Nils Bernstein: Developments in the Danish economy and
mortgagecredit system
Speech by Mr Nils Bernstein, Governor of the National Bank of Denmark, at the Annual
Meeting of the Danish Mortgage Banks' Federation, Copenhagen, 29 March 2012.
* * *
Thank you for inviting me to speak here today.
The global economy weakened in the 2nd half of 2011, chiefly as a result of the debt crisis in
several European countries. Euro area GDP fell in the 4th quarter, but data releases point to
stabilisation.
In the USA there is moderate growth and recovery in the labour market. Euro area
unemployment continues to rise, masking considerable differences across member states. In
Germany unemployment is falling.
Inflation has declined as previous increases in energy prices have dropped out of the
yearon-year statistics, but recent oil price rises pose a risk in this connection.
Yield spreads to Germany have narrowed following the most recent measures taken by the
European Central Bank, as well as further steps to tighten fiscal policy and introduce
structural reforms in the countries with the highest debts.
The growth outlook is subdued. The latest consensus estimates and forecasts from the
international organisations operate with a slight decline in euro area GDP in the first part of
2012, while other advanced economies are expected to post moderate growth rates. Strong
fiscal consolidation is underway in Europe in order to restore confidence in public finances
and create a basis for sustainable growth. In contrast, monetary policy is highly
accommodative and supports economic activity in all advanced economies.
The autumn was weak. The Danish economy virtually moved sideways, reflecting factors
such as falling public consumption, and expectations were formed in the shadow of the
European debt crisis. However, the situation now seems to be improving somewhat.
Our most recent forecast operates with output growth of just over 1 per cent this year. That is
not impressive, but it is higher than the growth expectations for the euro area.
The recovery is primarily expected to be domestically driven.
For some time, households and firms have been consolidating strongly. In the case of the
households, this reflects value losses on e.g. houses and equities, as well as the
employment situation. Firms, on the other hand, have been hesitant to invest, so that
business investment has reached a very low level.
Given the high savings ratio, wealth will, at some point, reach a level that the households find
suitable in view of the losses they have had. Normalisation of the low consumption ratio
could potentially lead to considerable growth since private consumption accounts for around
half of total demand.
Another reason why I believe we can say that the Danish economy is now slowly picking up
is that the fundamental balances are sound. We have a large current-account surplus and a
relatively strong labour market. Structural unemployment is low - and only slightly below the
current rate of unemployment. Interest rates are historically low and underlying prices are
stable.
On the other hand, house prices have, on average, dropped by 20 per cent since the peak in
2007 and fell by 8 per cent in 2011. Turnover is low despite the historically low interest rates,
and the market seems to be in a deadlock. Given the current interest-rate and income levels,
house prices should, in Danmarks Nationalbank's view, not be as low as they are at the
moment. Price falls may be self-reinforcing if buyers hesitate, expecting prices to come down
even further. So it is difficult to say exactly when the market will turn, but experience from
both Denmark and abroad shows that once the market begins to recover, it could move fast.
An important factor behind the large fluctuations in house prices seen since the mid-2000s is
the structure of housing taxes. If the property value tax in nominal terms is frozen, as it is
now, the effective taxation rate declines when prices go up, and vice versa. Combined with
deferred-amortisation loans, this has contributed to stronger fluctuations in house prices. The
same applies to the cap on the increase in land tax. As a result, tax on the large increases in
value seen during the boom is being phased in now, when prices are falling, making the
decline even stronger.
As regards property value tax, the solution is, in principle, simple. Freeze the rate of taxation,
not the amount in kroner. With the current outlook for the housing market, this will not lead to
higher taxes right now. But more appropriate housing taxes will help to dampen fluctuations
in the market - fluctuations that are detrimental to society and impede the implementation of
economic policy. The large balance sheets of Danish households, with high gross debt and
correspondingly large assets, also speak in favour of curbing house price fluctuations.
***
It is now around four years since the international financial crisis really hit Denmark. In the
meantime, it has led to the introduction of five bank rescue packages, each one aimed at
solving specific problems. In addition, Danmarks Nationalbank has made a number of
adjustments to its range of instruments to match market conditions, and credit institutions
have been offered extended credit facilities at Danmarks Nationalbank. The latest addition -
the option to raise 3-year loans - has given credit institutions an extra source of long-term
funding. In many ways, these options match those provided by the ECB for European banks.
The ECB's 3-year loans have been in high demand. 800 European banks participated in the
most recent operation.
The first 3-year operation in Denmark will take place tomorrow. The second operation will be
in September, and I think it would be wise to consider the two operations overall. Needless to
say, interest will depend on the individual credit institution's situation, as well as
developments in the private-sector capital markets. It is up to each credit institution to decide
whether or not it wants to participate. Seen from Danmarks Nationalbank's point of view,
there is no reason to turn down this opportunity if it makes business sense.
***
A financial crisis has direct costs in the form of e.g. credit losses, but also indirect costs in
terms of e.g. growth. So far, a characteristic of the Danish bank rescue packages has been
that the sector itself has borne the direct costs related to these packages. This is a good
principle, which has helped to reduce the negative impact on government finances. Events in
Europe over the last year have highlighted the significance of sound public finances. It is of
fundamental importance to us all that the Kingdom of Denmark has a high credit standing
internationally.
I think we can say that Denmark has addressed the problems as they arose. By this I mean
that distressed banks have been brought to our attention, and we have found solutions -
either winding-up via the Financial Stability Company, mergers with other banks or tailored
solutions. The result is a banking sector with a number of large banks and many small banks.
Some Danish banks are still struggling, and the near future will also bring mergers and
perhaps resolution of banks. But I believe that the problems have now been reduced to a
size that is manageable within the existing framework - although a few adjustments may be
necessary. As I see it, the model with the Financial Stability Company has worked well and
provided a robust and constructive approach to solving the problems.
***
The largest credit institutions are those that we call systemically important financial
institutions, or - in financial lingo - SIFIs. These institutions are important to society as a
whole and to financial stability. For everyone's sake it is essential that these private-sector
enterprises do not suddenly find themselves in dire straits so that the government must take
over. In future these large institutions must therefore be required to have extra strong
defences. For example, they must have extra capital, the option to convert loan capital into
subordinate capital as well as recovery plans, and they may be subject to additional
supervision. The aim is to ensure that they do not end up in a situation where they become
distressed. The Danish government has set up a committee to make recommendations in
this area. Its work should have high priority.
The group of large credit institutions also includes the mortgage banks. You are already
comprised by special legislation to ensure that confidence in the mortgage-credit system is
always intact. As you often point out yourselves, this system has stood the test of a couple of
centuries. Particularly during this financial crisis and the turbulent market conditions seen in
the last four years, Danish mortgage bonds have proved their high quality and liquidity.
In my opinion, the SIFI committee provides a welcome opportunity to investigate whether,
ultimately, mortgage-credit legislation provides a sufficient and appropriate contribution to the
defences protecting Danish mortgage bonds.
***
When you argue the case for the strength of the Danish mortgage-credit system in a
historical context, it is also necessary to consider the major changes that have taken place
over the last 10 years. Firstly, the volume of adjustable-rate loans has increased
substantially. This has created a refinancing risk, as 30-year mortgage loans are financed by
short-term bonds, often with maturities of only 1 year. Secondly, the option to defer
amortisation has made it possible for borrowers to borrow more with an unchanged monthly
payment. This has pushed up house prices and increased the vulnerability of borrowers and
mortgage banks. Thirdly, the requirement to pledge top-up collateral for covered bonds if
house prices fall has given mortgage banks an extra obligation. The rating agencies also
contribute to this requirement.
We have previously drawn attention to these factors and encouraged you to find solutions. I
appreciate that you have put on your thinking caps.
A number of good suggestions and ideas have been put forward, and I take this opportunity
to comment on them. Several aspects must be taken into account when determining the
most appropriate measures. Measures which respect that there is a certain degree of
standardisation of bonds, as this increases liquidity in the series and makes the market more
transparent for investors. Two of the primary success criteria are the handing of refinancing
risk and the need for top-up collateral, but stable framework conditions for the housing
market also play a significant role in the current situation. I also think that it would be wise for
you already to start considering the future international liquidity requirements.
In the long term, two-tier mortgaging and a conservative loan policy will reduce the need for
top-up collateral in periods when house prices are falling. Two-tier mortgaging will have the
faster impact of the two. I realise that you are facing different challenges in this area, and it
may therefore be natural to choose different solutions.
Danmarks Nationalbank has previously suggested another, more indirect way of reducing the
potential need for top-up collateral - by gradually phasing out deferred amortisation for
mortgage loans with a view to dampening fluctuations in house prices. A cautious approach
to deferred amortisation would also support the robustness of both borrowers and mortgage
banks.
Turning to refinancing risk, you have sought to spread the auctions for refinancing
adjustable-rate loans over the year as we agreed. This means that a smaller bond volume is
refinanced at any given time. So if an auction is a failure and the number of investors is
insufficient, this situation will be easier to manage. One mortgage bank has already spread
its auctions almost evenly on three dates. The rest have initiated the process and have from
2011 to 2012 increased the share of underlying bonds that do not mature at the turn of the
year from 14 to 23 per cent.
But more can and should be done to reduce the refinancing risk. For example:
- If refinancing is spread over the whole year and refinancing auctions are conducted
well in advance, this will reduce the impact of short-term shocks in the financial
markets considerably.
- Use of longer-term financing will reduce the total volume of loans to be refinanced
within a given period. That will increase robustness.
In addition, the ability of the individual borrower to bear the refinancing risk can be increased.
If individual loans are financed using several bonds with different terms to maturity,
shortterm market turmoil will affect only a small share of each loan. This will strengthen investor
confidence, even in a situation with a brief, but strong increase in interest rates.
I see no urgent need for further specific legislation in these areas as you are seriously
addressing the challenges yourselves.
Let me recapitulate:
Solutions may differ, but should serve the following purposes - in random order:
- refinancing risk must be reduced, - the need for any top-up collateral must be met
before it becomes relevant, - the procyclical impact of home financing should be
dampened, - and the vulnerability of homeowners to extraordinary changes in
financing conditions must be reduced.
It will require a huge effort, but you have already come a long way. Keep up the good work!
Thank you for your attention.