Abstract
This Selected Issues paper for Iceland reports that it faces a considerably less favorable inflation-output variability trade-off than do Canada or the United States. A number of measures should be considered that could help minimize the cost of inflation breaching the tolerance band and help to lower the probability of such events occurring. To effectively target inflation, central banks need to be forward looking, responding early to prospective demand pressures. Having housing prices explicitly in the target ensures that the central bank will monitor developments in the housing market closely.
III. Mortgage Market Developments in Iceland and the Role of the Housing Financing Fund1
A. Introduction
1. During the second half of 2004, there were important developments in the Icelandic mortgage market. The publicly-guaranteed Housing Financing Fund (HFF) significantly enhanced the efficiency of its mortgage financing and extended its general lending limits. The latter was in part in response to the entry of the commercial banks into the mortgage market in the second half of the year, a welcome development that will increase the banks’ domestic financial soundness. As a result, mortgage lending increased sharply and real mortgage rates declined substantially, adding further demand pressures to an already over-heated economy.
2. The purpose of this paper is two-fold. First, it will document the developments in the Icelandic mortgage market in 2004-05, as well as their impact on other parts of the economy, such as the housing market, residential construction, and household debt. Second, in light of these developments, and in line with the trend in other industrialized countries, the paper will suggest possible reforms of the HFF, aimed at maintaining the key positive aspects of the current system while allowing banks to profitably remain in the mortgage market.
B. Mortgage Market
3. There has been a rapid expansion in mortgage lending in Iceland in recent years, reflecting both the creation of the HFF in 1999 and its subsequent reforms, in particular in the last year, and the entry of commercial banks into the mortgage market in 2004. While the HFF has significantly increased the opportunities for affordable mortgage lending, the banks’ entry in 2004 provided for mortgage lending at even better conditions than were then currently available, and significantly boosted mortgage market competition. As a result, mortgage lending increased sharply, rising by ISK 119 billion or 63 percent in 2004, most of which took place in the last four months of the year. Mortgage rates have also fallen, with real loan rates declining from 5.10 percent to the current rate of 4.15 percent.
Housing Financing Fund2
4. The purpose of the public HFF is to promote home-ownership, in particular for low-income households and households residing in remote regions, by providing affordable mortgage credit. In contrast to its predecessor, the State Housing Board, which received explicit subsidies from the state budget for its social lending, HFF finances its social lending out if its own operations. HFF bonds carry a government guarantee and account for almost 80 percent of total government guaranteed debt. The very thin Icelandic capital markets at the time of the inception of the HFF provided a rationale for such broad-based government support despite a homeownership rate of more than 80 percent. Box 1 gives a short summary of the role and functioning of the HFF and recent reforms.
The Housing Financing Fund
The Housing Financing Fund (HFF) was created in 1999, replacing the State Housing Board. It is owned by the central government, exempt from corporate tax, does not pay dividends to its owners, and its bonds carry a government guarantee. The HFF is accountable to the Minister of Social Affairs but is financially independent and should meet its lending and operating costs from own revenues. While initially only the Housing Bonds Department was supervised by the Financial Supervisory Authority (FME), legislation was amended in 2004 to extend the FME’s regulation over HFF to cover all its business, in line with the situation of other financial institutions in Iceland.
Until July 2004, the HFF provided mortgage credit by issuing “Housing Bonds” to house buyers, which in turn were sold on the capital markets. In return, the HFF received “Mortgage Bonds,” collateralized by the underlying property. Housing Bonds were indexed to CPI, had a government guarantee, carried a fixed real interest rate of 5.1 percent, and had a maximum duration of 40 years. An additional fixed interest surcharge was added to the Mortgage Bond.
In July, 2004, the HFF significantly reformed they way it finances mortgage lending. The bond swap system was abolished and replaced by cash mortgages at market yields, financed by new, more streamlined, HFF bonds issued directly to the international capital markets. HFF bonds are indexed annuity bonds with installments twice a year and maturities of 10, 20, 30, and 40 years. They are listed on both ICEX and at Euroclear and in contrast to the old Housing Bonds, they do not carry a call option but remain open until maturity. As a result of the reforms, HFF’s mortgage lending rates, which need to cover HFF’s stipulated interest margin of 60 basis points, have declined from a fixed real rate of 5.1 percent to 4.15 percent.
Apart from general single-family mortgage credit, the HFF also provides direct loans to individuals with special needs; municipalities, businesses, and construction companies for rental housing; community homes for children and teenagers; and residential and nursing homes for senior citizens. Until July 2004, such supplementary loans were financed by issuing “Housing Authority Bonds;” now, these loans are also financed through the issuance of HFF bonds.
Loan limits have been successively raised, in response both to rising house prices and, in 2004, increased competition. Initially maximum loan-to-value ratios were set at 65–70 percent (the higher ratio for first-time homebuyers/builders), with a maximum loan amount of ISK 6.5–7.7 million. A “supplementary loan” of up to 25 percent of assessed value could be approved (see above), as long as the total loan amount did not exceed 90 percent of the property value. Maximum loan limits have since been successively raised to the current 90 percent maximum loan-to-value ratio, or ISK 15.9 million.
HFF is the largest institution in the Icelandic financial system. It is particularly dominant in the mortgage market, accounting for about 80 percent of the Icelandic residential mortgage market at end-September 2004. However, while still dominant, the HFF’s share of the residential mortgage market had fallen to about 65 percent at end–2004 as a result of the entry of commercial banks into the mortgage market.
Sources: HFF (2002-05); and Moody’s (2004–05).5. Reforms of the HFF, in particular in 2004, have contributed to a rapid increase in affordable mortgage financing. The HFF has successively been increasing its lending limits ever since its inception to match rising house prices. Still, average loan-to-value ratios have typically been below 50 percent given additional loan restrictions in terms of Icelandic krónur and fire insurance value. In the second half of 2004, the easing in lending limits was accelerated sharply, with already planned reforms moved forward as the HFF struggled to survive in the face of the new competition from the commercial banks. As a result, mortgage interest rates have declined, and mortgage amounts have increased—in the first quarter of 2005, the average HFF mortgage was twice the size of that during the same period in 2004. In the words of the HFF, “[i]n the space of two years, a revolution has taken place in general conceptions as to what should be considered a normal mortgage percentage and nominal interest rate for members of the general public who own or are purchasing real estate.”3
6. The HFF has played a unique and dominant role in the Icelandic mortgage and bond markets. Before mid–2004, almost 90 percent of households had an HFF loan and HFF bonds account for more than half of the Icelandic bond market. At end–2004, parliament reaffirmed the role of the HFF as a clear option for household mortgage financing, despite the entry of commercial banks into the Icelandic mortgage market.4
International Comparison
7. Few countries provide public support through the mortgage system to the extent that is done in Iceland today.5 In other countries in Western Europe, the trend has rather been to privatize banks that provide mortgages and create a market-oriented environment for housing credit institutions. Remaining interest rate subsidies for single-family housing are generally based on social needs, focusing on low-income households and individuals with disabilities. Also countries that traditionally have had a significant state presence in the mortgage market, such as France, have more limited involvement than is currently the case in Iceland. Box 2 gives a short overview of the degree of state intervention in the mortgage markets in some important comparator countries in Western Europe, the neighboring Nordics and some of the key economies, Germany and France. In contrast to the developments in these countries, the recent easing in the HFF’s lending conditions seems to point in the opposite direction, with the HFF reaffirming its position in the mortgage market in face of the increased competition from the commercial banks.
Government Mortgage Market Intervention: A European Perspective
Nordic Countries
Denmark: Mortgage credit is provided by specific private mortgage credit institutes, dating back to the 18th century. Mortgage credit is provided on competitive conditions, financed through the issuance of mortgage bonds. There are no subsidies of mortgage interest rates. Homeowners can deduct interest expenditures, including mortgage interest expenses, from their pre-tax income.
Finland: The main task of ARA, the State Housing Fund of Finland, is to finance state-subsidized rental housing production—about half of all rental dwellings in Finland are subsidized by the state. There are no general interest subsidies for private homeownership(which is mainly promoted through tax relief on mortgage interest payments, in line with the practice in most other Western economies); however, interest subsidies can be granted based on social needs.
Norway: Husbanken, the State Housing Bank, mainly lends for new housing, but also plays a role in providing social support targeted at low-income households, seniors, and individuals with disabilities. In 2002, 0.4 percent of GDP was allocated to grants and benefits, and 0.9 percent was allocated to new lending. The Housing Bank has participated in the financing of approximately 50 percent of existing homes in Norway. Given its focus on social lending, at end-2002 Husbanken only accounted for 14 percent of outstanding mortgages.
Sweden: The publicly owned SBAB was founded in 1984 to channel state housing loans; however, today there are no interest rate subsidies for single-family homes, and SBAB competes with the private mortgage institutions, accounting for 11 percent of the Swedish mortgage market. Interest rate subsidies are only available for multi-family houses, rental and condominiums, with the subsidy amount corresponding to the tax relief on mortgage interest payments available for homeowners.
Major Economies
France: There is public assistance through the mortgage system, mainly through a dedicated savings scheme—plan d’épargne-logement—which has been used for the purchase of 40 percent of owner-occupied housing. There are also regulations on private sector mortgages, and there is a regulated loan scheme—prét conventionné—for public sector institutions and lenders. Zero-interest mortgages are offered to low-income households. Although the exact scope of France’s public involvement in the mortgage market is difficult to assess, it seems well below that in Iceland, in particular considering a homeownership rate of only 55 percent.
Germany: Subsidies to the housing sector, including for the promotion of social housing, have declined significantly in recent years, decreasing by 21.4 percent between 2001 and 2004. Looking ahead, these subsidies are expected to decline further over the medium term, through 2007.
Sources: CBI (2004b); Federal Ministry of Finance of Germany; Vilhjálmsdóttir (2004); www.ara.fi; www.boverket.se; www.husbanken.no; www.realkreditraadet.dk; and www.sbab.se.Commercial Banks
8. There are currently four commercial banks in Iceland, Íslandsbanki, Kaupthing Bank, Landsbanki Íslands, and Sparisjóðabanki Islands (Icebank), accounting for almost 90 percent of total bank assets in 2003. Remaining bank assets are with the 24 savings banks, which account for some 25 percent of household deposits and for which Icebank serves as a banking institution. The current structure of the Icelandic banking system is the result of significant consolidation and privatization in recent years.
9. In the last few years, the access to international capital markets of the commercial banks has increased significantly. In particular the three largest banks, i.e., Kaupthing Bank, Landsbanki Íslands, and Íslandsbanki, which are rated by international rating agencies, have started to expand their operations internationally, establishing themselves in some ten countries, including the United Kingdom and Luxembourg. The increased access to foreign capital is evidenced both by the sharp increase in external debt of the banking sector, which had risen to 89 percent of GDP at end–2003, up from 6 percent in 1995, and a marked decline in domestic bank credit rates.
Real Interest Rates
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.1/ On indexed loans.2/ Deflated by CPI.Real Interest Rates
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.1/ On indexed loans.2/ Deflated by CPI.Real Interest Rates
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.1/ On indexed loans.2/ Deflated by CPI.10. Reflecting both the enhanced access to international capital as well as other important factors, in August 2004 the three largest commercial banks entered the market for first mortgages. Until then, commercial banks had mainly been active in the secondary mortgage market, offering loans with some 5 years of duration at about 5.6 percent real interest rates. While the improved access to long-term international capital has been important in providing financing assurances, the timing of the banks’ entry on the mortgage market mainly reflected:
▪ HFF reforms of July 2004, which implied more transparent mortgage financing, with a clearly stated, and quite generous, interest risk premium; left the HFF vulnerable to prepayments, as the new HFF bonds do not carry a call option;6 and which foresaw the increase in the HFF’s loan-to-value ratio to 90 percent, a development that would significantly reduce the secondary mortgage market for the banks;
▪ A complaint by the banks to the European Free Trade Association Surveillance Authority regarding the HFF’s alleged contravention of the European Economic Area competition rules was rejected in August 2004. Shortly thereafter, the first bank entered the mortgage market;7
▪ Excess liquidity in the banking system, reflecting in part the CBI’s decision in 2003 to lower reserve requirements from 4 percent to 2 percent;8 and a
▪ Marketing decision on the part of Kaupthing Bank, the first bank to enter the market. By taking the initiative, it might have solidified its position as the market leader.
11. The banks entered the mortgage market on terms that were more competitive than those provided by HFF at that time. Banks initially offered mortgages at fixed real interest rates of 4.3 percent, below the HFF’s then current rate of 4.8 percent, with maturities of 25 or 40 years. The maximum loan-to-value ratio was set at 80 percent, with no maximum loan limits in Icelandic krónur, compared with HFF’s rules at the time of 65–70 percent loan-to-value ratios, and loan limits of ISK 9.2–9.7 million. In addition, the mortgages offered by the banks are not confined to house purchases or construction but can also be used toward refinancing previous mortgages and for equity withdrawal. By end-November 2004, bank mortgage interest rates had come down further to 4.15 percent, the same level as then offered by the HFF. Furthermore, possibly in response to increases in the HFF’s lending limits (and in part in reaction to the increased competition among themselves), in November banks started offering 100 percent mortgages, although on more stringent conditions. In particular, these loans can only be used to finance house purchases and cannot exceed ISK 25 million. There is also a more careful evaluation of the house buyer’s debt servicing capacity.9
12. As a result, mortgage lending and bank external indebtedness increased sharply in 2004-05. From August 2004 through May 2005, the domestic banking system extended almost ISK 220 billion in new mortgage credit to households. Still, mortgage lending by the HFF and pension funds shrunk markedly during the same period, suggesting that a significant share of banks’ lending has been directed to refinancing of older, less advantageous loans. While total lending by domestic banks had risen by approximately 47 percent year–on-year, total lending by all financial institutions, including the HFF and the pension funds, had increased by less than 21 percent during the 12 months through March 2005. Reflecting the rapid expansion by commercial banks in the mortgage market in the last year, foreign debt of these institutions has also continued to increase, amounting to more than 140 percent of GDP in 2004 and growing by 64 percent over the 12 months through March 2005.10 However, their foreign assets have also increased, with net external debt of domestic banks amounting to 74 percent in 2004.
Domestic Money Bank Credit
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.Domestic Money Bank Credit
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.Domestic Money Bank Credit
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.
External Liabilities of Deposit Money Banks
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland, Statistics Iceland.External Liabilities of Deposit Money Banks
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland, Statistics Iceland.External Liabilities of Deposit Money Banks
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland, Statistics Iceland.Savings Banks and Pension Funds
13. In addition to the commercial banks and the HFF, there are also some 24 savings bank, almost 40 pension funds, five investment banks, four investment funds, and two leasing companies in the Icelandic credit market. The build-up of the pension funds in particular has contributed a great deal to the development of financial markets in Iceland; in 2003, they held 27 percent of the stock of marketable bonds and 40 percent of housing bonds.11 In response to the entry of the commercial banks into the mortgage market in the fall of 2004, both the savings banks and the pension funds took measures to adjust to the new competition.
14. In December 2004, the HFF and the savings banks reached agreement on cooperation in the mortgage market, including mutual lending/financing and credit rating. As the commercial banks entered the market for first mortgages, HFF lost its distribution channel for its lending. Instead, HFF and the savings banks have started cooperating, with savings banks now providing the distribution channel for HFF first mortgages. In turn, savings banks are offering second mortgages on top of the HFF loans, up to a total of ISK 26 million (still subject to a loan-to-value ratio of 90 percent). So far, these loans have been offered at the same interest rate as the HFF first mortgages. As a result, HFF’s market share of new real estate purchase agreements, which had tumbled to 24 percent by December 2004, had risen to 72 percent as of end-April 2005. Furthermore, with households prepaying (at no penalty) their less advantageous HFF loans and refinancing at better terms (with the possibility of equity withdrawal as well) with the commercial banks, HFF has bought second mortgages from the savings banks with excess liquidity. However, there is no formal agreement on this financing, which may well dry up later on as prepayments to HFF slow.12 Lastly, the HFF and the savings banks also introduced a new free-of-charge on-line system for credit assessment in December 2004.13
15. The pension funds have also adjusted to the new mortgage market conditions. The pension funds are concentrated, with the two largest accounting for 33 percent of total net assets at end-2003, and the ten largest for 70 percent. Total pension fund assets amounted to over 37 percent of the credit system, mostly invested in government guaranteed bonds, housing finance, and loans to members. While mainly maintaining their cautious lending conditions, key pension funds have adjusted or scrapped their lending limits in Icelandic krónur in response to the entry of the commercial banks into the mortgage market. Also, mortgage rates, which are set at a fixed premium above HFF bond yields, have declined.14
Mortgage Bond Market
16. The Icelandic secondary bond market consists of government bonds, HFF housing bonds, and other bonds issued by other government agencies and private firms and institutions, including the banks. While the CBI used to act as the market maker for the HFF bonds, an active market-making program on the stock exchange now ensures sufficient liquidity for benchmark government bonds and the key housing bonds.
17. The bond market is dominated by indexed bonds carrying government guarantees. Most issues with maturities exceeding 5 years are linked to the CPI and the majority of bonds carry a government guarantee, including the housing bonds, which are the market’s most liquid assets. At mid–2004, housing bonds accounted for 82 percent of the Icelandic bond market. Yields have been high by international standards, even in real terms, fluctuating between 4–8 percent over the last decade, even though they have come down significantly over the last few years.15
18. Yields have continued to decline in the last year. A s result of the reforms at the HFF in 2004 (which significantly enhanced the efficiency of its mortgage lending financing) and the entry of commercial banks into the mortgage market (which implied enhanced competition and further access to lower-cost foreign financing), HFF bond yields have come down from above a real yield of 3.8 percent July 2004 to a current yield of about 3.6 percent. Yields dipped temporarily to close to 3.4 percent in mid–February, probably reflecting Standard and Poor’s upgraded rating for the Re public of Iceland’s and the HFF’s long-term foreign obligations.16 However, yields subsequently rose above 3.5 percent again, where they have since remained. Looking ahead, banks may eventually turn to the domestic bond market to finance their mortgage lending, potentially leading to upward pressure on bond yields.
25-year Housing Bond Yield
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.25-year Housing Bond Yield
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.25-year Housing Bond Yield
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.
HFF Bond Yields
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.HFF Bond Yields
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.HFF Bond Yields
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.19. a floor for the domestic bond market yields.17 There are concerns that pension funds might lose interest in the bond market if yields dip below this threshold. While such a high expected yield may have been warranted in the past, it may be more difficult to defend in the current environment with very low international interest rates. At the same time, the 3.5 percent real requirement applies to the average yield, with HFF bond yields constituting the lower end of possible returns. Pension funds are allowed to hold up to 50 percent of their assets in equity, which may be particularly attractive given the funds’ long planning horizon.
C. Housing Market
House Price Developments
20. Rising house prices in Iceland in recent years, in line with the developments in many other advanced economies, have contributed to the higher demand for mortgage lending. At the same time, the significant easing in mortgage market conditions in Iceland in 2004-05 further contributed to the upward pressure on house prices by allowing households to finance a larger portion of home purchases, facilitating in particular the purchase of housing for first-time buyers and for larger properties, and by lowering the cost of housing finance. The slowdown in housing construction in 2004 also contributed to the upward pressure on prices, as discussed further below. In May 2005, the 12-month increase in house prices for the country as a whole was 28 percent, compared with an increase of 7 percent in construction costs. Most of the increase took place in the capital area, where house prices rose by 18 percent over the first four months of 2005 compared with the same period last year, and for single-family homes, whose prices rose by 37 percent during the 12 months through March 2005; average house prices in the regions increased by 13 percent over the same time period.18
House Prices and Construction Cost
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
1/ Deflated by CPI.Source: Statistics Iceland.House Prices and Construction Cost
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
1/ Deflated by CPI.Source: Statistics Iceland.House Prices and Construction Cost
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
1/ Deflated by CPI.Source: Statistics Iceland.21. The sharp increase in house prices has spilled over to CPI inflation. Housing costs account for about 20 percent of the CPI in Iceland, more than in many other European countries.19 Furthermore, between August 2004 and April 2005, mortgage interest rates in the housing cost component of the CPI were based on 5–year moving averages, implying that the sharp fall in rates in the fall of 2004 was only partially reflected in the CPI. Instead, since May 2005, 12–month averages are used to calculate the impact of mortgage rates. In February 2005, 12–month inflation rose to 4.5 percent, above the CBI’s tolerance limit, prompting the Bank to issue a report detailing the causes and prospects for bringing inflation down again.20 After peaking at 4.7 percent in March (CPI excluding housing rose by 2 percent over the same period), inflation has since come down, reflecting in part the revised methodology for calculating average mortgage rates. As a result, 12–month inflation measured 3.5 percent in July 2005; excluding the housing component, inflation was only 0.1 percent during the same period.
Housing Construction
22. Housing construction has been reasonably responsive to rising house prices. After only modest housing construction in the second half of the 1990s, housing construction started taking off in 2001-02 following a considerable rise in house prices (in particular relative to construction costs). Housing construction has since accelerated, increasing by 13 percent in real terms and amounting to 5.5 percent of GDP in 2003; it currently constitutes about one fifth of total investment in the economy, even when taking into account the power-plant investments. In 2004, however, housing construction only increased by a preliminary 3 percent, compared with an expected 13 percent, in turn contributing to the upward pressure on house prices.21
23. In 2005-06, housing construction is expected to accelerate. Current forecast are for a 12 percent (or more) increase in 2005 given the strong income growth, falling unemployment, rising house prices, and easing mortgage conditions, and in light of the meager outturn in 2004.22 The projected strong increase in residential construction should have a dampening effect on house price increases, while at the same time, however, adding to the current investment boom and overheating.
D. Household Debt
24. After increasing continuously since the lifting of the widespread credit rationing in the 1980s and the subsequent liberalization of the domestic financial market, household debt rose exceptionally fast in 2003. Household debt increased by more than 15 percent in 2003, mainly reflecting the rapid increase in mortgage lending; at end–year, household debt was estimated at 178 percent of disposable income or 97 percent of GDP, up from 65 percent of GDP in 1995 and 14 percent at the beginning of the 1980s.23 Preliminary data suggest that household debt stood at 102 percent of GDP in 2004. Close to 70 percent of total debt is related to housing and therefore collateralized, and almost 90 percent consists of price-indexed loans.
25. Even though at these magnitudes Icelandic households are among the most indebted in the world, there has also been an increase in household assets. In particular, given the rising house and equity prices, and taking into account pension fund assets, the net worth of Icelandic households has increased and is broadly in line with the G–7 countries. Reflecting the large share of mortgages in household debt, owner-occupied dwellings remain the largest assets, or some 35 percent of total assets.24
Household Debt
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.Household Debt
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.Household Debt
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A003
Source: Central Bank of Iceland.26. Country-specific factors also account for the relatively high level of household debt in Iceland compared with other countries. To a large extent, the high level of debt can be explained by the high homeownership rate (83 percent), the well-funded pension system and accumulation of pension rights over the last two decades, and the young age of the population, which has been estimated to account for some 60 percent of Iceland’s large external liabilities relative to other countries.25 Also, debt in terms of disposable income will increase, ceteris paribus, the larger is the government sector.26
27. As a result of the rapid increase in household indebtedness, debt service obligations have also increased. According to CBI estimates, in the last few years total household debt service has increased to almost 40 percent of disposable income from about 15 percent in 1990.27 For comparison, household debt service in the United States was 13 percent of disposable income in 2003, which however also reflects the higher public sector income (and therefore lower disposable income) and higher homeownership rate in Iceland.28
E. Macroeconomic Concerns
28. The significant relaxation in mortgage market conditions in 2004 as a result of both reforms and easier lending conditions at the HFF and the entry of commercial banks into the market has come at a cyclically inopportune time. The Icelandic economy is currently characterized by strong demand and inflation pressures given the ongoing industrial investment projects. The already strong private consumption has only been further boosted by the enhanced availability of mortgage credit, which has allowed not only for lower interest rates and larger mortgage amounts but also for refinancing and equity withdrawal.
29. Lending growth in 2004-05 has so far been significantly faster than when the Icelandic economy began to overheat in 1998–2000. In the past, episodes of such excessive growth in Iceland have been followed by significant disturbances, including a surge in inflation, negative GDP growth, increased unemployment, and a worsened current account position. The international experience also points to the danger of very rapid credit growth potentially leading to banking sector problems further down the road.
30. Private consumption is expected to increase sharply in the next few years as a direct result of the easier mortgage credit. According to a study by the CBI in June 2004, an increase in the HFF’s maximum loan-to-value ratio to 90 percent would imply an additional increase in private consumption of 1.5–2 percent annually for the next three years. These conclusions were reached under quite cautious assumptions, also attempting to take into account the entry of commercial banks into the mortgage market.29
31. The very high levels of household debt may also give rise to systemic concerns. While short-term prospects are fairly stable given the low risk of negative income shocks with the large investment projects under way, looking ahead there may be reasons for concerns. In particular the possibilities of negative income effects as the investment projects are completed or of a sharp reversal in house prices (the “bursting of a bubble”), which could lead to collateral values falling below loan values, give rise to concern. Also, there are general concerns of deteriorating credit quality as mortgage loan limits have been relaxed. In fact, the number of unsuccessful attempts at collecting household arrears has apparently risen significantly in the last number of years, almost tripling since 1999, even though this may also be attributable to other factors, such as enhanced efficiency in collections.30
32. Looking ahead, for those households that do not have fixed interest mortgages, there are also interest risks. While most mortgages carry fixed interest rates, some do not. Two of the three banks that entered the mortgage market last year also issue mortgages with interest rates set for 5 years only, although so far, customers have apparently mainly preferred fixed-rate mortgages.31 As international interest rates return to more normal levels, domestic mortgage rates may also start to increase, adding on to households’ debt servicing burden.
33. There are also obvious concerns of spillover from mortgage market easing to house price inflation and CPI inflation, as discussed above. Still, some have questioned the impact of credit easing on house prices. In particular, while noting the short-term inflation concerns, the HFF has consistently down-played the impact of mortgage market easing on long-term house prices, instead stressing the importance of wage developments for the housing market.32
F. Role of HFF in the Mortgage Market
34. Given the Icelandic economy’s vulnerability to cyclical developments, the timing of reforms such as those at the HFF becomes an important policy tool. The HFF, as a public institution, should strive for coordinating its policies with other government policies, taking into account the cyclical position of the economy. Indeed, the planned reforms at the HFF were discussed in 2003, when the HFF noted that the main share of the relaxation in lending conditions would come into effect “when the expansionary impact of the approaching heavy industrial developments begins to ebb, and should thus play a role in maintaining stability in the Icelandic economy.” It was also noted that “ in fact, a basic prerequisite that the planned stages outlined in these proposals should not be introduced unless the objectives of stability are achieved.”33
35. However, in the event, the HFF reforms have materialized at the same time as the peak of the investment projects, adding fuel to an already over-heating economy. In order for the HFF to remain an important player in the mortgage market, the increase in the HFF’s loan limits in 2004 was moved forward in response to the entry of commercial banks into the mortgage market. Given these concerns, the cyclical considerations became less important.
36. Looking ahead, the recent developments in the Icelandic mortgage market provide an opportunity for reform of the HFF aimed at maintaining the benefits of the current system while also allowing for banks to remain profitably in the mortgage market. The entry of commercial banks into the mortgage market has been a positive development from a longer-term financial stability perspective. Holding a larger portfolio of first mortgages will help diversify banks’ balance sheets and stabilize their earnings provided this activity can be sustained profitably. However, this will not be the case if they are forced to compete directly with the state-subsidized HFF. Consequently, expeditious reform of the HFF is necessary, which should be guided by the following principles:
□ Banks and savings institutions should have access to funding that allows them to compete profitably for first mortgages;
□ The funding expertise that has been developed by the HFF should be fully utilized;
□ Economies of scale in funding should be retained so that Iceland receives the lowest possible cost of mortgage finance, and domestic bond markets remain liquid;
□ Competition in the retail mortgage market should continue to be strong; and
□ State support should be tightly focused on ensuring access to homeownership for those with low incomes, and those residing in remote regions of the country, where the presence of banks is very limited.
37. Such a reformed system could, for example, result in the HFF acting in the whole-sale market for mortgage financing. This would entail buying first mortgages from the banks, and selling them on to international investors in the shape of mortgage-backed securities.34 In such a scenario, with the HFF providing finance for private banks, it should not carry a government guarantee. Still, it should be able to receive a favorable international credit rating given the quality of the underlying pooled mortgages as well as the HFF’s built-up expertise in this area. Lastly, social lending should be more tightly focused on the needy than is currently the case, and could be channeled explicitly through the government budget.
G. Conclusions
38. In most countries, the rationale for the government to provide mortgage interest rate subsidies is to promote homeownership. In particular, subsidies are typically geared toward the most needy, such as low-income households and persons with disabilities, which may not have access to affordable housing financing in the private market. Meanwhile, in Iceland, the HFF implicitly subsidizes, through its access to government guaranteed borrowing, all households equally, despite very high per capita income and homeownership rate compared with most other countries. While the limited availability of affordable mortgage lending may have provided a justification for this generic subsidization in the past, this justification is no longer warranted given the entry of the commercial banks into the mortgage market, and banks’ enhanced access to the international capital markets.
39. The entry of domestic commercial banks into the Icelandic mortgage market has increased the soundness of the financial system. Indeed, with the entry of commercial banks into the mortgage market in 2004, as also recommended by the IMF’s Financial Sector Assessment Program on Iceland, the Icelandic capital markets have received a welcome boost of fresh international capital.35 Furthermore, banks are provided with additional domestic stability and profitability by allowing them to diversify their asset base. Also, banks will be better able than the HFF to undertake the necessary credit checks, which will become increasingly important as loan-to-value ratios increase.
40. Forcing banks to compete with the HFF may induce them to take on excessive risk. Looking ahead, commercial banks are likely to remain in the domestic mortgage market and will increasingly provide competitive alternatives to HFF lending. Meanwhile, forcing banks to compete with the HFF may induce them to take on excessive risk on the liability side.
41. These circumstances constitute a golden opportunity for expeditious and bold reform of the HFF aimed at maintaining the positive aspects of the current system, while also enabling banks to profitably remain in the market for first mortgages. Such reform should be based on the following principles. First, HFF’s funding expertise should be fully utilized, and the current economies of scale in funding and pooling of risks should be retained. Second, domestic financial institutions should have access to funding that allows them to compete profitably for first mortgages. Third, public housing support should be tightly focused on ensuring access to homeownership for low-income households and households residing in remote regions of the country.
References
Central Bank of Iceland (2004a), Monetary Bulletin, Vol. 6, no. 3, September, http://www.sedlabanki.is/.
Central Bank of Iceland, (2004b), Monetary Bulletin, Vol. 6, no. 4, December.
Central Bank of Iceland, (2004c), The Economy of Iceland, November.
Central Bank of Iceland, (2005a), Monetary Bulletin, Vol. 7, no. 1, March.
Central Bank of Iceland, (2005b), “Report to the Government on Inflation beyond the Tolerance Limit,” February 18.
Central Bank of Iceland, (2005c), Monetary Bulletin, Vol. 7, no. 2, June.
Economist Intelligence Unit, The (2005), “Iceland,” Country Report, London, April.
Federal Ministry of Finance of Germany (2005), “19th Subsidies Report of the Federal Government (Summary)—Development of Financial Aid and Tax Relief Measures of the Federal Government from 2002 to 2004.”
Housing Financing Fund (2002), “Annual Report 1999–2001,” http://www.ils.is/.
Housing Financing Fund, (2002-05), Monthly Reports.
Housing Financing Fund, “Process in Housing Finance.”
International Monetary Fund (2001), “Iceland: Financial System Stability Assessment,” Country Report no. 01/85, June, http://www.imf.org/external/country/.
International Monetary Fund, (2003a), “Iceland: Financial System Stability Assessment Update, including Report on the Observance of Standards and Codes on the following topics: Banking Supervision, Insurance Regulation, Securities Regulation, Payment Systems, and Monetary and Financial Policy Transparency,” Country Report no. 03/271, August.
International Monetary Fund, (2003b), “Iceland: 2003 Article IV Consultation—Staff Report,” Country Report no. 03/266, August.
Íslandsbanki (2005), “ÍSB Weekly—26 July,” www.isb.is/english.
Moody’s Investors Service (2004), “Housing Financing Fund,” November.
Moody’s Investors Service, (2005), “Housing Financing Fund,” March.
Organisation of Economic Co-operation and Development (2005), “Iceland,” Economic Surveys, February.
Republic of Iceland (1998), “Act on Housing Affairs,” no. 44, June 3, http://www.ils.is/default.asp?cat_id=18.
Republic of Iceland, (2005a), “The Icelandic Economy—Economic Outlook 2005–2010,” Ministry of Finance, no. 1, January 25, http://eng.fjarmalaraduneyti.is/Publications/EconomicOutlook/.
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Standard & Poor’s (2005), “Research Update: Republic of Iceland LT FC Rating Raised to ‘AA-’ On Better Financial Stability; Outlook Stable,” February 10.
Vilhjálmsdóttir, Hjördís Dröfn (2004), “Housing Support and Public Housing Funds in Iceland and Abroad,” in Central Bank of Iceland Monetary Bulletin, no. 4, pp. 53–65.
Prepared by Ann-Margret Westin
This section is mainly based on HFF (2002-05).
HFF (October 2004).
As the banks entered the mortgage market last fall, there were concerns whether they intended to stay more permanently or not. See e.g. HFF (November 2004).
The focus here is on the mortgage market. However, Iceland has one of the lowest levels of government support for homebuyers through the tax and welfare system compared with other advanced countries.
Even under the new system, HFF can add a marked-to-market requirement on prepayments in “extreme circumstances,” when the Fund’s “viability is in danger.” Apparently the HFF has still not exercised this option.
While this ruling has been appealed (no further decision has yet been made), it is likely that the initial decision will prevail as the complaint refers to the situation before banks entered the market when the HFF still was the key provider of first mortgages. However, if successful, the appeal could have a bearing on the focus of the HFF’s activities going forward.
Many banks confessed to the need to “park” its liquidity somewhere.
CBI (2004b). In the event, few mortgages have so far been issued with 100 percent loan-to-value ratios, with most banks issuing mortgages with an LTV of 70–80 percent at the most.
CBI (2004c).
Interestingly enough, given its excess liquidity, the HFF has also been extending loans to the commercial banks in the amount of some ISK 80 billion over the past few months, an activity which is not part of HFF’s core mandate but rather falls under risk or liquidity management (see Íslandsbanki, 2005).
See e.g. HFF (December, 2004).
E.g. the Commerce Pension Fund, the largest private pension fund, keeps some 20 percent of its portfolio (some ISK 20 billion at end–2003) in mortgages and only lends to members. Mortgage rates are set at 50 basis points above HFF bond yields. While the maximum loan-to-value ratio of 65 percent has been retained, the ISK 6 million lending limit was scrapped last fall, with the median mortgage now at ISK 7–8 million.
CBI (2004c).
Both ratings were increased from A+ to AA-; however, the HFF’s outlook was rated negative, in contrast to stable for the Treasury (Standard & Poor’s, 2005).
The 3.5 percent real yield must normally be applied for the actuarial assessments for discounting pensions and future premiums. Also, domestic fixed-income indexed bonds are discounted at a 3.5 percent real yield, irrespective of their book value.
CBI (2005a and 2005c).
The EIU (2005). At the same time, it may be argued that the Central Bank’s inflation target should exclude house prices, as does the European Economic Area’s Harmonized Index of Consumer Prices.
CBI (2005b).
These data are preliminary and may be revised later. Also, there were large regional differences in housing construction in 2004, with housing starts declining in the capital area compared with 2003 while rising sharply in the rest of the country in connection with the large-scale investment projects (Republic of Iceland, 2005b).
Republic of Iceland (2005b). The Central Bank projects an even stronger increase in construction in 2005, of more than 20 percent (CBI, 2005c). At the same time, the ongoing large infrastructure investments in Iceland may put a damper on other investment activities in the economy, including housing construction.
These data take into account the reclassification of household debt that was done in September 2003, when some ISK 93 billion, or 10 percent of household debt, was reclassified as corporate or municipal debt.
CBI (2004c).
IMF (2003b).
Also, in contrast with most other countries, disposable income in Iceland excludes interest payments, hence further reducing the denominator.
CBI (2004a).
Furthermore, leasing arrangements, which are not formally recorded as debt and therefore not included in strict definitions of debt service, are very common in the United States.
See CBI (2004b).
In addition to improved efficiency in handling such distraint actions, the steady decline in the average age of households (with younger households having not only less assets but also smaller debts) may in part help explain the increase in unsuccessful attempts at collecting household arrears (CBI, 2004a).
One of the banks only issues mortgages with 5-year reset clauses.
HFF (August–September 2003 and April 2004).
HFF (May 2003).
This would be in line with the situation in the United States, where Fannie May and Freddie Mac act in the secondary mortgage market.
IMF (2001 and 2003a).
