Nils Bernstein: Proposals for mortgage credit regulation
Speech by Mr Nils Bernstein, Governor of the National Bank of Denmark, at the annual
meeting of the Danish Mortgage Banks' Federation, Copenhagen, 30 March 2011.
* * *
Growth in the global economy has accelerated over the last year and has become more
robust. But recent events have, once again, shown how unpredictable the world is. The
turmoil in the Middle East - with an armed conflict in Libya - and the natural disaster in
Japan with its alarming consequences will not halt the global economic upswing, but they will
have an impact.
* * *
Combined with a number of other factors, the upswing has contributed to a global price hike.
Inflation is driven by rising food and commodity prices. Commodity prices are now almost
back at the high level seen before the financial crisis. It looks as if the crisis just led to a short
interruption of an upward underlying trend in commodity prices.
With higher inflation, the level of interest rates is likely to normalise sooner than the markets
have previously expected. The anchoring of inflation expectations is important if the higher
prices are not to spill over to wages and trigger a price-wage spiral. The European Central
Bank has stressed its commitment to keeping inflation at bay, and there is reason to believe
that an undesirable price-wage spiral can be avoided, as long as there is plenty of spare
capacity and labour.
The financial crisis and not least the European sovereign debt crisis have clearly shown that
there is a need for stronger economic cooperation in the EU. And so far the EU has been
ready to respond to this need. The first important step was taken in the autumn, when the
Commission and the Van Rompuy task force presented their proposals for strengthening the
Stability and Growth Pact and other aspects of economic cooperation. The member states
have now agreed on a series of amendments to strengthen fiscal discipline and - as a new
element - introduce a surveillance mechanism to prevent fundamental macroeconomic
imbalances in EU member states, including those outside the euro area.
The second important step was taken on 11 March, when the heads of state or government
of the euro area member states agreed on the Euro Pact. The pact is first and foremost a
strong political signal of shared determination to introduce initiatives to strengthen
competitiveness, employment, fiscal discipline and financial stability. As a non-euro area
member state, Denmark did not have to join the Pact. At Danmarks Nationalbank we are
pleased to note that there was broad support for doing so in the Danish parliament,
Folketinget. But I should add that words must always be followed by action if the Pact is to
have any value.
The third important step is the agreement to establish a permanent crisis resolution
mechanism - the European Stability Mechanism, ESM. This debt-financing mechanism is to
be established for euro area member states from mid-2013 and will replace the temporary
financing mechanism for euro area member states in sovereign debt difficulties. Together
with IMF funding and possibly bilateral contributions, the ESM will help to ensure adequate
responses to future sovereign debt crises. An important element of the plan is that the ESM
will offer loans only if macroeconomic stabilisation programmes are implemented at the same
time, imposing stringent economic policy obligations on the recipient member state.
Danmarks Nationalbank welcomes these improvements of the framework for economic
cooperation. Since our currency is closely tied to the euro, Denmark will benefit from
operating within the same overall economic framework as the euro area member states,
thereby contributing to robust economic cooperation in the EU. But the strength of the
cooperation can only be put to the test in practice.
The need for stronger economic cooperation is reflected in the different economic situations
of the individual EU member states at present.
The best-performing member states are characterised by a long period of moderate wage
inflation relative to productivity developments, as well as balanced public finances. Germany
and Sweden are cases in point. It is also worth noting that these two member states did not
have housing bubbles that burst.
At the opposite end of the scale we find a group of member states with large sovereign debt
problems and sagging competitiveness. Their large government budget deficits and external
deficits as well as their high government debts reflect that consumption and investment have
been exceeding output for a long time. This can continue for a while, but naturally it is not
sustainable in the long run. Consumption and investment have been driven by factors such
as rapidly rising house prices that subsequently plummeted.
Denmark is probably somewhere in between these two extremes.
For the last 5-6 years, the Danish economy has seen an excessive boom followed by a deep
recession that we are only slowly working our way out of.
In the wake of the crisis, the private sector has been consolidating strongly. Corporate
investments are low compared with earnings, and over the last 18 months private
consumption has increased far less than disposable incomes. This means that consumption
as a ratio of disposable incomes is low by historical standards. Real disposable incomes are
likely to grow at a much slower pace in the coming years, but nevertheless we expect private
consumption to increase somewhat, so that the consumption ratio will approach its normal
level. We also expect a certain increase in private investment as firms benefit from rising
demand, both at home and abroad.
Based on the above, Danmarks Nationalbank expects growth in Denmark to be just under
2 per cent p.a. this year and the next few years. This is slightly higher than the expected
growth rate in the euro area, and also higher than the underlying growth in Denmark's output
potential. As a result, net unemployment is set to decline slowly towards its structural level of
around 100,000. Structural unemployment is the level of unemployment that is sustainable in
the long term and that is compatible with low and stable Danish inflation in line with that of
the euro area.
Although the loss of output was unusually large during the crisis, unemployment was so low
at the outset that net unemployment has not risen much above its structural level after the
crisis. Furthermore, as I have already mentioned, the economy is set to grow at a solid pace
by Danish standards in the coming years.
We can also see that the European sovereign debt crisis has made international investors far
more aware of whether individual countries are pursuing responsible fiscal policies.
That is why Danmarks Nationalbank repeatedly urges the Danish government to maintain the
tight fiscal policy planned for the coming years. We do not need any new stimulus packages
at the moment. If, contrary to expectations, the international economy goes into reverse
again, it would be sad if Denmark uses up all its fiscal policy room of manoeuvre right now -
at a time when the economy is actually moving forward.
If our expectations are exceeded, it would not be good to have exploited the scope for growth
beforehand. In that case the risk of renewed overheating would be imminent.
* * *
Denmark experienced strong cyclical fluctuations in the last decade. They were not only
attributable to the international financial crisis, but were to some extent self-inflicted. Partly
because fiscal policy had been eased during the boom, and partly because we have
introduced a number of housing market structures that amplify rather than dampen cyclical
fluctuations. These include the freeze on property value tax in kroner and the development of
new loan types, notably loans with deferred amortisation. They are also known as loans with
payment holidays. Since more than half of all mortgage loans are now with deferred
amortisation, the holiday has almost become permanent.
The freeze means that the effective property value tax declines in a boom when house prices
go up. On the other hand, it cannot decline when house prices go down. Analyses in
Danmarks Nationalbank's most recent Monetary Review (English version to be issued) show
that price fluctuations can be dampened if the property value tax is, once again, allowed to
move in parallel with house prices.
Our analyses also indicate that home buyers to some extent see amortisation of mortgage
loans as an expense in line with, say, interest and housing taxes. So the use of
deferredamortisation loans amplifies fluctuations in house prices. If prices go up, loans with
amortisation entail a larger increase in overall payments to service the loan compared with
deferred-amortisation loans. The higher costs dampen the demand for housing and curb the
price rise. Conversely, if house prices fall, loans with amortisation entail a larger decline in
the payments compared with deferred-amortisation loans. This stimulates the demand for
housing and helps to buoy up the market. In other words, loans with amortisation help to
stabilise house prices. This favourable effect is lost as deferred-amortisation loans gain
ground. Our analyses show that deferred-amortisation loans have contributed more to the
fluctuations in house prices than the freeze on property value tax.
To dampen the strong fluctuations in the housing market, Danmarks Nationalbank has
suggested that the link between property value tax and property value should be
re-established and that access to new deferred-amortisation loans should gradually be
phased out.
There have been widespread concerns that our proposals could be detrimental to the
housing market. On the contrary; the aim is to increase stability and provide a bulwark
against excessive fluctuations in both directions. As for the potential problems in connection
with the transition to a more stable system, I would like to emphasise two factors.
Firstly, our proposals do not affect existing deferred-amortisation loans. We simply suggest a
gradual and gentle lowering of the threshold for new mortgage loans with deferred
amortisation.
Secondly, we do not propose restoring the property value tax to the somewhat higher level
applying before the tax freeze was introduced in 2002. That is another issue - which I will not
discuss here.
We are merely suggesting that further erosion of the property value tax should be prevented
by letting taxes match developments in property value in future. This could act as an
automatic stabiliser. If interest rates suddenly begin to rise unexpectedly, pressing house
prices down, our proposal means that the property value tax automatically decreases, and
this will dampen the price fall.
The stabilising effects of these proposals would provide considerable gains for the economy.
That would also be in the interests of homeowners. If our proposals are rejected, we would
like to hear other suggestions for preventing large future fluctuations in house prices that
could jeopardise economic and financial stability.
* * *
Both internationally and in Denmark economists are discussing the lessons to be learned
from the financial crisis, and the future regulation of the financial system in the light of this
experience. As I see it, an artificial distinction is being made in Denmark. In simplified terms
you could say that there is broad understanding that the requirements for banks must be
tightened. In contrast, there seems to be little understanding that the same could apply to the
activities of mortgage banks. In my opinion, we also need to focus on mortgage credit.
Danmarks Nationalbank's proposal to phase out deferred-amortisation loans and realign
property value tax is one response to the lessons learned from the financial crisis. It can also
provide part of the answer to another important question: how do we ensure the underlying
collateral of covered bonds if house prices fall? I have previously pointed out that the need to
provide additional collateral in that situation could have a destabilising effect, and I have
encouraged the Ministry of Economic and Business Affairs to look into the issue. The
problem is that mortgage loans granted on the basis of covered bonds cannot exceed 80 per
cent of the value of the home. If the price falls so that the total mortgage exceeds 80 per cent
of the value, the mortgage bank must raise additional collateral to bridge the gap. A
permanently lower loan-to-value ratio for mortgages would directly address this issue, but as
you know, it was not possible to muster support for this solution when covered bonds were
introduced.
Slow and gentle phasing-out of deferred-amortisation loans would help to solve the problem,
as falls in house prices would be cushioned and the mortgages would gradually be repaid,
thereby reducing the risk of conflicting with this rule. We need mechanisms that will
automatically support compliance so that it will not be necessary to issue new debt
instruments at a time when house prices are falling. But I am open to other suggestions. You
just have to remember that money is most difficult to come by when you need it the most.
* * *
Let me now turn to the popular adjustable-rate mortgage loans. Variable-rate loans can
actually help to stabilise the economy, provided that the Danish economy is moving in synch
with that of the euro area. In that situation we will "import" euro area interest rates, which will
fit in well with economic developments in Denmark. But if we are at another cyclical stage, it
is, of course, important for fiscal policy to compensate for this.
For a number of years, variable-rate loans have meant lower expenses for homeowners. The
more widespread use of these loans make households more vulnerable to rising interest
rates. If the yield on the bonds used to finance adjustable-rate loans rises, homeowners must
foot the bill - even if the increase is extraordinarily high, perhaps in connection with a
currency crisis. It is very important that homeowners are aware of this risk and have taken it
into account in their budgets. I have the impression that most households will be resilient to
the rise in interest rates resulting from ordinary cyclical developments.
What concerns me most about adjustable-rate loans is their inherent refinancing risk.
Mortgage banks offer 30-year loans financed via short-term bonds - often with annual
refinancing. Another lesson learned from the financial crisis is that there is a real risk that
these markets will stop functioning at times, or that interest rates soar to extraordinary levels.
I have already said on several occasions that it is a good idea to spread the auctions, and I
would like to acknowledge - once again - the initiatives taken in this respect. I strongly
encourage all mortgage banks to follow suit.
Refinancing risk is part of the product design. This is the risk that the forthcoming regulation
on stable financing is addressing - and should address. The details are not in place yet, but
it is planned to take effect in 2018. This will require major structural adaptations that cannot
be achieved overnight. The mortgage-credit market is like a super tanker. It takes time to
change the course and gradually adapt, so preparations must start well in advance.
Mortgage banks should already begin to develop products that will adequately address the
issue of refinancing risk.
I have also made it clear to the financial institutions that use of Danmarks Nationalbank's
lending facilities is not an acceptable solution for managing refinancing risk. I take this
opportunity to repeat that message. Securities should only be pledged as collateral to
Danmarks Nationalbank in connection with ordinary monetary-policy operations. If we find
that the system is being misused to support the housing market, we will take action and
perhaps have a friendly talk with the institution in question. We have done that before.
Eligibility as collateral must not be a precondition for a given mortgage-credit product.
* * *
Today I have presented a number of proposals for regulating various issues in relation to
mortgage credit in order to make the system more resilient to future developments. The
financial crisis has demonstrated that rare misfortunes do actually strike from time to time.
This should be taken into account in financial regulation. This applies not only to banks - but
also to mortgage banks.
Finally, I would like to thank the Federation for our good cooperation during the past year and
for inviting me to speak at today's meeting.
Thank you for your attention.