04 December 2011

Swedish Time Bomb Still Ticking but Signs of Imminent Explosion Becoming Harder to Ignore

It’s about Swedish mortgage market of course. Since 2009 there are concerns that this market may have overheated. Indeed, extensive analyses have been carried out by the Riksbank and by the Swedish National Housing Finance Board during the last 18 months. In September 2011, IMF warned Sweden that a disorderly correction of house prices has the potential to destabilise the financial system through the funding channel. Despite of that, the overall message to the markets by the authorities has been that everything is perfectly under control. Yes, house prices and household indebtedness have risen to record levels, but several Swedish-specific factors explain the high credit quality of household mortgages. As an observer, I should say that there are several signs that should make us particularly concerned. Let’s take a look.

Although the recent empirical analysis by the Riksbank concludes that Swedish housing prices are largely explained by fundamental factors, a closer look reveals that many of these “fundamental” factors are not that fundamental at all. Instead, rapid growth in housing prices from 1995 to 2007 has been fuelled by a vigorous circle of financial innovations, decreasing interest rates, rising wages etc. Subsequently measures such as Riksbank stepping in to accept a wider range of covered bonds as collateral from banks, as well as new tax deductions prevented Swedish housing market from a collapse in the crisis of 2008-2009. One contributor to the resilience has definitely been implicit backing by the public finances. The long term demographic shift towards metropolitan areas combined with the limited housing supply is perhaps one of the few real reasons for housing prices to rise, yet it hardly explains the almost exponential price growth during the past 10-15 years. The funny thing is that no one seems to have a good answer to the question of why the housing supply has been limited.

There appears to be at least one significant omission in the information that Riksbank and IMF are disclosing about the Swedish housing market, namely: “How many of the outstanding loans are interest only right now?” The September 2011 technical note by IMF points out that: “Financial innovations have eased access to credit and reduced financial constraints for first time buyers. Increased competition among mortgage lenders has resulted in a wider array of mortgage products now widely available to Swedish households. These include “interest only” loans or “amortization-free” mortgage loans which allow the deferral of the payment of the principal for a given period of time or even until the end of the loan.” Yet no numbers are being provided. We may only assume that this information is being deemed as market sensitive.

According to SVT (Sveriges Television) (21 November 2011) approximately half of the Swedish housing loans are amortization-free, i.e. the loan principal is not being reduced. The case is illustrated with an example of SEB: on average, SEB’s customers are reducing their principal home loan only by SEK 700 each month, although the average outstanding loan amount is SEK 900,000. A quick calculation shows that with such a pace, repayment of the whole amount would take more than 100 years. Of course, this example is far too simplified, but we do have the explanation to the very low mortgage default rates in Sweden: if a customer has to pay interest only, then his or her probability of default is naturally very low (especially given Swedish three-year unemployment insurance).  
Not least importantly, the history of low defaults and the implicit public sector guarantees have enabled Swedish banks to calculate Europe’s lowest risk weights and capital requirements for the mortgage loans in Sweden. That’s how e.g. Handelsbanken can have a Core Tier 1 capital ratio of 14.7% (as of September 30, 2011) whilst its CET 1 / total assets on- and off-balance sheet (Basel III) ratio is only 2.9% (Data source: Riksbank, Financial Stability Report 2011:2). The other three of the Big Four Swedish banks have rather significant leverage ratios too.

Naturally, the above factors have contributed to the Swedish covered bonds being perceived as safe instruments by the investors. That’s how covered bonds have become an important funding source for the Swedish banks, accounting roughly 20% of their total funding. That’s why the outstanding stock of covered bonds has risen from 40 percent of GDP to over 160 percent of GDP during the past couple of years. That’s the trick that brought funding costs down for the Swedish banks and “helped” to fuel the housing prices.

It’s obvious that there is “air” in the Swedish housing prices. The question is: how much? Recent empirical analysis by the Riksbank suggests that prices are roughly 20 percent above their long term trend. This should be considered as a fairly modest assessment as some others indicate an overvaluation of more than 60%. The fact that the price correction has been postponed this long makes the later number more realistic.

The other not less important question is the timing of the “explosion”. This is something that is difficult to answer, yet there are clear signs that we do not have to wait for long:
* Home price downturn is now under way already (see for example the SEB’s Nordic Outlook, November 2011);
* Officials are apparently not discussing crucial issues publicly (first of all, I mean the proportion of interest only loans);
* New facts are coming into daylight about the performance of Swedish covered bond market during the crisis of 2008-2009 (earlier it was told that the market functioned; now the September report by IMF reveals that it only functioned thanks to the Riksbank’s interventions);
* Swedish banks have underestimated their need for capital (for example, Swedbank has been considered as overcapitalised, but in reality it has to increase its CET 1 ratio to reach the EBA’s target of at least nine per cent while taking into account the transitional rules from Basel 1 to Basel 2); this means that they are now cutting back lending and/or raising interest rates for the customers (which is bound to lead to a negative feedback effect in the form of increasing credit losses).

On the other hand, low government debt and independent central bank still provide some room for manoeuvring. The basic message by the Riksbank is that it will “print” as much money as needed. We will see, but I’d not consider Sweden as a “Safe Haven”, and right now I do not think that it’s a good idea to get more exposed to it.


  1. Q: "The funny thing is that no one seems to have a good answer to the question of why the housing supply has been limited."
    A: Heavy over-regulation of rental market and cartel like behavior of construction market.

    Q: “How many of the outstanding loans are interest only right now?”
    A: About 70% or bit more. There is sometimes misleading information provided, that just about 50-something % does not amortize. This is calculated at the customer level. Often customer amortizes just one tranche out of two or three. Annual cash amortization of the full mortgage book is between 1-2%.

    1. Wow, thanks for the answers indeed:) May I ask, what's the source of this information?