Eva Srejber: Future issues for the housing market in Sweden against the
background of Basel II
Speech by Ms Eva Srejber, Second Deputy Governor of the Sveriges Riksbank, at the annual meeting
of the Swedish Association of Municipal Housing Companies (SABO), Taeby, 8 January 2002.
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Introduction
I should like to begin by thanking you for the invitation to come here and the opportunity to discuss this
evening's theme of future issues for the housing market.
At the beginning of May 2001 I gave a talk to SABO Byggnadsförsäkrings AB on the property market
and economic trends in Sweden. I then took up the question of why and how the Riksbank monitors
the property market. The focus for this evening will be on what the future may hold for the property
market and granting of credit for the purchase of property and housing. My talk should therefore be
seen (and heard) as a complement to, or continuation of, my earlier talk.
My talk this evening will primarily deal with our view of the housing market and the role it plays with
regard to financial stability and potential growth. I will then go on to describe the credit granting
process and current changes that will affect this process. I will conclude with a look towards future
developments.
The role of the housing market for financial stability and potential growth
Let me begin, however, with brief description of the housing market from the Riksbank's perspective.
Those who wish to go into this subject in more depth can read our most recent Financial Stability
Report. As we know, the property sector consists of two parts: the housing market and the commercial
property market. The Riksbank studies the property sector for two main reasons. One reason is that
property companies comprise the largest individual borrowers from the banking groups -
approximately 15 per cent of the banks' lending is to property companies. Properties are also the
dominant form of collateral for loans. Loans with property as collateral comprise almost 50 per cent of
the bank's lending against collateral. The health of the companies in the property sector therefore has
repercussions for financial stability.
The growth rate for credit has remained at an average level of just over 6 per cent a year for the past
four years, which exceeds annual GDP growth by a few percentage points. It could be considered
cause for concern to have a higher growth in credit than in fundamentals, i.e. GDP, and it is easy to
recall developments at the beginning of the 1990s, but since then there has been a change in the
focus of monetary policy and fiscal policy towards macroeconomic stability. At the same time, the
effects of earlier as well as new structural reforms, such as the tax reform, the pension reform and
deregulation, have also contributed to the Swedish economy becoming less sensitive to disturbances
now than it was in the 1980s. In addition, the experiences of the financial crisis have also led to a
change in behaviour in the financial sector. The financial situation appears stable and the banks'
increase in lending is not so high that it can be interpreted as greater risk-taking in the financial sector.
Approximately SEK 420 billion of the total lending by mortgage institutions comprises loans to
purchase apartment blocks. This is a large percentage, almost 40 per cent of the total lending by these
institutions. However, the figures on lending during the 1990s show that both the percentage and the
volume of lending in this area is declining. Statistics provided by the mortgage institutions with regard
to gross flows of loans for various purposes with apartment blocks as collateral confirm this picture. In
1991 new building was the reason for most of the lending, while renovation and extensions accounted
for only a minor part. During 2001, on the other hand, new building accounted for a small part,
renovation and extensions for even less, while the largest percentage was for other purposes.
Why is this? Naturally, it is related to the way the sub-markets function. The market for single-family
dwellings functions well with buyers and sellers agreeing on a market price when houses are sold.
Once a single-family dwelling has been built, the market functions well without any major disturbances
from restrictions or regulations.
The market for apartment blocks, on the other hand, is more complex, as it is affected by a number of
different regulations and restrictions. This has led, for instance, to the relationship between rents and
prices in this market not being stable. Normally, there should be a connection between the
development of prices and rents for apartment blocks, as the future cash flows that constitute the
basis for the valuation of the property are primarily governed by rent income. However, the statistics
regarding prices and rents for apartment blocks show that the rise in prices of apartment blocks has
been clearly higher than the rises in rents since 1995. A similar development took place between 1987
and 1990, although the price rise was much more rapid then. The price increase at the end of the
1980s was driven by expectations of future price rises. Regulations in the form of the utility value
system and central rent negotiations provide modest changes in rent every year. The changes in rents
do not vary substantially in connection with economic activity and demand. These regulations may
have a stabilising effect on the property sector in that they stabilise income flows, given that the
vacancy rate for housing is low and does not vary. Stable income flows are a good thing from the
lender's perspective.
Do these regulations cause any problems? I can see two main problems, which I shall discuss. The
first is that price formation for rental properties in relation to tenant-owned properties is distorted,
which means that the stock of tenant-owned apartments may come to comprise an overly large part of
the total apartment stock. This could be negative for growth, as it could mean that, for instance, young
people and other groups with a shortage of capital may experience difficulty in entering the housing
market and moving to where the jobs are. Prices of apartment blocks are largely governed by prices
for tenant-owned apartments, as apartment blocks are currently sold most often in connection with a
changeover from rental property to tenant-owner associations. This means that as long as the utility
value principles apply for apartment rents and prices for tenant-owned apartments remain high, the
difference between the development in rents and prices will remain. As the utility value system limits
the income a rental property can generate, the market value of rental property is also limited, and both
the owner of the rental property and the future tenant owners profit if the property is transferred at a
price somewhere between the market value for rental properties and the market value for
tenantowner apartments. Despite the fact that prices for tenant-owned apartments have fallen slightly, the
difference between the price of apartment blocks sold to tenant-owner associations and the price of
rental properties indicated by rent levels. One explanation could be that when property owners sell
rental properties for conversion to tenant-owner associations, they take a larger part of the price
difference between the two property types.
While the utility value principle has certainly contributed to an evening out of rent levels over the
economic cycle, it has also contributed to making it more profitable to allow apartment blocks of rented
apartments to be converted to tenant-owner apartments than to sell them to another owner and
continue to run them as rental properties.
The second problem is that the regulation of rents, in connection with a number of other institutional
factors, is holding back new production of rental properties where there is a demand for housing. The
way prices on apartment blocks develop in future will depend on the supply and demand situation, as
well as on regulations. The total growth in demand is steered mainly by population growth, while the
distribution of demand around the country is steered by where growth occurs. In general, housing
construction has been much lower during the 1990s than in previous decades. According to the
National Board of Housing, Building and Planning's most recent nation-wide forecast for the number of
apartments in apartment blocks where construction has begun, just under 11,000 apartments had
been started last year and just under 13,000 will be started this year, from a level of just over 9,000 in
2000. This can be compared with almost 42,000 new apartments in apartment blocks begun in 1990,
immediately prior to the property crisis. Residential construction of apartments in apartment blocks in
relation to the population increase has been lowest in Stockholm county, followed by Skåne county
and Västra Götaland county.
One ray of hope is that the number of building permits granted for apartment blocks is continuing to
increase, which indicated a continued increase in new production of apartment blocks. Factors such
as regulated rents for rental properties, i.e. the utility value system, a lack of land with planning
permission in growth regions, the construction of the municipal tax equalisation system, the imbalance
between traffic situations and housing in growth regions and long planning processes probably all
contribute to the relatively low level of residential construction, even in areas where demand is high. A
further restriction is the lack of competition in the construction sector. This is demonstrated in the
developments in prices and wages in the sector. Construction workers' wages have increased more
than those of industrial workers in recent years. Another example is that the costs of construction
materials, which constitute approximately one-third of total construction costs, have shown price
increases over and above other industrial products for some time now, with price rises even during
periods of low demand. One important explanation for this is the fact that the construction trade is
concentrated to a small number of large companies. In some markets, for instance, those for cement,
reinforcement steel and plasterboard, one company accounts for more than 50 per cent of total sales.
This can mean that utility value rents do not cover total production costs in growth regions where land
and construction costs are relatively high.
It is evident that the total regulatory framework does not contribute sufficiently to ensuring that supply
follows demand.
The low level of construction and the high level of immigration to metropolitan regions contribute to
prices in the market for apartment blocks being relatively little affected by the current lower level of
economic activity. Property companies' earning capacity should thus be relatively stable, which is
positive from the point of view of both the company owners and creditors. However, the weak level of
residential construction has led to sluggishness in the housing market. The fact that it is possible to
move between residential areas and between regions stimulates mobility among the labour force and
flexibility in the functioning of the labour market, which affects economic developments. A clear
example of this is the Stockholm region, which has a housing shortage. This has probably led to a
lower growth for the Stockholm region than would have otherwise been the case. As 25 per cent of
Sweden's economy lies in Stockholm, this affects the entire country's growth potential. A housing
sector that does not function properly will thus affect the country's potential growth, as it will become
more difficult for labour to move to where the jobs are. For this reason, it is in my opinion important
that a review is made of the total complex of regulations governing the functioning of the housing
market, in order to allow it to function better. From the Riksbank's point of view, a higher potential
growth means that demand in Sweden can be higher at the same time as price stability can be
maintained.
The credit granting process
If the housing market can become more flexible, it will enable new construction where housing is most
needed. These new investments will need to be financed. It is therefore important to be aware of the
professionalisation of the credit granting process that has occurred within the financial institutions
following the bank crisis. This is reinforced by the new capital adequacy rules that are being worked
out. The modern credit granting process focuses more on the individual borrower's cash flows. This
individualisation means that the interest paid will to a greater extent reflect the market's valuation of
the profitability of the individual object, e.g. a particular property.
Does the banks' setting of interest rates vary between different borrowers and credit objects? How is
credit granted today? How do the banks assess a loan application? I shall not explain these processes
in detail, but outline the most important elements. Credit granting is part of the banks' core business. It
involves mediating savings to borrowers. As managers of our savings, the banks have always needed
to be able to assess, measure and manage the risks inherent in these operations. The four major
banks regularly monitored by the Riksbank have similar procedures with regard to granting corporate
loans. The bank assesses the risk in a particular loan on the basis of two aspects: the customer's
ability to repay and the collateral that can be offered. The customer's ability to repay is the more
important of these two aspects. For obvious reasons, loans without collateral are assessed more
stringently. The fact that the banks now focus more on the ability to repay than on the value of the
collateral is a lesson learned from the bank crisis in the 1990s.
Before a loan is granted, it is necessary to assess the risk of default in the form of a suspension of
payments or bankruptcy. This means that the banks consider stable cash flows to be more interesting
than whether a project can provide a higher yield than expected. On the basis of the bank's
assessment, the borrower is assigned a risk classification. This classification contains both
quantitative and qualitative factors and the risk grade is reviewed annually. The quantitative analysis is
based on the company's profit and loss statements and balance sheets, while the qualitative analysis
is based, for instance, on the company's competitiveness and the quality of its management. When
making the decision to grant a loan, the assessment of the customer's ability to repay is supplemented
with information on the specific loan, for instance, the amount of the loan and the collateral the
borrower can offer against the loan. The most common form of collateral is mortgage deeds, but other
types of collateral do exist. In addition to these internal assessments, the banks may supplement their
analysis with external credit assessments. There are some independent external credit assessment
companies in the market. These use various means to estimate, for instance, the likelihood of
bankruptcy in almost all Swedish companies.
The risk involved in a loan can also be affected by the terms of the loan agreement signed by the bank
and the customer. This is because the loan agreement can contain certain clauses entailing specific
measures to be triggered in the event of various credit events. Examples of such events could be that
the company's solvency falls below a particular predetermined level or that the owner conditions
change. If one of these events occurs, it may comprise grounds for renegotiating the loan agreement.
The starting point for the banks' pricing is an overall assessment of the customer. This means that
pricing is not solely dependent on the bank's risk classification of the loan, but also on the other
income the customer may be expected to provide. What the banks lose on the swings, they may
regain on the roundabouts. The banks' pricing can take into account risk classes and collateral, but
there is not always a direct connection between prices and risk classes. However, developments in
regulations and on the capital market favour a stronger connection between interest rates on loans
and risk classification of the borrower.
The banks' credit assessment procedure is not a static process. The major Swedish banks currently
have well-functioning organisations, methods and systems for assessing loans and managing credit
risk. Developments in financial theory and rapid advances in IT over the past decade have created
new and improved conditions in this field, and the banks have made good use of this.
As a borrower it is important to be aware that the individualisation in the modern credit granting
process has also been taken up in the shaping of the new capital adequacy rules, where it will be
possible to price loans more fairly.
Why do we have capital adequacy rules? As the banks play such a central role in the payment system,
and the costs of disturbances in the system and in the credit market would be very large and have to
be borne not only by the borrowers and lenders, but by society as a whole, the banks have long been
subject to scrutiny and oversight with regard to their risk-taking. Since 1988 we have had an
international agreement, the Basel Accord on capital adequacy rules. This involves, in simple terms,
regulations as to how much capital a bank must hold with regard to different borrower groups for each
hundred krona it lends out. It is much more costly for the banks to finance themselves by holding their
own capital than through borrowing, just as for other companies. A higher capital adequacy
requirement for taking bigger risks will thus lead to the banks being forced to charge more for lending
money to higher risk borrowers. This is a regulatory system that is used by 120 countries and it
contributes to financial stability around the world.
However, the current capital adequacy rules from 1988 are divided into 4 fairly rough risk classes,
which do not very well reflect the risk with various borrowers. For instance, the risk classification
means that all companies are in the same risk class, despite the fact that they can differ markedly from
one another. There has therefore been intensive work on further developing these rules by the Basel
Committee, in which both the Riksbank and Finansinspektionen (the Swedish financial supervisory
authority) participate.
The idea with the new rules is that the risk weighting will better reflect the actual credit risk. This
means that the banks will become more thorough in assessing the relationship between the risk in the
credit and its yield. An increased risk will therefore be marked in the banks' pricing of loans, i.e. the
interest rate. There are both advantages and disadvantages with the proposed capital adequacy rules.
The proposed rules mean that the banks must hold more capital if the risks in their given loans
increase. If they do not have more capital than the rules require, they must either acquire more capital
or reduce the risks in their lending. In this type of situation, the bank may choose not to renew loans,
which could have extremely negative consequences for the borrowers. The new rules thus risk
reinforcing the sequence of events. However, there are many positive consequences; a more sound
and individual risk assessment, which will better protect savings and reduce the risk that taxpayers,
through the central government, will have to step in, opportunities for cheaper loans to borrowers who
constitute a low risk but also increased interest rate costs for companies that are high risk. A fairer
pricing of loans, in other words.
Unlike shares, where it may be considered exciting to take risks and hope for a high return, boring
loans are cheap loans for borrowers. By this I do not mean that loans for apartment blocks are boring,
but they are normally considered stable and durable. Characteristic for loans is a small expected profit,
but with the low risk of very large losses. Loans that cost a low interest rate are therefore slightly
boring loans with stable cash flows that generate stable interest payments and regular repayments, in
other words, low risk.
So how will the new capital adequacy rules affect loans and credit granting to public utilities
companies? A first reflection is that the banks will study credit objects and the companies concerned in
a more individual manner than before. A second thought is that the banks, when pricing loans, will look
at the cash flow from the loan, which in this case can be equated with the company's cash flow. In
most cases, your companies have a large value in their properties as collateral and this will continue to
be a positive thing for you, but as I said earlier, the banks today focus firstly on the customer's ability
to repay and then on the collateral offered.
What is important to a company that has loans?
• Meticulous balance sheets and profit and loss accounts for the present time and going back
a number of years.
• Low vacancy rates in the housing stock and rents that are paid on time.
• The banks will not merely evaluate the size of the cash flows, but also their stability.
• Orderly and well cared for property stock, i.e. property management is important.
It is therefore important to have good knowledge of the bank's actions and method of working. The
difference in interest rate between borrowers of varying risk classes will be greater in future than it is
today. It will therefore be important for companies applying for loans to present themselves as
attractive borrowers to the bank or the capital market. If they want a low interest rate on their loans as
a result of their negotiations with the bank, it is important to be able to demonstrate a company that
has been stable and well managed for a number of years. The proposed changes in the capital
adequacy rules will apply with effect from 2005, but developments in the capital market could very well
lead to the banks' credit granting being adapted gradually to the new rules in advance of their
introduction. It is therefore important for capital-intensive operations to prepare now for a more
individualised credit assessment in future. The opportunities for finding competitive financing on the
loan market at a low interest rate will be available to those who can convince lenders that their
operations will generate stable future income. Higher risks, e.g. in the form of varying income flows will
cost more.
Looking towards the future
I can see two important issues for the industry to consider for the future. The first is the financing of the
new construction that is needed, where the effects of the modern credit granting process and the new
capital adequacy rules will affect SABO's operations. It will be a sensitive issue for housing companies
in municipalities with high vacancy rates and declining populations, particularly in the light of your own
report issued just before Christmas. Previously, municipalities and municipal operations with municipal
guarantees have been able to obtain loans on improved terms. In addition to the property as collateral,
a municipal housing company has been able to use the municipality's guarantee as collateral. In
future, it is not so certain that this will lead to improved loan terms to the same extent as now. For one
thing, the municipality's credit rating could fall because it takes on another large credit commitment,
which would lead to higher loan costs for both the municipality and the housing company. For another
thing, there are some credit providers who have already ceased granting loans to municipalities with a
poor ability to repay. This situation will probably be accentuated by the advent of the new capital
adequacy rules, with more individual assessments of each borrower. Given this, it will be even more
important to consider the four points I mentioned earlier.
The other important issue is to implement a review of housing policy, as it is important to obtain the
construction needed in the regions where jobs are available. This will enable Sweden's economy to
develop well. One example of possible changes is the introduction of market-adapted utility value rents
or the complete disappearance of the utility value system.
It is possible that more market-adapted rents would contribute to increased production of new
properties as a result of increased demand, unlike the current utility value regulated rents where
increases in demand do not result in sufficiently large new production of apartment blocks of rental
apartments in growth areas. It is often said that a changed, market-adapted system would lead to
higher rents, but the question is whether this scenario would not only apply to the more attractive
residential areas of the metropolitan regions and university towns. There are currently approximately
22,000 apartments vacant throughout the country and scenarios indicate that the vacancy rates in
certain areas may increase further. What would market rents involve for areas in Sundsvall, Karlskoga,
Boden or Bergsjön in Gothenburg? Would the rents in a market-adapted system be reduced in these
areas to be able to compete with the single-family dwelling market? Yes, that is possible, but the
question is whether the vacancies would be filled in all of the "emigration" regions? It would probably
only apply to regions within commuting distance of jobs. However, if market rents and other changes
in the regulations may mean that housing is built where it is needed, which will enable the labour
market to function better, this could in any case improve Sweden's potential growth.
There are indeed a number of important future scenarios that need to be considered by both the
housing companies themselves and the banks as lenders.