[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.
