Between mid-2022 and earlier this year, existing home sales fell from an annualized rate of almost 7 million sales per month to just 4 million, a record pace of contraction and an overall drop in magnitude only slightly shy of the 2008 financial crisis. There are currently only about 600,000 homes on the market, compared to 1.5 million before the pandemic. Prices remain close to record highs, but given such thin liquidity, are virtually meaningless.
The freeze in transactions is a function of interest rates.
Homeowners borrowed and repriced about $3trn worth of mortgage debt (half of the entire outstanding amount) in 2002-22—either through purchases or refinancings—at emergency-level low interest rates. Today, one third of mortgage debt carries an interest rate below 3%.
Contrast that with the going rate on a 30-year fixed rate mortgage: at the time of writing, above 7%. Since existing homeowners can’t ‘port’ their mortgage to a new home, or sell it to the would-be buyers of their home (except in rare circumstances), moving houses entails losing a cheap mortgage and resetting at a much higher rate. Borrowers are “locked-in” by the golden handcuffs of their cheap mortgages.
This dynamic has always existed in the US housing market, but—given the swing from rock bottom rates to the highest borrowing costs in a generation, and in such a short amount of time—this mortgage lock-in effect has never been so strong.
A mortgage originated at a lower rate than prevailing rates is worth less than par—this is an unrealized loss to the lender and an unrealized gain to the borrower. Unsurprisingly, pandemic-era borrowers are unwilling to lose their collective $700 billion worth of these gains.
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Mortgage lock-in prevents home prices from adjusting to the shock of higher financing costs. This is, in particular, a burden for the ~2 million Americans who are first time home buyers every year. Millennials are the biggest cohort of buyers these days, and in 2022, 70% of them were first time buyers.
The sprawling edifice of American intervention in the mortgage market—from the Federal Housing Administration (FHA), to the government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, and Ginnie Mae, to Federal Home Loan Banks (FHLBs)—are premised on the goal of making home ownership more widely available. But amidst rising rates, mortgage lock-in is an impediment to achieving that goal.
If the stickiness of the asset is a problem for prospective first time buyers, the inflexibility of the liability is a problem for existing owners. Aside from locking owners into their current homes, the rigidity of mortgages in the face of rising interest rates means that an increasing number of borrowers are ‘underwater’ or very close to it—they hold a mortgage that is close to, or exceeds, the value of their equity in their home.
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Mortgage lock-in also has less obvious but more harmful, widespread, and long-lived effects. Not least: it exacerbates declining levels of geographic mobility. Americans are staying in their homes longer. They are evincing a declining willingness to move neighborhoods, cities, or states in order to find work that better matches their skills. By giving Americans a powerful incentive not to move, mortgage lock-in contributes to a handful of modern-day macroeconomic problems, including anemic productivity growth and neo-feudal levels of income inequality.
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Mortgage lock-in doesn’t exist in Denmark because borrowers can buy back their loans at market prices in the secondary market.
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In the US, banks originate mortgages but then sell them onwards to GSEs for bundling into mortgage backed securities. But Danish mortgage finance operates on the ‘balance principle’: bank lending is funded by the issuance of bonds which precisely match the cash flows of the underlying mortgages. Danish banks retain ownership of mortgages, including their credit risk. These remain on their balance sheets within ring-fenced ‘cover pools’.
Securitization of these assets is not via mortgage backed securities but instead via ‘covered bonds’. Cash flows pass directly from borrowers to covered bond investors, with the mortgage bank acting as servicer.
Covered bond investors are highly secured: they have exclusive recourse to the segregated cover pool of assets on the issuing bank’s balance sheet, and (nonexclusive) recourse to the overall assets of the issuer.
Danish mortgage banks are specialized institutions that only issue and distribute mortgages without maturity transformation (a form of narrow banking). They are barred by law from taking deposits.
The balance principle and generally tight regulation ensure a very stable market—since its creation in 1797, the Danish covered bond market has not experienced a single default in a bond series.
The allowance for repurchases below par is facilitated by the fact that Danish mortgage-backed bonds are pure pass-through securities: each specific mortgage can be traced directly to a bond that is traded in the secondary market. This means that when a mortgagor wants to terminate the loan, it is possible to identify the bond it was financed through and buy back an equivalent portion at the prevailing market price.