20 November 2010

Swedish Housing Market

For several years, Swedish housing market with its very low losses even during the recent financial crisis has been a safe harbour for money. Now concerns have arisen if this market might be in bubble. More precisely, do the house price developments depicted in Figure 1 below present a bubble? Swedish financial supervisory authority Finansinspektionen is even so concerned that it capped maximum loan-to-value ratios of new loans to 85% starting from 1 October 2010 (i.e. new loans should not exceed 85 per cent of the home's market value). In the beginning of 2010, the Executive Board of the Riksbank decided to appoint a commission of inquiry into the risks in the Swedish housing market. The commission is aimed at examining the relationship between the housing market and the Riksbank’s objective and tasks, and expected to present its final report in January 2011.
The worries of authorities are understandable: during the financial crisis Riksbank had to increase its balance sheet even more than the much-talked US Federal Reserve (in relative terms of course, and largely because of the losses that Swedish banks suffered abroad). Now the country cannot afford itself bursting of local housing bubble unless it wants to share the fate of the less lucky European countries that had “succeeded” in building up too big and too risky financial sector. But coming back to the original question: the answer depends on households’ actual ability to buy housing at such price levels. The following figure illustrates the situation by comparing the cumulative growth of Swedish households’ median income and the cumulative growth of their borrowings starting from the year 1990.

What we see is that up to 2002 the growth of income and the growth of borrowings were more-less in line. From this point on growth of borrowings has considerably outpaced income growth. Sure, this development cannot be sustainable. The question is not if a bubble is being built up, but when excesses will be corrected and what the consequences will be.

From the past experience we know that excesses may and usually do last long, as long as lenders are willing to lend and there is anybody who is able to sign a credit contract. When thinking about the possible consequences of Swedish housing bubble bursting now, a 30-50% price drop in residential real estate prices doesn’t look impossible. Namely, according to the data presented in Financial Stability Report 2010:1 by Riksbank, as of at the end of 2009 the Purchase Price Coefficient was 1.54. This coefficient is defined as the purchase price of a property in relation to its assessed value at a particular point in time. Not arguing about the assessed values, but just assuming that at some point purchase prices will turn back to the equilibrium, we see how big the drop may be... It is obvious that in case of such a drop, many of the home loans granted in recent years would be “underwater” (i.e. loan amount exceeding the price of property).

If all this is well known, why lenders continue lending at such a pace? Our earlier discussion on Bankers and Prisoner’s Dilemma provides an explanation. It’s not different this time.

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