The era of cheap mortgages is at an end Market Report

The era of cheap mortgages is at an end Market Report February

Titel: The era of cheap mortgages is at an end, Market Report, February Published by: Sweden s National Housing Credit Guarantee Board (BKN) Author and contact person: Alexandra Leonhard, + ()8-55 7 Co-Author: Bengt Hansson, Sebastian Johansson Data gathering: Marie Rosberg

BKN s Market Report February The variable mortgage rate in Sweden rose during autumn and mortgage customers were advised to change banks if they were unhappy with their interest rate. When the Riksbank cut its base rate in December, many banks chose to leave the recently increased interest rate on variable mortgages unchanged, although following some pressure they did reduce it, albeit by less than the Riksbank s 5 points. Public debt concerns in Europe have put pressure on the banking sector (including in Sweden), which at the same time has seen new rules introduced requiring it to increase equity and liquidity. This costs money and someone has to pay for it. Can Swedish households expect variable mortgage rates to remain low in the future? Debt owed by Swedish households grew by only just over 5 in and almost all of this increase can be attributed to higher mortgages. Since, household debts have increased as a result of larger mortgages. On average, mortgages increased by a year between and. Some Swedish households are heavily in debt, making them sensitive to illness, unemployment or a fall in house prices. Furthermore, around half of the loan stock has been lent at variable interest rates, which begs the question of whether households are carrying a worryingly large interest rate risk. Households can insure against sudden large increases in interest rates by fixing their rate. However, a fixed rate is usually considerably more expensive than the variable rate, which leads many to choose a variable interest rate. But does a fixed mortgage interest rate have to be more expensive than a variable one? Are there mortgage markets in other countries that are able to offer households more favourable conditions for longer fixed-interest periods on mortgages? This report compares the Swedish mortgage market with the Danish and German markets. We have chosen these markets because they operate differently to the Swedish market and have a tradition of fixed interest rates, which insure households against interest rate increases. The Danish mortgage market is over years old and despite domestic and international financial crises has never caused lenders any significant losses. It was nevertheless decided that the market should be liberalised by introducing loans with shorter fixed-rate periods as well as non-amortising loans. We are therefore able to observe the consequences of this, particularly as the new system The two largest are the Danish state bankruptcy of 8 and the global depression of the 9s. bears a greater resemblance to the Swedish system, with short fixed-rate periods and variable interest rates. In Germany, on the other hand, the old system of long fixedrate periods is still in place, and the overall cost of a fixedrate mortgage is often lower than a variable-rate mortgage. In Denmark, households with -year fixed-rate mortgages are able to repay them early without paying any interest differential compensation. In Germany and Sweden, on the other hand, a charge is payable for repaying a mortgage early. In Sweden this cost is linked to the government borrowing rate, which can be called into question, since this has fallen by more than the interest rate on mortgage bonds in recent times. The current system is also asymmetrical in the sense that if the interest differential were negative at the time of early repayment, the borrower would not receive money back from the bank. This shows that interest differential compensation is structured in a way that suits the banks rather than the customers. Low interest burden despite increased debt Swedish mortgages have grown by almost since 99 and in amounted to over of disposable income. In spite of the strong increase in mortgage loan stock, interest rate costs as a proportion of disposable income have actually fallen. As a result, the interest burden is lower today than it was 5 years ago. 8 99 Figure. Interest payments and outstanding mortgages in Sweden 99 99 99 998 8 Interest payment after tax/disposable income Mortgages/disposable income (right axis) Source: Statistics Sweden (Savings barometer and National accounts) If we compare interest payments in Sweden with those in Denmark, we can see that they are higher in Denmark. This can be explained by the fact that mortgages 8

BKN s Market Report February represent a much larger proportion of disposable income in Denmark, where they amounted to over of disposable income in 9. Interest payments of disposable income 9 8 7 5 Figure. Interest payments and outstanding mortgages 5 7 9 * 5 5 Interest pay. DK Interest pay. SE Interest pay. DE Mortgages DK Mortgages SE Mortgages DE *) Forecast Sources: Statistics Denmark, Deutsche Bundesbank, Eurostat and Statistics Sweden 5 Outstanding mortgages of disposable income The interest payments in Denmark and Sweden correspond to interest payments after tax since they are tax deductible here, which is not the case in Germany. This makes it possible to compare the households actual interest payments. The reason for the increased interest burden in Denmark is that from lenders were permitted to offer loans without a requirement for amortisation. In addition, interest rates fell and for a short time it became more advantageous to have a variable-rate loan instead of the traditional mortgage with a -year fixed-rate period. Many people refinanced their old loans with new variable ones. In Germany, in contrast, loans are falling as a proportion of disposable income. This can be explained by the fact that the banks require amortisation and significantly higher deposits before they will approve a loan to a household to purchase a house or flat. There is also a cultural aversion to taking on debt, which may also be linked to the fact that interest payments are not tax-deductible. Interest payments as a proportion of disposable income have fallen in Germany. They also do not vary over the See market report of BKN (Swedish National Housing Credit Guarantee Board), Kortsiktiga hushåll i riskzonen- lärdomar för framtiden [Short-sighted households in the risk zone lessons for the future], October for more information. years, as they do in Denmark and Sweden. In Sweden and Denmark, interest payments have fluctuated as the base rate has risen and fallen, since a large proportion of mortgages are financed with a variable interest rate. Figure shows that only a fraction of German mortgages have a variable interest rate. The high level of debt in Denmark means that interest payments represent a larger proportion of disposable income in Denmark compared to Sweden. The reasons for the strong increase in borrowing in Denmark are the previously mentioned non-amortising loans, aggressive lending from the banks and an increase in house prices (it feels less risky to borrow if the value of your house has gone up). Non-amortisation meant that household borrowing costs (amortisation plus interest) fell despite the fact that interest rates rose. Cost of variable versus fixed interest in Sweden, Denmark and Germany Today, 5 of household mortgages in Sweden are financed with a -month interest rate, which is classed as a variable interest rate. This proportion has fallen sharply during the last two years. At the beginning of, almost 7 of the mortgage loan stock was financed with a variable interest rate. Although the proportion of variable-rate loans has fallen, this means that in spite of everything, half of all mortgages are associated with interest rate risk. The Riksbank is forecasting a repo rate of by the end of. If we assume that the banks margins, which right now are around. percentage points (February ), remain constant, the mortgage interest rate will reach approximately 5.. Such a high mortgage interest rate has only been observed a few times since 99. The last time this happened was for a few months at the beginning of autumn 8, when the variable mortgage rate reached levels of around. Mortgage rates and the global financial crisis had an impact on house prices, which fell by. between June 8 and January 9. This demonstrates how sensitive Swedish households are to interest rate increases. In Germany only half a of mortgage borrowers The variable mortgage rate is actually an interest rate that is fixed for months. As this is a very short fixed-rate period, such loans are considered to be variable-rate loans. In this report, loans in Germany and Denmark with a period of less than one year are considered to be variable, with all others considered to be fixed. Riksbank monetary policy report, February.

BKN s Market Report February 5 have a loan with a variable interest rate 5. The proportion of Danish mortgages with a variable interest rate has more than doubled over the last eight years as many people abandoned the traditional system of mortgages fixed for years. years is a very long time, but the system does allow loans to be repaid early without having to pay interest differential compensation (see section on interest differential compensation). In Germany, of loans are fixed with a period of longer than ten years, with -year and 5-year fixes available, for example. However, as in Sweden, German lenders also require interest differential compensation in the event of early repayment. After ten years, however, German mortgage holders can repay their loans early without any interest differential compensation. BnSEK 5 5 5 dec- Figure. Mortgages and of loans with flexible interest rate dec- dec-5 dec- dec-7 dec-8 dec-9 dec- Swedish mortgages (left axis) Denmark Sweden Germany Source: Deutsche Bundesbank, Statistics Denmark, Macrobond, Statistics Sweden. In this figure flexible mortgages are defined as mortgages with a fixed interest rate over a period shorter than one year (even in Sweden). Cambell and Cocco () studied variable-rate and fixed-rate loans in the USA for the period from 97 to 5. They found that it was far more common for households with variable interest rates to have difficulty meeting interest payments on their mortgages than those with 5 According to data from the Deutsche Bundesbank in December, which excludes sole traders with mortgages. Sole traders represent around of households with mortgages in Germany. For more information on the mortgage markets in Germany, the Netherlands, the United Kingdom and Denmark, see BKN s report, Bolånemarknader för väl fungerande bostadsmarknader en internationell jämförelse [Mortgage markets for well-functioning housing markets an international comparison],. dec- 7 5 fixed interest rates 7. Those with variable interest rates mainly default on payments following interest rate increases, which give them an interest rate shock, which in turn leads to cash flow problems. This observation may be of interest to Sweden, as the mortgage loan stock is increasing and the proportion of loans with variable interest rates is high compared with Germany and Denmark. Why do mortgage borrowers in Sweden prefer variable interest rates? One reason why many people choose a variable interest rate in Sweden is because the banks have offered borrowers variable interest rates with a considerably lower average interest rate than a fixed-rate loan. Without going into the details of monetary policy, it may be observed that there has been a downward trend in base rates in Sweden, Germany and Denmark since the beginning of the 98s. 9 8 7 5 99 998 Figure. Policy rates 8 Denmark Sweden Germany UK USA Source: Macrobond During this period, borrowers with variable interest rates have been able to take advantage of cuts in interest rates as mortgage rates have fallen in line with the repo rate. In countries where fixed interest rates and long fixed-rate periods are the norm, borrowers have not been able to benefit from the low interest rate climate to the same extent as in Sweden, for example. A person who bought a house in Germany in January and fixed the interest rate for ten years, when the average mortgage rate was 5., would not be able to benefit from the interest 7 J.Y. Cambell and Cocco, J.F. (), A Model of Mortgage Default, NBER Working Paper, No. 75.

BKN s Market Report February rate cuts unless he/she was willing to pay interest differential compensation to the bank or building society. Danish borrowers, on the other hand, would have been able to repay their fixed-rate loan using a new variablerate loan without paying interest differential compensation, as permitted by the Danish mortgage system. Figure shows that this is exactly what Danish borrowers chose to do in - and 9. Nonamortising loans were introduced in, which led to a further desire to repay traditional loans and move to nonamortising loans with a lower variable interest rate. As long as house prices increased, the equity in the house also increased and there was little or no incentive for households to amortise. This pattern of behaviour was also observed in Sweden, where -year loans with fixed interest rates do not exist. The longest term for Swedish mortgages is ten years and interest rates on fixed-rate loans has been considerably higher than on variable-rate loans for a relatively long time. The difference between a fixed-rate loan with a term of five years and one with a term of ten years is therefore not as great. comparisons and in the arithmetic example below. These real interest rates are calculated as the nominal interest rates less actual inflation. 5 jan- jan- Figure. Flexible real mortgage rates jan-5 jan- jan-7 Source: Eurostat and Marcobond jan-8 jan-9 jan- Denmark Sweden Germany jan- jan- 9 8 7 5 Figure 5. Mortgage rates in Sweden The interest rate for variable-rate loans has on average been highest in Germany and lowest in Sweden. Shortterm variable-rate loans are classed as bridging loans in Germany and are only used for very short-term financing and it is widely known that these are not the most advantageous type of mortgage loan. 7 Figure 7. 5-year real mortgage rates jan-98 jan- jan- jan- jan- jan-8 -month 5-year -year jan- jan- 5 Source: Macrobond Figures 5-8 illustrate mortgage rates on new loans. The figure 5 shows that the variable interest rate has on average been lower than the two fixed interest rates. The figures below show the interest rates on loans with similar fixed-rate periods 8 in the different countries. In order to enable a comparison to be made of the interest rates in countries with slightly different inflationary trends, we have used real interest rates in the interest rate 8 Unfortunately, no data is available from 997 for mortgage rates in Denmark and Germany, so the series only goes as far back as. - jan- jan- jan-5 jan- jan-7 Source: Eurostat and Macrobond jan-8 jan-9 jan- Denmark Sweden Germany Interest rates that are fixed for five years, on the other hand, are lowest in Denmark and highest in Sweden. We can also see that inflation is higher than the nominal interest rate on five-year mortgages in Denmark (the real jan- jan-

BKN s Market Report February 7 interest rate is negative). about the mortgage markets in these countries. 7 5 Figure 8. -year real mortgage rates An arithmetic example If a Swedish borrower decided to buy a house with a mortgage fixed for ten years in January, he or she would have had to pay a real annual mortgage interest rate of.8, while someone who chose a variable interest rate at the same time would have paid a real annual mortgage interest rate of. on average up to the present day. We will continue to use real prices and interest rates in order to enable an accurate comparison of the costs in the different countries. jan- jan- jan-5 jan- jan-7 Source: Eurostat and Macrobond jan-8 jan-9 jan- Denmark Sweden Germany The real mortgage interest rate for ten-year mortgages is again highest in Sweden. The interest rates in Denmark and Germany are very similar to one another. In other words, it is much more expensive to fix interest rates in the long term in Sweden than it is in Denmark and Germany. - - Figure 9. -year mortgage rate minus <-year rate jan- jan- jan-5 jan- jan-7 jan-8 jan-9 jan- jan- jan- jan- jan- Let us assume that a household borrowed SEK.5 million to buy a house in January. The household had the choice of either financing the loan with a variable interest rate or fixing the interest rate for five or ten years. Let us assume that the fixed-rate five-year loan rolled over to a new five-year loan in January 8 at the interest rate applicable at that time. The overall real interest cost between January and December was SEK 5, in real terms if the household had opted for a variable interest rate. If the household had instead chosen to fix the interest rate for five years, the cost would have been SEK 85,, while if it had chosen to fix the interest rate for the entire period, i.e. ten years, the household would have had to pay SEK 77,. Of course, the household is not aware of this when deciding which type of loan to choose in January. All the household can consider is how high the long-term government borrowing rate is compared with the shortterm rate, i.e. the slope of the return curve. If the curve is steep, this indicates that the short-term interest rate is low compared with the long-term rate and can be expected to rise in the future. The figure below shows the annual cost for each possible choice made by the household in January. The cost of the fixed-rate loans falls as a result of inflation reducing the size of the loan over time. Denmark Sweden Germany Source: Eurostat and Macrobond The ten-year fixed mortgage rate is significantly higher than the three-month rate in Sweden. Only when the financial crisis was at its worst during autumn 8 did the ten-year rate fall below the three-month rate. This has been the case for long periods in Denmark and Germany, which is an indication that something must be different

8 BKN s Market Report February Figure. Yearly mortgage cost on a.5 million SEK mortgage - three different types of mortgages - Sweden. Cost of mortage, thousand SEK 9 8 7 5 5 7 9 år- <-year 5-year -year Source: Macrobond Y-M (right axis) The average slope of the government bond yield curve ( year months) is marked with green crosses. When it is low (e.g. 8) it means that the -year interest rate is low compared to today s interest rate. The figure above clearly shows that over the eight years only in 8 would the household have wished to have fixed-rate interest instead of variable. Overall, however, those who fixed their interest rate for ten years in would have paid the most over the period. If we look at Denmark now and assume that a Danish household borrows SEK.5 million in January to buy a house 9 and has the same options for financing its mortgage. The real variable interest rate was an average of. between January and December. If the household had opted for a fixed interest rate for five years, the average real interest rate would have been.9 per annum with the ten-year fixed rate at. per cent. In other words, the difference between the shortterm and long-term interest rates was less than in Sweden. The Danish household would have incurred a total interest cost of SEK 559, if it had opted for a variable interest rate. If it had chosen instead to fix the interest rate for five or ten years, the cost would have been SEK 579, and SEK, respectively. The difference in interest costs between fixed and variable interest rates is therefore less than it is in Sweden. The difference is also not as great if we examine the annual interest rate cost compared with Sweden. Of the eight years in the period, the household would have benefited from having a fiveyear fixed rate for four of those years.,5,5,5,5 -,5 Slope of the yield curve Figure. Yearly mortgage cost on a.5 million SEK mortgage - three different types of mortgages - Denmark. Cost of mortage, thousand SEK 9 8 7 5 5 7 9 <-year 5-year -year Y-M (right axis) Source: Eurostat and Macrobond During the financial crisis 8 the slope of the yield curve was negative in Denmark which means that the short-run interest rate was higher than the long-run. During the slope of the yield curve has been considerably steeper in Denmark than in Germany and Sweden. The Swedish yield curve is less steep because the interest rate on short-run government bonds is higher in Sweden compared to the other countries. The -year interest rate is almost equally high in the three countries. The same arithmetic example for Germany gives a similar result to that of Denmark. Figure. Yearly mortgage cost on a.5 million SEK mortgage - three different types of mortgages - Germany. Cost of mortage, thousand SEK 9 8 7 5 5 7 9 <-year 5-year -year Y-M (right axis) Source: Eurostat and Macrobond It would have been more expensive if the household had fixed the mortgage for five or ten years compared with having a variable interest rate, although the difference between loans with a variable interest rate and those with,5,5,5,5 -,5,5,5,5,5 -,5 Slope of the yield curve Slope of the yield curve 9 To simplify the example, we are assuming that all countries use Swedish kronor (SEK). As previously mentioned, variable interest rates are not used to finance ordinary mortgages, but only for short-term bridging financing. In this example, however, we assume that this would have been possible in order to demonstrate the differences between the different interest costs.

BKN s Market Report February 9 long and short fixed-rate periods was considerably less than in Sweden. In real terms, the total interest cost for a variable-rate loan between and was SEK 5, in Germany. If the German household had chosen to fix the interest rate for five years, the interest cost would instead have been SEK,. If the household had fixed the loan for ten years, the total cost would have been SEK 7,. The arithmetic example shows that the interest costs in Denmark and Germany are very similar for variable-rate loans and ten-year fixed-rate loans respectively. Those who chose to fix their interest rate for ten years in January would have paid 9 more by than if they had opted for a variable interest rate. In Sweden, those who chose to fix their interest rate for ten years would have had to pay 7 more during the same period. It should not be forgotten, of course, that the total interest cost for those choosing a variable-rate loan is significantly lower in Sweden than in both Denmark and Germany. In Sweden, the real interest cost of a variablerate loan was SEK 5, for the period as a whole, whereas in Denmark it was SEK 559,. Cheap variable-rate loans in Sweden Why has it been so much more profitable to choose a variable interest rate instead of a fixed rate in Sweden? Some might say that this could be because of different levels of risk involved in mortgage financing in different countries, requiring different levels of risk premium. If we assume that the interbank rate provides a measure of the banks counterparty risk, which may of course vary between countries, we can eliminate this factor by subtracting the interbank rate from the variable mortgage rate. This gives the figure below, which shows that Sweden has the lowest average margin on variable-rate mortgages. The German and Danish banks extract higher margins from customers choosing a variable interest rate, which could explain why German borrowers in particular choose not to finance their house purchases using variable-rate loans.,5,5,5 jan- Figure. Flexible mortgage rate minus the interbank rate jan- jan-5 jan- jan-7 Source: Eurostat and Macrobond jan-8 jan-9 jan- Denmark Sweden Germany Between October 8 and May 9 the mortgage rates (nominal) fell with close to percentage points in Germany and Sweden (Denmark. percentage points) due to the central banks actions to remedy the crisis. The flexible mortgage rate was immediately affected and fell by.8 percentage points in Sweden. In Germany the mortgage rate was only lowered by.5 percentage points and it explains why the spread increases drastically in the figure above. Figure shows that the interest rate on German variable-rate mortgages is almost three percentage points higher than the interbank rate. This is considerably higher than in Sweden. On average, the margins in Sweden, Denmark and Germany are.8,.7 and.89 respectively. This means that the Swedish banks offer short-term mortgage rates that are lower than those of their colleagues in Denmark and Germany. In contrast, mortgage rates on loans with longer fixed-rate periods are relatively expensive in Sweden. Loans with longer fixedrate periods are largely financed through mortgage bonds and we are therefore calculating the difference in interest rates between mortgage bonds with a term of five years and a five-year mortgage rate. jan- jan- Figure also shows how the margin trend fell until 8 in all countries, but began to rise again during 9 most strongly in Denmark and Germany.

BKN s Market Report February age points,75,5,5,75,5,5 -,5 jan- jan- Figure. 5-year mortgage rate minus 5-year mortgage bond rate jan-5 jan- jan-7 jan-8 jan-9 jan- Sweden Germany -year Denmark Source: Eurostat and Macrobond Unfortunately there are no statistics available for five-year mortgage bonds for Denmark. Nor are there any statistics available for Swedish ten-year mortgage bonds. We have therefore chosen to illustrate the margin between tenyear mortgages and ten-year mortgage bonds for Denmark instead. The margin for five-year mortgages is slightly higher in Sweden than in Germany. Over the period, the difference is on average.79 percentage points in Germany, while in Sweden it is.8 percentage points. This shows that the margins are quite similar and do not explain why fixed-rate loans are considerably more expensive in Sweden than in Germany. This may be because Swedish lenders have higher financing costs. If we consider only the five-year mortgage bond interest rate, the Swedish rate has averaged.9, while the German rate has been slightly lower (.5 ). This shows that Swedish lenders have higher financing costs and explains why Swedish five-year mortgages cost more than German mortgages with the same term. Common for all three countries is the fact that the household in the example would have achieved the best result by having a variable interest rate. However, this conclusion must be interpreted with care. The reason why a variable interest rate would have been cheaper is that policy rates continually fell during this period. Since the beginning of the century, monetary policy has focused on stimulating growth by cutting interest rates. If we had performed the same arithmetic example using January 5 as the start year, the results would have been as shown below (i.e. just before the ECB and the Danish Nationalbank began a series of interest rate increases; the Swedish Riksbank started increasing rates a year and a half jan- jan- year later). Table. Real aggregate mortgage expenses between 5 and. Country Fixed-rate period (SEK) < år -5 år 5- år Sverige 575 59 9 Danmark 99 9 9 88 Tyskland 595 5 7 79 Source: Eurostat and Macrobond The table shows that the cost difference between a variable interest rate and fixed interest rates is again greatest in Sweden. The interest cost of a variable-rate loan is considerably lower in Sweden than in Denmark and Germany. In contrast, it is significantly higher if the household opts to fix its mortgage for ten years. In both Germany and Denmark it would have been cheaper to fix the loan for five years compared with having a variable rate. Large fluctuations in housing costs for households with variable-rate mortgages If we go back and examine the interest costs in Sweden between and the present day, it is clear that households with a variable interest rate have had to absorb large fluctuations in interest. In the arithmetic example above, the annual interest cost in was SEK 5,. Two years later it was SEK 7, (adjusted for inflation), which is an increase of. If households are able to afford this, there is of course no reason to fix the mortgage interest rate, particularly not in Sweden, which has a higher margin on longer fixed-rate periods. This shows, however, that relatively small changes in interest rates can have a major impact on the housing costs of a household if debts are large and interest rates are variable. Compared with other types of housing, it should be noted that people who live in rented accommodation are actually protected against large rent increases. Landlords are not permitted to compensate for any increased interest costs by increasing rent to the same extent. This demonstrates that there is a feeling that it is desirable and provides security to know what housing costs will be in the future. There is of course a certain benefit to knowing that interest payments will remain within specific parameters or that the interest rate level will remain

BKN s Market Report February constant in the future. It should also be remembered that the arithmetic example above is very short-term. Six or eight years is a very short period compared with the length of time that lenders calculate the mortgage will be outstanding. This also only reflects the trend over the past period and not what the trend is expected to be over coming periods. According to the Swedish Financial Supervisory Authority (Finansinspektionen), the amortisation period is -5 years for a top-up loan and - years for the basic loan among those lenders who actually do want borrowers to amortise their basic loan. Information from Household finances 9 (Statistics Sweden) shows that the average amortisation period is 5 years for tenant-owned properties and 7 years for single-family houses. We are able to confirm, however, that variable-rate shortterm mortgages have been cheaper than fixed-rate mortgages, which has led most Swedish households to choose the former. There is also another reason why a short-term loan may be considered advantageous in that no interest differential compensation is payable if the loan is repaid early. Conditions of interest differential compensation vary between countries In the USA, as in Denmark, it is possible to repay a fixed-rate loan without paying interest differential compensation, and many people did this when interest rates fell (see Figure ). Lea and Sanders () are critical of this system. They believe that it leads to uncertainty for lenders and can intensify house price rises, while at the same time all borrowers are forced to pay indirectly for the ability to repay their loan early. Generally speaking it is more expensive to finance a loan in the longer term. A financial analysis of a bank s cash flow shows that when a borrower fixes the interest rate on a loan for five years, the bank has to finance this for five years. If the borrower decides to repay the loan early, the bank has paid too much for its long-term financing, as it was not as long as it should have been. This means additional costs for the bank and so banks in Sweden, Germany, Canada and France, for example, use interest differential compensation to cover these costs. Banks in the USA are not allowed to do this and can therefore suffer large losses if customers choose to repay or Finansinspektionen (), Den svenska bolånemarknaden och bankernas kreditgivning [The Swedish mortgage market and banks lending]. M. Lea and Sanders, A. (), Do we need the -year fixed-rate mortgage?, Working Paper, No. -5, Mercatus Center at Georg Mason University. refinance their loans at times when the short-term interest rate is lower than the long-term rate (which is usually the case). The banks compensate for this cost by charging all borrowers a higher interest rate. It has also been observed that low interest rates can lead to increased borrowing and rapidly rising house prices. This was in fact the case in Denmark 5 and the USA before house prices there fell dramatically. The major problem in the USA, now that the house price bubble has burst, is that the government and the central bank are financing a large proportion of the mortgages taken over by Freddie Mac and Fannie Mae (fixed-rate loans with low interest rates). Put simply, this means that American households were able to increase their borrowing while house prices were rising by refinancing their old loans and releasing equity which is now being financed by the American taxpayer. Interest differential compensation exists in many countries, but is limited in some, such as France, Italy and Spain. In Germany it is limited to the extent that banks are expressly forbidden from making a profit from interest differential compensation. Banks are only allowed to cover the additional cost they incur when a customer repays a loan early. As previously mentioned, however, fixed-rate loans can be repaid after ten years without paying interest differential compensation, provided they have a term of more than ten years. Loans from Bausparkassen 7 (building societies) can also be repaid early without paying interest differential compensation. This enables German house-buyers to choose a fixed-rate loan and so insure themselves against interest rate risk without having to pay interest differential compensation if they wish to repay the loan early. This is not possible in Sweden, since all fixed-rate loans are associated with interest differential compensation. When a person sells a house, the fixed-rate loan can be repaid without paying interest differential compensation if the new owner agrees to take over the A report written by an expert group for the European Commission found that this is precisely the case in the USA, i.e. that US mortgage rates are higher because the banks compensate for the cost of early repayment by applying a higher interest rate to mortgage lending (Report of the Mortgage Funding Expert Group, European Commission, December, Brussels). 5 Danske Research () found that many borrowers chose to refinance their mortgages when the long-term interest rate fell in Denmark (Danish Covered Bond Handbook,, Danske Bank). For more information, see Table, p. in Lea, M. (), International Comparison of Mortgage Product Offerings, Research Institute for Housing America. 7 There is no equivalent to Bausparkassen in Sweden. This is a closed and self-supported system where a number of people save in order to be able to buy a house in the future. These savings finance the loans to house-buyers. A deposit of at least is required in order to obtain a loan from the Bausparkassen.

BKN s Market Report February loan 8. It is also possible to take your mortgage with you if you are buying a new house. This must be a house or a tenant-owned property. If you are buying a holiday home or a farm property, you cannot take your mortgage with you, as loans on such properties are not classed as mortgages. In Sweden, interest differential compensation is calculated as follows: Interest differential compensation=(mortgage interest rate-(ask rate for a government bond with the same fixed period+ percentage point) )*size of outstanding debt*remaining period. If the interest rate for fixed-rate mortgages were lower than the ask rate for government bonds (plus one percentage point), thus giving negative interest compensation, the borrower would not receive any money from the bank. In other words, interest compensation is not symmetrically distributed between the lender and the borrower. The system therefore favours the banks over households. Mortgage holders repaying their loans early have recently been further disadvantaged by the fact that the government borrowing rate has fallen.,5,5,5,5 -,5 Figure 5. Mortgage bond and mortgage rate minus government bond rate jan-9 jan-98 jan- jan- jan- year 5 year Mortgage minus government rate 5 year Source: Macrobond The government borrowing rate has recently fallen and the difference between this rate and the mortgage rate and the mortgage bond rate has increased considerably, 8 This can mean, however, that the sale price of the house is correspondingly lower. jan- jan-8 jan- jan- particularly with a five-year term. We can also compare the interest rate on mortgage bonds with the government borrowing rate in Denmark and Germany. The difference between the mortgage bond rate and the government borrowing rate is measured as the housing credit risk.,5,5,5 -,5 - feb- Figure. Credit risk: mortgage bond minus government bond rate feb- Source: Macrobond feb- feb- feb-8 feb- Sweden 5Y Germany 5Y Denmark Y We can clearly see here that the credit risk for mortgage bonds has been highest in Sweden since 7. This is mainly because the government borrowing rate has fallen rather than the mortgage bond rate has increased. Between and 9, the government borrowing rate averaged.8, while between 9 and it was.. This compares with an average interest rate on mortgage bonds of. and.5 respectively. In other words, the government borrowing rate has fallen by more than the interest rate for mortgage bonds. There could well be a case therefore for considering whether interest differential compensation should be calculated using the government borrowing rate. And also whether the interest rate on government bonds is the best way of measuring the banks ability to reinvest the money from repaid mortgages. Is this the end of cheap variable-rate mortgages? This is a highly relevant question when considering whether to fix a mortgage rate or allow it to be variable. During the autumn and winter, the Swedish media reported that banks mortgage customers will have to pay higher costs as a result of increased capital requirements. The margin between the average mortgage rate and the -month STIBOR has increased considerably over the feb-

BKN s Market Report February past year and is now reaching levels last seen in 99. It is worth noting, however, that the margin is still lower than in Germany and Denmark (see Figure ). age points,8,,,,8,,, jan-9 Figure 7. Margin -month mortgage rate minus interbank rate, Sweden jan-98 jan- Source: Macrobond jan- The question, however, is whether the low margins of recent years can be considered sustainable in the long term or exceptional and a thing of the past? In December, some bank chiefs suggested that the repo rate and the variable mortgage rate are not connected. The figure below shows the relationship between the interest rate on variable-rate mortgages, the -month STIBOR and the base rate. As above, we can see that the margin between the mortgage rate and the STIBOR is currently somewhat higher than the average since 989 (average:.5, Jan :.8). In contrast, the difference between the mortgage rate and the repo rate remains lower than the average (average:.7, Jan :.). The close correlation between the base rate and the mortgage rate between and 9 appears to represent a unique situation rather than a normal state of affairs. jan- jan- jan-8 jan- jan- 8 jan-9 Figure 8. Interest rates in Sweden jan-98 jan- jan- jan- jan- jan-8 jan- Flexible mortgage rate Policy rate STIBOR -month Soucre: Macrobond We are therefore able to observe that the mortgage rate mostly follows the base rate, but that this is not necessarily always the case and the margin between them has been unusually small over the last ten years. We are now seeing a structural shift where the variable mortgage rate is no longer as closely linked to the base rate as it was before. We can also compare the relationship between the different interest rates with those in Germany and Denmark. Here again we are comparing data between and the present day. jan-

BKN s Market Report February 8 7 5 jan- Figure 9. Interest rates in Sweden - jan- jan-5 Source: Macrobond jan- jan-7 jan-8 jan-9 jan- Flexible mortgage rate Policy rate STIBOR Again, we see data describing the mortgage rates on new loans. Observe that, the scale on the y-axis in figures 9- are the same. In Sweden the flexible mortgage interest rate represents the -month rate while in Germany and Denmark it represents the mortgage rate on mortgages fixed over a period less than one year. We can see above the close relationship between and 9. The situation in Germany is a little different. 8 7 5 jan- Figure. Interest rates in Germany - jan- jan-5 jan- jan-7 jan-8 jan-9 jan- jan- jan- <-year mortgage rate Policy rate EURIBOR Source: Eurostat and Macrobond It is clear here that the base rate is considerably lower than the variable mortgage rate, although there is a strong correlation. The relationship in Denmark is more like the one in Germany. jan- jan- 8 7 5 jan- Figure. Interest rates in Denmark - jan- jan-5 jan- jan-7 jan-8 jan-9 jan- <-year mortgage rate Policy rate CIBOR Source: Eurostat and Macrobond In both Denmark and Germany, the margin between the variable mortgage rate and the base rate is greater than it is in Sweden. This indicates that Swedish banks have begun to adapt margins to a level more closely approximating that in other countries rather than increase them to unreasonable levels. In order to understand the difference and movement between the base rate and the mortgage rate, we need to examine how the banks finance mortgage lending. Until now, Swedish banks have been able to offer mortgage borrowers very attractive interest rates. New rules are forcing banks to finance their lending on a more long-term basis, which means that the banks will no longer be able to offer borrowers such cheap shortterm loans. How are Swedish mortgages financed? The banks finance their operations through equity (such as shares) and borrowing (loans, sale of mortgage bonds and bank bonds). It is cheaper for banks to finance their operations through borrowing rather than equity, since creditors take precedence over shareholders in the event of bankruptcy. Shareholders therefore demand a higher risk premium than lenders. Loans to banks are also considered to be guaranteed by the government. One example of a government guarantee is the deposit guarantee and the fact that the government can be compelled to act as guarantor for the banks because they are vital to the system and are needed in order to maintain the financial system in pressurised situations. These government guarantees mean that lenders require a lower risk premium when lending to banks. This will change somewhat in the future, however, as ratings agencies (S&P, jan- jan-

BKN s Market Report February 5 Moody s and Fitch) have begun to exclude the indirect government guarantee when calculating a bank s credit rating. This has resulted in the entire banking sector being downgraded in principle, which means more expensive borrowing for banks. The support loans from the Riksbank and the Riksgälden (Swedish National Debt Office), which offered the banks very favourable low-cost loans, have also in principle expired 9. Swedish mortgages are primarily financed through mortgage bonds. Since 8, all Swedish mortgage bonds are in principle classified as covered bonds. Figure illustrates how the spreads on these have widened compared with the government borrowing rate and shows that the credit risk for mortgages has increased. Covered bonds are issued (sold) by building societies and banks. The Swedish Act on Issuance of Covered Bonds [Lagen om utgivning av säkerställda obligationer (:)] describes how this may be done and what rules apply. The Swedish Financial Supervisory Authority (Finansinspektionen) is the authority responsible for ensuring compliance with this law. Covered bonds, as the name suggests, are covered by a cover pool of assets. This means that if the bank or building society were to enter into bankruptcy, the cover pool would still remain. Those who have invested in the covered bonds would then claim against the cover pool rather than the bank or building society. This makes covered bonds safer than uncovered bank bonds where investors risk losing part of their investment if the issuer (the bank or building society) enters into bankruptcy. The cover pool consists of various types of loan and can contain up to:. 75 of the market value of real estate, site leasehold rights and tenant-owned property that is intended for residential use,. 7 of the market value of real estate that is intended for agricultural use, and. of the market value of real estate, site leasehold rights and tenant-owned property that is intended for commercial or office use. The market value of property used as security for mortgage lending in the cover pool is reviewed on a regular basis. The portion of mortgages that cannot be covered by the cover pool is financed through bank loans and the issuing of bank bonds. As the cover pool is linked to the market value, it may reduce in size if house prices fall. According to Janzén, Jönsson and Nordberg (), the Swedish banks have diversified their cover pool and no mortgages reach the maximum limit of 75, meaning that price falls do not have an immediate impact on the cover pool. However, large house price falls may affect the willingness of foreign investors in particular to buy covered bonds in Sweden, since very large price falls reduce confidence. As previously mentioned, the majority of mortgages in Sweden are financed through covered bonds. The situation is similar in Denmark, but different in Germany. Germany s mortgage market is more diversified than the Swedish and Danish markets. Bausparkassen, for example, occupy an important position and they finance solely through loans and not through covered bonds. The figures below illustrate the relationship between the size of outstanding mortgages and covered mortgage bonds (CB) in nominal domestic currency, as well as covered bonds as a proportion of GDP. Bn SEK 5 5 5 Figure. Mortgages and covered bonds, Sweden 8 9 * *) Forecast Covered bonds (CB) Mortgages CB as share of GDP (right axis) Source: Swedish Bankers Association, Macrobond and Statistics Sweden. 5 5 75 5 5 9 BKN (9) covered this in Varifrån kommer pengarna? [Where does the money come from?], Marknadsrapport [Market report], May 9. Here we also indicated that short-term interest rates will rise and that The cautious are planning for higher mortgage rates (p. 7). See Riksbanken (), Den svenska finansmarknaden [The Swedish financial market ]. There are various kinds of covered bonds. In other countries, for example, there are covered bonds for ships and the public sector. So far in Sweden, only covered mortgage bonds have been issued. Janzén, H. Jönsson, K. and Nordberg, A. (), Husprisfall- konsekvenser för finansiell stabilitet [House price falls Consequences for financial stability] in Riksbankens utredning om risker på den svenska bostadsmarknaden [Riskbank examination of risks on the Swedish housing market], Sweden s Riksbank, Stockholm. For more information, see: BKN (), Bolånemarknader för väl fungerande bostadsmarknader, En internationell jämförelse [Mortgage markets for wellfunctioning housing markets an international comparison].

BKN s Market Report February Bn DKK Bn EUR 5 5 5 8 Figure. Mortgages and covered bonds, Denmark 8 9 * *) Forecast Covered bonds (CB) Mortgages CB as share of GDP (right axis) 5 5 Source: Denmarks Nationalbank, Statistics Denmark and Macrobond. Figure. Mortgages and covered bonds, Germany 8 9 * *) Forecast Covered bonds (CB) Mortgages CB as share of GDP (right axis) Source: Association of German Pfandbrief Banks, Deutsche Bundesbank, ECBC and Macrobond. Under Basel III, covered bonds and government bonds will become more desirable for the banks. The issuance of covered bonds is also growing very strongly in Sweden. Basel III requires banks to hold more equity and have greater liquidity from June. The Riksbank and the Swedish Financial Supervisory Authority are going even further, however, and want to see even stricter requirements for Sweden s four major banks. They believe that the banks should have core capital as a Deutsche Bank Research (), Solvency II and Basel III, Reciprocal effects should not be ignored, Frankfurt am Main. 75 5 5 5 5 75 5 5 proportion of their risk-weighted assets 5 from and from 5. This means that the banks must hold greater security for each krona lent, which will probably see them exercise greater restraint in their lending. The banks earnings from loans to house-buyers were debated in the media in autumn. Using data from Statistics Sweden, we have estimated that Swedish lenders earned a total of around SEK 7 billion after tax between and on the margin between interest income and interest cost for mortgages 7. Bn SEK 9 8 7 5 Figure 5. Estimated profit on mortgages 8 Profit after tax on mortgages Source: BKN s own calculations and Statistics Sweden as share of GDP (right axis) BKN has calculated the profit at building societies using the net interest income and the size of outstanding mortgages. Profits fell between and 8 when the margin between the mortgage rate and the interbank rate was at its lowest (see Figure 7). The emergency measures of the Riksbank and the Riksgälden in 9 reduced the financing costs of mortgages, resulting in record profits for building societies and banks, which at the same time increased lending by almost. Who is sitting on the interest rate risk? In Sweden, households only bear interest rate risk if they have a variable-rate mortgage. Mortgages are also personal, which means that as a mortgage holder, you 5 Risk-weighted assets means that the risk to the assets is assessed on the basis of applicable capital adequacy requirements. Finansinspektionen (), FI vill se högre kapitalkrav för svenska banker [FI wants to see stricter capital requirements for Swedish banks], statement --5, www.fi.se. 7 We have assumed that all lenders have had the same margin on their mortgages as building societies have had.,5,,,,,

BKN s Market Report February 7 cannot simply give the house back to the bank and be done with the loan and the high interest payments. In the example above, we saw that relatively small interest rate increases can result in large increases in interest costs for a mortgage of SEK.5 million. There is a major interest rate risk here. Suppose interest rates were to increase. This results in higher interest payments for households with variable-rate mortgages. House prices, which are sensitive to interest rate movements, will fall 8. After a while, the household has difficulty paying the high level of interest and decides to sell the house. The price of the house has fallen, however, and the household has to sell at a loss. The loss is unfortunately so large that the purchase price is not enough to repay the mortgage in full. Since a mortgage is personal, the household is liable to repay the remaining portion of the debt, including interest. This happened to some households during the financial crisis of 99. In other words, it is households that are sitting on the risk in Sweden. Fixed-rate periods are mostly ten years, compared with the traditional Danish system which has fixed-rate periods of years. Under the traditional Danish system, mortgages are financed directly on the credit market through mortgage bonds. If a household is forced to sell its house, the mortgage bond is bought back at the prevailing market price. As a result, bond prices follow house prices more closely. If interest rates go up, the house price falls, as does the bond price. In other words, the capital market bears the interest rate risk. Table. Matrix of interest rate risk Actor Flexible rate Fixed rate Households SE, DK (new) Credit market DK (trad.) Bank/building society DE, SE Under the new mortgage system in Denmark, households bear the risk of the interest rate increasing sharply. Germany, like Denmark, has a long tradition of mortgages being financed through mortgage bonds called Pfandbriefe. Here, however, the bond is not as closely linked to the mortgage as it is in Denmark and it is the bank that bears any losses in this system. Broaden the range of mortgages Mortgage customers have different needs and different abilities to cope with interest rate increases, house price 8 Leonhard, A. (), Inflation targeting and monetary policy, an econometric analysis of 7 OECD countries and the Eurozone, Universität Duisburg-Essen, forthcoming. falls and deposit requirements, for example. Before the Swedish Financial Supervisory Authority s requirement for 5 deposits was introduced in Sweden, several other options were discussed for putting a brake on the increase in lending. This discussion is now underway in the United Kingdom, where there is opposition to a mortgage ceiling. The reason for this is that there are many young people who have not yet been able to save up a large deposit but who have a good job and salary and are therefore able to afford relatively high housing costs (interest and amortisation) but are unable to pay a high deposit. In this way, the mortgage ceiling may prevent young people with a good income from buying their own house. Lea and Sanders () advocate a wide range of options on the mortgage market to take into account the fact that households have very different needs and abilities. BKN s latest market report (Oct ) shows that households act with a short-term focus. SBAB Bank found that between and, variable-rate loans represented on average 7 of SBAB s new lending, fixed-rate loans with terms of - years were 5 and fixed-rate loans with a term of ten years were 8 9. This indicates that borrowers very rarely look more than four years ahead and that they base their decision solely on the difference between the fixed and variable interest rates at the time the loan is taken out. A UK study has also shown that the majority of UK borrowers focus only on the direct, short-term costs of a loan and not on the long-term costs. As a result, they do not perform a long-term calculation that compares different mortgage products and options when taking out a mortgage. It should also be added that when a household has a mortgage approved, it is the bank that decides whether or not the customer is given the loan. This means that the customer may feel in a weak position and may accept the bank representative s suggestion of how the mortgage should be financed so as not to jeopardise the approval of the loan. There also appears to be short-term behaviour in Sweden, which has led to a high level of debt while interest rates have been low. This high level of debt makes Swedish households and banks vulnerable. To reduce this vulnerability, it is desirable for households to have more options to choose from. Households with large debts quickly feel the effects of seemingly small interest 9 SBAB Bank (), Val av bindningstid [Choice of fixed-rate period ], SBAB Bank Specialstudie [SBAB Bank Special Study]. Financial Services Authority (), Choosing a mortgage, Report of a research review and qualitative research on the mortgage buying process, Consumer Research 8, United Kingdom.

rate increases. If interest and amortisation payments also represent a relatively large proportion of income, the household is very sensitive to interest rate increases. In this case it may be safer for the household to fix the interest rate on its loans and so insure against interest rate increases. As previously mentioned, variable-rate loans with an interest rate cap are available in Denmark. These would certainly also be of interest to Swedish households with large debts. A number of Swedish banks offer mortgages with an interest rate cap, although the maximum period for these caps is five years. The premium for this is relatively high, however, and the level of the interest rate cap varies greatly between banks. There is also a suggestion that the EU should have a crossborder mortgage market. However, it will take several years before this can become a reality. Conclusions Being heavily in debt is risky. The ever-increasing house prices and low variable interest rates have given many people a sense of security. As interest rates start to rise, as a result of factors on the credit market that cannot be fully controlled by the Riksbank, it may be time to question the mortgage market and to broaden the range of loan products, which may reduce the interest rate risk of households at a reasonable cost. The Danish and German mortgage markets offer loans with long fixed-rate periods, which have lower interest costs than the Swedish loans. In Sweden there are no loans with a fixed-rate period longer than ten years and it is also expensive to repay a fixed-rate loan early. Interest differential compensation depends on the difference between the mortgage rate and the government borrowing rate. As the government borrowing rate has fallen relative to the mortgage rate in recent times, those who wish to repay their loans early will have to pay a higher level of interest differential compensation than before. If the interest rate on a fixedrate loan to be repaid early is lower than the government borrowing rate, the borrower does not receive any money back from the bank. In other words, the system is asymmetric and favours the bank. In Sweden, a system similar to the Danish system would protect households against interest rate increases. The ingenious thing about this system is that it also protects households against falling prices. The German system, with its long terms, also reduces the interest rate risk for indebted households. The era of cheap variable-rate mortgages is at an end, as the banks financing costs are increasing as a result of rules and requirements for longer-term financing and greater equity. The credit risk within the banking system and for mortgage bonds has increased, which also means more expensive mortgages. The short-term cheap mortgages that were closely linked to the base rate between and 9 were the exception rather than the rule. Neither Danish nor German banks and building societies have managed to offer their customers margins on variable interest rates as low those Sweden has offered. See Appendix I, En Europeisk bolånemarknad [A European mortgage market], in BKN s report, Bolånemarknader för väl fungerande bostadsmarknader En internationell jämförelse [Mortgage markets for well-functioning housing markets an international comparison], ().

BKN s Market Report February 9 About BKN The Swedish National Housing Credit Guarantee Board, BKN, is a government agency under the Ministry of Health and Social Affairs. BKN plays two roles a role as the government s expert agency and a role as a market participant. As an expert agency BKN monitors and analyses issues relating to housing finance, housing- and housing construction markets. As a market participant BKN administers government credit guarantee programmes for housing development. BKN also gives support to reconstruction of housing companies that are owned by the municipality in weak housing markets, administers government support to municipalities who supply rent guarantees, and provide first-time-home-buyers with home purchase guarantees.

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