Richard Florida
by Richard Florida
Wed Jan 28th 2009 at 12:47pm UTC

Sensible Swedes

Sweden’s Sloped Curve posts in English telling us what an absolute mess the U.S. mortgage system is and what needs to be done to fix it (via Mark Thoma).

First of all, I believe that prepayment penalties are key. In Sweden, if you pay off a fixed-rate mortgage before it expires, you have to pay for the interest rate differential between the fixed rate you’re paying and the fixed rate the lender can get in the market by investing the money you lent in an equal investment. With 10 years left on a mortgage, this can work out to a very hefty sum …

Secondly, I do believe that there should be no closing costs or points involved in getting a mortgage. This means that, as long as your mortgage is not a fixed rate mortgage, you can move your loan to another lender at any point in time, with zero cost. This promotes competition and promotes the use of adjustable rate products …

You also need to make mortgage recourse loans. You need to make sure that mortgage decisions are based on the verified income of the borrower, and not only on the assets of the borrower …  Also, you need to make sure that you can not borrow nearly 100% of the property value.

Finally, one thing that is desperately needed is new and strong regulation on what sort of mortgages that can be securitized. This also means that we can rather easily find solutions to how to get the other things to happen. New laws regarding the creation of mortgage backed securities could require that any mortgage packaged into an MBS fulfill the requirements I mention. It would be illegal to market mortgage based securities if they do not fully consist of recourse mortgages with prepayment penalties, no closing costs, a verified income that is high enough to handle the mortgage and a reasonable loan-to-value.

If this was to be implemented in the US, I believe the the federal reserve would have the tools necessary to better ensure sane credit availability and avoid the current boom and bust cycle.

BTW, we have a very similar system in Canada, where our banks remain stable, houses continue to be sold, and mortgages are still being given out.

It’s amazing to me that we (that is the U.S.) would let our housing and mortgage system undermine our banking system and real economy.

13 Responses to “Sensible Swedes”

  1. Buzzcut Says:

    Yeah, that’s about 10 “reforms” too many.

    Securitization has to go. Freddie and Fannie need to be dissolved. They’re too big, they took down the entire economy, and are unregulatable. Why would we want them back?

    Pre-Fannie/ Freddie, banks made home loans of no more than 80% of the homes value, and they held the loans to maturity. That system worked well. There’s just no reason to go with securitization.

    Other than that, encouraging ARMs is not a good idea. Too much interest rate risk for homeowners. Part of this crisis is because of the proliferation of ARMs.

    Some mortgages are no cost, and some have prepayment penalties. It is up to the borrower and lender to sort that out. I don’t see why we would want to regulate that. What does that solve?

  2. Nashvilian Says:

    I don’t undrstand what the author considers prepayment penalties the key to. Debt servitude, perhaps?

    Mortgage payments are heavily interest laden early in the payoff period. If a 30-year loan is paid off ten years early, most of the interest due from that mortgage has been collected. I’d think the bank happy to get that money back and loaned out for a fresh ammortization.

  3. hayden fisher Says:

    For once, I agree with Buzzcut.

    Eliminating closing costs = eliminating commissions and the service that commissioned employees provide in order to get deals done. That would be disastrous on a number of levels.

    Pre-payment penalties would create a chilling effect and leave a lot less flexibility in the market. America’s flexibility has has always been the hallmark of its economy and allowed it to bounce-back from setbacks. We need elasticity in the market. Like now, companies are cutting jobs; banks are liquidating assets on a fire-sale basis; the housing market is correcting quickly, painful in the short-term, necessary in the long-term; etc. Our economy will bounce-back faster because of our flexibility.

    ARM’s should be regulated. Loan requirements should be in place. We need common-sense regulation and transparency. Would we administer an SAT exam and expect students not to cheat? Of course not. Why are we surprised by all of the cheating on Wall Street and Main Street that has occurred in the absence of meaningful common-sense regulation. We need regulation; but we also need to leave flexibility in the market.

  4. hayden fisher Says:

    …that is, administer SAT exams without proctors in the room…

  5. Buzzcut Says:

    One unmentioned difference between Swedish and American mortgages: Swedish banks can go after your income and other assets if you default. American banks only get the house when they foreclose.

    In general, Swedish banks have a lot less risk than American banks do. If you’re penalized for refinancing, and they can go after your income and assets if you default, they’re fat, dumb, and happy, aren’t they?

    Isn’t it amazing how much more anti-corporation we are here in allegedly capitalistic America than in allegedly socialist Sweden?

  6. Michael Wells Says:

    I don’t understand why prepayment penalties are good, nor how if you moved to another lender (i.e. refinanced) it wouldn’t trigger the penalty? And do penalties apply if you sell the house?

    Closing costs are mostly real — inspections, title insurance, filing fees. If they’re not separate I think they’d have to be rolled into the mortgage, possibly a minor advantage.

    If we’re talking about real estate commissions, that’s another matter. In my neighborhood, houses often sell by word of mouth. But putting up a “For Sale by Owner” sign seems to be the kiss of death. If I couldn’t sell quietly through my neighborhood and friendship networks in a month or so, I’d definitely sign with a realtor who’s well known in the neighborhood.

    I agree on the need for regulation and to rein in securitization.

  7. Sloped Mind Says:

    As the author of the article, I wanted to reply to a few of the comments.

    1: Yes, Fannie and Freddie have to go. Securitization has to go in the current form (which I write in the entry) and be replaced by securitization based on very strict rules that will create MBSs of decent quality.

    5: It’s not an unmentioned difference, that is one of the key points I bring up.

    6. Closing costs aren’t actual necessary costs. Title insurance is (as far as I understand) needed because of deficiencies in the US land records laws. These can be fixed. Other countries do not have this cost. Filing fees should be extremely low with a modern IT-based system. Inspections aren’t needed as long as you operate with recourse loans (you can go after the income), as long as the income is high enough and as long as the loan-to-value is sane. I didn’t say all this because the entry was already long, but most of the closing costs are just consequences of poor laws and regulation. Hence, they need to go. It’s not a huge deal though, not comparable to the securitization changes or move to recourse loans.

    Finally, the existence of pre-payment penalties is an important reason for why things like 30-year mortgages do not exist in Sweden. To improve the monetary policy transmission mechanisms it’s important to move people to adjustable rates. It’s important to understand that the adjustable rates I’m talking about have little to do with the US ARMs that are often apallingly bad products.

    I mean really simple adjustable rate mortgages that adjust for example every 30 or 90 days. With those there is no risk of a reset coming as a surprise after years of some introductory rate.

    Most importantly, if almost all people have adjustable rates, the central bank never has to raise rates very high to deal with credit bubbles. The risk of having an adjustable rate becomes a whole lot smaller when a whole society is moved to adjustable rates, because the central bank can make fine tuning rate changes with big effects rather than the wild rate swings the federal reserve is doing.

    Pre-payment penalties are only really important to be able to make sure that almost the whole society is shifted onto products that allow the central bank to support stability in inflation, credit conditions and interest rates. If this can be done in other ways, you don’t need to remove the pre-payment penalties.

  8. Nashvilian Says:

    Sloped Mind,

    Don’t Swedes recieve inheritance? What kind of bonuses do they get? Do stay-at-home spouses sometimes seek employment for a second income? There’s three good reasons why you always want to avoid pre-payment penalties. Those penalties discourage the responsible action of paying down one’s debt as one gets the money to do so. And the mortgage is typically the most pervasive debt.

    Also, how much payroll tax is taken in Sweden? I know; how Swedes prepare for retirement and pay for medical benefits is probably a dissertation in itself. Americans, between Social Security and vehicles like a 401k, put about an eighth of their income into retirement, and when matched by their employers it totals a quarter of their income. Some have nearly half their paycheck taken as taxes and pre-tax retirement investment before they cash it, then pay over half of the remaining to pay the mortgage. So the typical mortgage runs 30 years. Even at that, the bubble caused people to overspend to buy what was once affordable homes and now many are dependent on credit to make ends meet.

    American’s biggest problem when it comes to affordability, IMHO, is the thirty-year mortgage. If we saved for retirement consecutive with paying a mortgage, instead of concurrently, we’d be paying as much as half our income (assuming the employer matching continued) towards the mortgage, giving us the ten year mortgage as standard. We’d also save in interest an amount around 75% of the principal amount!

    But no, in essense we borrow from the mortgage company to pay into retirement at a huge cost, and STILL many people arrive at retirement having a mortgage or rent that retirement benefits must cover.

  9. Michael Wells Says:

    I think one of the misconceptions here is that the US is similar enough to Sweden for these changes to work or even make sense. Sweden is 9 million people in 173,000 square miles, or about the population of Metro Chicago in the area of California. The largest city, Stockholm is 761,000 people and wouldn’t make the list of 25 largest U.S. cities (#25 Cleveland is 2 million+). Sweden’s population is pretty homogenous and (I’d guess) not terribly mobile. The U.S. is big, diverse and mobile. I doubt if the cases are comparable.

    Second, for better or worse, American’s have decided not to have a social democracy, which means if someone takes your income you don’t eat. Making income loan collateral feels to me like indentured servitude.

    Third, every state makes its own laws so changing things like land record laws isn’t one job, it’s 50. And inspections when buying a house are for the buyer’s protection as well as the lenders.

    So yes, we need to fix our housing and mortgage market, and we may have something to learn from Sweden and Canada. But I doubt if their systems are a model for the U.S.

  10. Sloped Mind Says:

    8: Few people ever have to pay any prepayment penalty in Sweden because they do not have fixed rate mortgages. If they do have fixed rate mortgages, the remaining time period is normally short enough for any penalty to be of a small size.

    With an interest rate that resets often, the compounded interest rate differential for the remaining term of the current interest rate becomes close to nothing. With an interest rate that resets every 30 days, you are obviously guaranteed to be able to pay off the debt every 30 days without any penalty no matter what happens. In reality you can always pay off any adjustable rate loan (with adjustable we mean an interest rate that resets at least every 3 months) on the same day as you like without any substantial cost to the lender, and hence no penalty.

    The prepayment penalty would only kill the market for 30-year mortgages (because it would be very risky considering that you might want to move within 30 years), it wouldn’t actually be something people paid when they prepay their mortgage.

    The payroll tax is around 32%, and part of that goes to private social security accounts that you have control over in terms of deciding how that money is invested. We made the reforms the US are debating to our old age social security over a decade ago.

  11. Michael Wells Says:

    I’m not sure I’d want to buy a continually resetting interest mortgage. U.S. Mortgages went from 5% in 1970, to 9% in 1975, to as high as 15% in the early 1980’s. Whether or not this were done in 30 day increments so you saw it coming, it would still force many people out of their homes.

    Maybe Sweden’s inflation isn’t as volatile as here, and there are probably other subtleties but at first glance it doesn’t look attractive.

  12. Michael Wells Says:

    I take it back, Wikipedia says metro Stockholm is 2 million — about Cleveland size.

  13. Buzzcut Says:

    Micheal, still good points about Sweden demographics, geography, etc.

    If we’re going to compare something, it should be Swedes to… Swedish Americans. I wonder how things would look if we could statistically isolate that one ethnic group and compare their finances to that of Swedes. I’d guess that they come out way ahead (near zero unemployment, incomes way above that of Sweden, lots of wealth, etc. etc.)

    Continuously reseting ARMs are available. You can certainly get a 1 year ARM, which would reset every year. They’ve got near zero market share. They’ve got way too much interest rate risk for the borrower.

    Now, if everybody had continuously reseting ARMs (say, reset every month), would monetary policy work so well that rates would never have to go up mutch? Interesting argument, but how would we know?

    Seems like a risky experiment to perform on the American people.