Housing Finance Revolution'', coauthor Richard K. Green, Housing,
        Housing Finance, and Monetary Policy: Symposium Proceedings,
        Federal Reserve Bank of Kansas City, January 2008. Reprinted in The
        Blackwell Companion to the Economics of Housing: The Housing Wealth
        of Nations, eds. Susan Smith and Beverley Searle, London: John
        Wiley & Sons, forthcoming 2010.http://www.kansascityfed.org/
        Publicat/Sympos/2007/PDF/Green_Wachter_0415.pdf
                                     ______

                     PREPARED STATEMENT OF ALEX J. POLLOCK
                 Resident Fellow, American Enterprise Institute
                               September 29, 2010

        Mr. Chairman, Ranking Member Corker, and Members of the
    Subcommittee, thank you for the opportunity to be here today. I am Alex
    Pollock, a resident fellow at the American Enterprise Institute, and
    these are my personal views. Before joining AEI, I was the President
    and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.
    From 1999 to 2001, I also served as President of the International
    Union for Housing Finance, a trade association devoted to the
    international exchange of housing finance ideas and practices, and
    continue to be a member of its Executive Committee.
    A Middle of the Pack Home Ownership Rate, GSEs Notwithstanding
        As we begin the last quarter of 2010, our housing finance system
    (as well as those of some other countries) is still struggling in the
    wake of the great housing bubble of 2000-06 and its collapse into the
    panic and serial crises of 2007-09.
        Housing finance cannot be considered apart from its effects on
    house prices. When you push a lot of credit at an asset class, its
    price tends to rise. American housing finance practices and subsidies
    helped inflate house prices during the bubble. Then U.S. average house
    prices fell by more than 30 percent from peak to trough--something, we
    must remember, which was previously considered impossible. This brought
    them back to their long-term trend line and to the levels of 2003, with
    all of the losses and turmoil with which we are so familiar. A
    memorable decade! One of its lessons is to try to remember that things
    considered impossible can nonetheless happen.
        As we develop other lessons for the next decade, there is no doubt
    that it is educational and useful to examine American housing finance
    in international perspective.
        Comparing our housing finance system to other countries, we
    discover that one thing remarkable and indeed unique in the world about
    American housing finance was the dominant and disproportionate role
    played by Government-sponsored enterprises, namely Fannie Mae and
    Freddie Mac, wielding their ``implied'' Government guaranty. Based on
    this ``implied'' guaranty, massive amounts of their debt securities
    were sold around the world, so that foreign institutions could help
    inflate U.S. house prices without worrying about the risk and later be
    bailed out as creditors by American taxpayers. Of course the
    ``implied'' guaranty always was a real U.S. Government guaranty, as
    events have amply demonstrated, but it did not have to be accounted for
    as one.
        In the days of Fannie and Freddie's pride, their representatives
    and political supporters used frequently to say, ``American housing
    finance is the envy of the world!'' It really wasn't, at least based on
    my discussions with housing finance colleagues from other countries.
    But many Americans--including members of Congress--thought it was, just
    as they mistakenly thought and said that the U.S. had the highest home
    ownership rate in the world. We didn't and don't.
        This is apparent from the table of Comparative Home Ownership Rates
    on page 3. The U.S. ranks 17th of 26 economically advanced countries,
    or about two-thirds of the way down the list.
        I think we can agree that we would like our society to have a
    property-owning democratic citizenry, which includes widespread home
    ownership. But the international perspective makes it clear that many
    countries achieve home ownership levels as high or higher than ours
    with no GSEs. It turns out that these levels can be achieved without
    tax deductions for the interest paid on home mortgages, without our
    very unusual practice of making mortgages into nonrecourse debt,
    without Government mandates to make ``creative'' (that is, riskier)
    loans, without 30-year fixed-rate loans, and with prepayment fees on
    mortgages. Of course, as bubbles and busts in other countries show, you
    can also get in trouble with different systems.
        At a minimum, we should never assume that the particular historical
    development so far of the U.S. housing finance system is definitive.
    Canada
        The better credit performance of Canadian housing finance over the
    last several years has become well known. The proportion of Canadian
    mortgage loans more than 90 days delinquent in the first quarter, 2010
    was less than \1/2\ percent. This is about one-tenth the ratio of U.S.
    mortgages over 90 days delinquent at that time, which was 4.9 percent.
    If we add to the U.S. number mortgage loans in foreclosure to look at
    serious delinquencies, it jumps to 9.5 percent. Quite a contrast, as
    many people have remarked.

        Canada makes a pertinent comparison for the U.S. It is in
    population and economic size much smaller, of course--about one-tenth
    in both cases--but is in many ways very similar.
        Both countries are rich, advanced, democratic, and stable, have
    sophisticated financial systems and pioneer histories, and stretch from
    Atlantic to Pacific. But Canada has no housing GSEs; mortgage loan
    interest is not tax deductible; it does not have 30-year fixed rate
    mortgages; it does have prepayment fees.
        Mortgage lending is more conservative and creditor-friendly.
    Canadian mortgage lenders have full recourse to the borrower's other
    assets and income, in addition to the security interest in the house.
    This means there is less incentive for underwater borrowers to ``walk
    away'' from their house and mortgage. No tax deduction for interest
    probably increases the incentive to pay down debt. Most Canadian
    mortgage payments are made through automatic debit of the borrower's
    checking account and can be matched to paycheck frequency--a technical
    but important behavioral point. Canadian fixed rate mortgages typically
    are fixed for only up to 5 years. Subprime mortgages were a much
    smaller part of the market.
        This relative conservatism has meant that Canadian banks, the
    principal mortgage lenders, while experiencing some pressure, have come
    through the international financial crisis in much better shape than
    their U.S. counterparts, with (as observed above) mortgage
    delinquencies so far well behaved.
        There does not appear to have been a home ownership price to pay
    for this relative credit conservatism. Canada's home ownership rate is
    68 percent vs. 67 percent for the United States. Two very different
    housing finance systems, one, as it turned out, much riskier than the
    other, produced virtually the same home ownership rate.
        It is important to recognize that Canada does have an important
    government body to promote housing finance, which has a substantial
    role: the Canada Mortgage and Housing Corporation (CMHC). Among its
    principal activities is insuring (guaranteeing) mortgage loans, another
    is securitizing some of the insured loans. So you could think of it in
    one sense as a combination of FHA and Ginnie Mae. (Its mortgage
    insurance program was originally modeled on the FHA in 1954.)
        CMHC's mortgage insurance is a major factor in the market, covering
    about C$470 billion out of total mortgage debt of about C$ 950 billion,
    or roughly half of Canadian mortgages. This is the same proportion as
    the combined Fannie and Freddie in the U.S. (over $5 trillion out of
    about $10 trillion).
        Whether or not you like the idea of such a scale of government
    financing, you have to say that, in contrast to the American GSEs, at
    least CMHC's status is completely clear and honest. It is a 100 percent
    government-owned and controlled corporation. Its government guaranty is
    explicit, so it operates with the formal full faith and credit of the
    government of Canada. It also provides housing subsidies which are on
    budget and must be appropriated by Parliament.
        Canada in this respect looks superior to the U.S. in candor, as
    well as credit performance.
        However, CMHC does obviously represent a large government
    intervention in the housing finance market. Recalling our previous
    point about the interaction of housing finance and house prices, one
    Canadian criticism is that this intervention has caused excessive
    inflation in Canadian house prices. Indeed, Canadian house prices
    measured relative to a base of the year 2000, have now risen higher
    than U.S. relative house prices at the top of the bubble, as shown in
    the following graph.

        A general rule is that as long as house prices are rising, mortgage
    loan performance will be good. Some Canadian commentators worry about
    whether their house prices are in a bubble. The Fraser Institute, a
    Canadian free-market think tank, has called the Canadian mortgage
    system ``a high taxpayer-vulnerability model.''
        In response to these worries, Canadian regulators have taken
    important countercyclical actions to lower the maximum loan-to-value
    (LTV) ratios on some of the riskier classes of mortgage loans. In other
    words, they now require larger down payments and allow less leverage of
    the properties. Such countercyclical movement in LTV limits, in my
    opinion, is an excellent idea and necessary to moderate the inevitable
    cycles in real estate credit. We should stay tuned to the highly
    interesting Canadian housing finance story.
    Matching Mortgage Assets and Mortgage Funding
        The traditional and still typical Canadian mortgage has a long-term
    amortization schedule (up to 35 years for CMHC-insured mortgages), but
    with an interest rate fixed for 5 years, after which the interest rate
    is reset for another 5 years, and so on. Shorter fixed periods are also
    common, but the debt service to income ratios are to be approved based
    on the prevailing 5-year rate.
        About two-thirds of mortgages remain on the balance sheet of the
    lenders, which are dominated by five nationwide banks. The 5-year fixed
    rate mortgage loans are often funded by the issuance of 5-year fixed
    rate certificates of deposit, which gives a very good natural matching
    (that is, no derivatives required) of the banks' assets and
    liabilities. Obviously, such matching is also available for shorter
    fixed rate periods.
        This is a straightforward answer to a fundamental problem of every
    housing finance system: how to match the nature of the mortgage asset
    with an appropriate funding source, so that you are not lending long
    and borrowing short. Different approaches distribute the risks among
    the parties involved, including lenders, investors, guarantors,
    borrowers and the government, in various ways. The classic example of
    not achieving the needed match is the infamous collapse of the American
    savings and loan industry in the 1980s.
        There are clearly some basic variations:

        Variable rate mortgages funded with short-term deposits;

        Medium-term fixed rate mortgages funded with medium-term
            fixed rate deposits or bonds;

        Long-term fixed rate mortgages funded with long-term fixed
            rate bonds or mortgage-backed securities.

        In general, variable rate mortgages put the risk of rising interest
    rates in the first place on the borrowers. To have long-term fixed rate
    mortgages requires funding by some form of access to the long-term bond
    market. Every housing finance system must address this fundamental
    asset-liability question; the answer results in a particular
    distribution of risks.

    Denmark
        The most perfect solution in theory, which also functions very well
    practically in its national setting in an admittedly small country, is
    that of the housing finance system of Denmark. It has been admired by
    many observers. Explicitly governed by what it calls the ``matching
    principle,'' the interest rate and prepayment characteristics of the
    mortgage loans being funded, which include long-term fixed rate loans,
    are passed entirely on to the investor in Danish mortgage bonds.
        At the same time, there is a total ``skin in the game'' requirement
    for retention of credit risk by the mortgage lenders. The mortgage
    banks retain 100 percent of the credit risk of the loans, in exchange
    for an annual fee, thus insuring alignment of incentives for credit
    performance. Deficiency judgments, if foreclosure on a house does not
    cover the mortgage debt, are actively pursued.
        The fundamentals of the Danish mortgage system go back over 200
    years. There are no GSEs or government housing banks. This is a private
    housing finance system built on what appear to be quite robust
    principles. It generates a home ownership rate of 54 percent, below
    that of Canada or the U.S.
        Some years ago, when the proud hearts of Fannie and Freddie had not
    yet had their fall, I participated in an exchange with the Association
    of Danish Mortgage Banks. They explained their mortgage bond- and skin
    in the game-based system to me, then I explained the American GSE-
    centric mortgage system to them.
        When I was done, the CEO of one of the leading Danish mortgage
    banks said this: ``In Denmark we always say that we are the socialists
    and America is the land of free enterprise. Now I see that when it
    comes to mortgage finance, it is the opposite!''

    England
        England has a large economy, is financially very sophisticated, and
    has an entirely different housing finance structure. It also has no
    GSEs. The traditional and still typical English mortgage is a variable-
    rate loan financed by deposits in banks or mutual building societies.
    The interest rate on these loans can be changed up or down at the will
    of the lender, so everybody's rate changes at the same time. This is a
    natural asset-liability matching for the depository institutions, but
    is risky for the borrowers.
        England had a housing boom and bust in the 21st century cycle, as
    we did. Indeed, the first casualty of the financial panic was an
    English mortgage lender, Northern Rock, which was a well-known
    securitizer of mortgages. Northern Rock failed in 2007, long before
    Bear Stearns did, when the wholesale investing market refused to
    continue investing. This was followed by first a run on its retail
    deposits, then by the nationalization of the bank.
        England also had a unified financial regulator, the Financial
    Services Authority, whose jurisdiction included mortgage lenders as
    well as all other financial intermediaries. This unified regulatory
    structure did not avoid the crisis.
        Still, England has a home ownership rate of 68 percent, just ahead
    of the U.S.

    Germany
        Some German banks got into serious trouble in the housing bubble,
    but by investing in U.S. mortgage securities and other foreign
    mortgages, not in their domestic mortgage lending market, which is
    quite conservative. It generates a home ownership rate of 46 percent,
    which would not be politically acceptable in an American setting.
        Nevertheless, there are two German housing finance ideas worthy of
    study. One is its mortgage covered bond (Pfandbrief). With a statutory
    basis more than 100 years old (and it is claimed, a history going back
    to Frederick the Great of Prussia), the covered bond has provided a
    relatively stable source of bond-based mortgage financing.
        Covered bonds allow a fixed rate funding for fixed rate mortgage
    loans, and keep the credit incentives of the lender intact, since the
    lender remains responsible for 100 percent of the credit risk and the
    loans stay on its balance sheet. But they provide access to the bond
    market, in addition to deposit-based funding, and are indeed a major
    component of the German bond market. The mortgage loans serve as
    collateral for the bonds, which are also senior obligations of the
    issuing mortgage lender.
        Many people have proposed, and I agree, that the U.S. should
    introduce covered bonds as a mortgage funding alternative--one which
    does not involve a government guaranty. The German experience suggests
    these lessons:

        There needs to be a statutory basis for these bonds, not
            merely a regulatory one, to insure the bond holders' rights to
            the collateral are truly protected.

        The mortgage loans serving as collateral for them (the
            ``cover pool'') should be subject to conservative credit
            standards, to reduce the volatility and uncertainty of their
            credit behavior.

        A second German housing finance idea for consideration is
    emphasizing (we should say, rediscovering the needed emphasis) on
    savings as part of sound housing finance. Thus, the German building and
    savings banks (Bausparkassen) continue to practice the traditional
    ``savings contract,'' by which the borrower commits to a regular
    savings program as part of qualifying for a mortgage loan.
        I am not recommending their specific program, but the general
    principle. We have completely lost the emphasis on savings as part of
    housing finance. We need to rediscover it.

    Switzerland
        Switzerland may just be mentioned as a case of the variety
    exhibited by housing finance in international perspective. It is a
    wealthy country with a very large and sophisticated financial sector.
    It has mortgage debt outstanding of about 100 percent of GDP, somewhat
    higher than in the U.S.
        Yet Switzerland has a home ownership ratio of only 35 percent, the
    lowest on our list.
        It is an unusual housing finance example. So is the American GSE-
    centric system, which has collapsed at heavy taxpayer expense, as did
    the American savings and loan system which preceded it.

    Conclusion
        The variety of international experience suggests that there is
    every reason to think broadly and openly about the possibilities for
    developing a better, post-GSE U.S. housing finance system for the
    future.
        Thank you again for the opportunity to share these views.