Sweden’s fundamental housing bubble?

In recent years, Sweden has simultaneously experienced rising levels of household debt, soaring home prices and below target rates of inflation.  

The Riksbank, Sweden’s central bank, has long expressed its concern over the rising level of household debt and the related price increases in the housing market, while at the same time it tried to raise inflation to the official target level of two percent annual CPI inflation.

The aggregate level of household debt was about 175 percent of the disposable income at the end of 2013, and above 400 percent on average for households with a mortgage in the three largest metropolitan areas.

Trying to achieve higher inflation while simultaneously keeping household debt in check proved to be a tough balancing act. In July of 2014 the Riksbank started lowering the repo rate from 0.75 percent to boost inflation. By March of 2015 it reached -0.10 percent.

In confronting this tradeoff, the Riksbank stated that the repo rate would have been lowered sooner if there had not been concerns about rising level of household debt.

But even given these concerns, the Riksbank can no longer ignore the fact that CPI inflation has been way under target for a long time, which inevitably weakens the credibility of the official inflation target. This raises the policy issue of whether the task of managing the potential build-up of risk in the housing and mortgage market should be assigned to the Riksbank or to other regulatory bodies.

A good place to start to understand how Sweden is handling these macroprudential issues is the 2013 summary report “Preventing and managing financial crises” (SOU 2013:6), by the Financial Crisis Committee.

The report concludes that the relatively recent experience from the Swedish banking crisis in the early 1990s was important for the successful Swedish crisis management during and after the more recent financial crisis. In light of the depth and extent of the crisis, the relevant authorities cooperated closely, despite unclear responsibilities. Confidence in the financial markets was maintained, lending to businesses and households continued and no big credit crunch occurred.

However, the crisis revealed several weak points concerning the knowledge and analysis of systemic risks, as well as a lack of tools and a clear governance structure to manage, mitigate and prevent financial crises in the future. The Riksbank’s mandate to maintain price stability and a safe and efficient market for payments, limited it to monetary policy.

The need for an explicit mandate for macroprudential regulation was clear and the Financial Crisis Committee proposed that the responsibility should be shared between Finansinspektionen (the Swedish Financial Supervisory Authority) and the Riksbank.

In 2012, the Riksbank and Finansinspektionen jointly set up the Council for Cooperation on Macroprudential Policy. The purpose of the council was to prevent the build-up of systemic risk in the financial system. It also provided a forum for the discussion of analyses and the development of tools and methods in the area of macroprudential supervision.

However, the ambiguity over the assignments of specific responsibilities remained unsatisfactory.

In 2013, the mandate for macroprudential regulation was given to Finansinspektionen. This was motivated by the fact that Finansinspektionen already performed microprudential regulation, like capital and liquidity requirements, for individual institutions. Giving them the mandate for macroprudential regulation was considered a natural extension to do the same for systemically important groups or sectors.

Another motivation for assigning Finansinspektionen the single mandate was that it is a government agency, while the Riksbank is an independent authority that answers to the Swedish parliament and not the government.

The Council for Cooperation on Macroprudential Policy was replaced by the Financial Stability Council at the end of 2013. The Financial Stability Council consists of; the minister of Financial Markets (chair of the council), the director general of Finansinspektionen, the director general of Riksgälden (the Swedish National Debt Office) and the governor of the Riksbank.

The purpose of the council is to effectively manage a crisis situation, and in normal times discuss issues relating to financial stability.

The government and the authorities represented in the Financial Stability Council decide independently what measures should be taken within their respective areas of responsibility.

The reasons behind the rising level of household debt and the related price increases in the housing market are widely discussed, and there has been talk of a Swedish housing bubble since at least 2009. In January of 2015, SNS (the Center for Business and Policy Studies) released their report “The Swedish Debt.”

In the report the authors conclude that the level of household debt is not a cause for concern for the stability of the Swedish financial system.

They explain the increased level of household debt with increased home ownership and higher home prices, which are primarily driven by fundamental factors such as: (I) a regulated rental market with de facto price ceilings which discourage supply and (II) a distorting tax system that favors home ownership in various ways.

The higher home prices can, largely, be explained by: (III) insufficient supply to meet the increased demand for housing (particularly in the metropolitan areas), (IV) higher real incomes and (IV) a long period with low real interest rates.

Another channel for increased household debt is that when rental buildings are sold and converted into housing cooperatives, debt is shifted from institutes to households and we observe this as a rising level of household debt.

These are basically all the same conclusions that were reported in “The Riksbank’s commission of inquiry into risks on the Swedish housing market” from 2011. It seems like much of the housing market is driven by a combination of fundamental factors that are all going in the same direction.

And there is a near consensus among economists in Sweden that a fundamental problem with the Swedish housing market is the regulated rental market. Rents are set in negotia-tions where central organizations representing landlords and tenants agree on “fair rents” (bruksvärde).

Rents can only reflect the “value of use,” determined by the size and standard of the apartment, with little regard given to the attractiveness of its location. For central locations of the major metropolitan regions, rents set in this way are significantly lower than market rents. This not only affects the profitability of developing new rental apartments, it also leads to inefficiencies and adds time to the already long wait for a regulated rental contract.

In 2013 ,the shortest wait for a rental apartment in Stockholm, located 30 minutes outside of the city, was four to five years. The average waiting time in Stockholm City Center was at least 16 to 17 years. For Stockholm as a whole, the average waiting period was eight to nine years.

In the minutes from the latest Financial Stability Council meeting in November of 2014, the Council describes the resilience of the Swedish financial system as good, although there is, to a varying degree, an unease about the high and rising level of mortgage debt for Swedish households.

The concern about the build-up of household debt is not so much for financial stability’s sake as it is for macroeconomic stability, in the event of a shock to the housing market or the real economy.

A Swedish household can’t walk away from its debt, and regular mortgages have had a loan-to-value cap at 85 percent since 2010,  (i.e. require a down payment of at least 15 percent). So the primary concern is not that the banking sector will incur large credit losses from the mortgage market, but instead how the debt level will affect consumption and the real economy.

More than half of Swedish households choose adjustable rates for their mortgages and this can make their consumption more sensitive to changes in the interest rate. A report on the macroeconomic effects of a drop in the housing prices made by Konjunkturinstitutet (National Institute of Economic Research) in 2014 suggests that, in response to a 5 percentage point drop in housing prices over four consecutive quarters, consumption could drop 2 to 3 percentage points and only return to the trend level of consumption after four to five years.1

To deal with the rising level of mortgage debt, Finansinspektionen has announced a mandatory amortization rule, for certain leverage ratios, aimed at households that are considered to be especially likely to reduce their consumption of goods and services in response to worsening economic conditions.

All new2 mortgages with a loan-to-value ratio above 70 percent will have to be amortized with at least 2 percent of the original principal per year, down to a 70 percent loan-to-value ratio (the property value is fixed as the price paid at the time of purchase).

For mortgages with a loan-to-value ratio between 70 percent and 50 percent, the annual amortization requirement will be at least 1 percent per year of the original principal.

For mortgages with a loan-to-value ratio below 50 percent there is no required amortization, because it is believed that these households will not likely reduce their consumption of goods and services in response to deteriorating economic conditions.

As an addendum to this new amortization rule, banks will be allowed to grant a temporary exemption from the rule if a household falls on hard times.

The amortization requirements that have been put forth by Finansinspektionen were wel-comed by the Financial Stability Council, but the Riksbank wanted to see further provisions to handle the mortgage build-up.

For example, higher down payment requirements, stricter requirements for credit approvals, restricting the amount a household can borrow at an adjustable rate; a loan-to-income measure for loans; increased taxation on housing; removed or reduced interest rate tax deductions; and, most importantly, a reformed rental market.

These suggestions were not backed by the rest of the council, who worry that the “frail” economic recovery can’t be disturbed by further interventions to the financial markets. Instead, the council agreed that the amortization requirements should be further analyzed with respect to regional and distributional aspects.

Monetary policy is a potent but blunt tool for macroprudential concerns and the Riksbank was not given the mandate for macroprudential regulation, so the solutions to these macroeconomic stability issues has to come from other authorities. In this case one specific solution reigns supreme: restore the price mechanism.

Rent control greatly reduces mobility in the housing market; it leads to an inefficient utilization of the housing stock; it creates a black market for rental contracts; and it discourages the development of rental apartments.

Without a well functioning rental market we can’t make an informed comparison of the costs of renting and owning an apartment, which makes it even harder to say anything about a correct valuation of the housing market.

On the homeowners’ side there is need for tax reform with regard to housing, to make sure households carry the full weight of their obligations.

At the moment the political will to reform the housing market is limited to talk of building more low cost rental housing. No one wants to come out in support of any reform that would raise the cost of living for voters.

But without reform that addresses both the supply and the demand side of the housing market, we should not expect the developments in the housing and mortgage markets to change dramatically anytime soon. In short the dilemma of a booming housing market with below target inflation, reflects largely micro policy constraints on housing supply and lowered interest rates.

 

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Johan Grip

Johan Grip
PhD student
Department of Economics
Uppsala University, Sweden 
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