...and implications for the Icelandic mortgage market.
Financial indexation is the practice of linking the value of a financial obligation or contract to a variable index rate that may fluctuate over time. Common types of such rates used in contracts include stock market indices such as the Dow Jones Industrial Average which measure the market value of a set of underlying stocks. Another type of index is the London Interbank Offered Rate which measures average short-term interest rates being offered by members of the British Bankers' Association to each other on a given day, or at least whatever rates they might report as such. Yet another type of index might measure the price of a commodity such as oil, gold or the exchange rate of a foreign currency or even a basket of currencies and commodities which fluctuates according to the underlying market conditions. Financial contracts that derive their price from any such variable index rates are generally known as derivatives and are sometimes combined with loan agreements to form even more complex instruments which are the subject of structured finance theory.
Iceland has a relatively long history of widespread financial indexation and as it turns out, most household mortgages are not really what most other countries would recognize as such. The most common type of mortgage loan in Iceland is actually more like the complex derivative type of financial instrument, a loan for a term of 40 years at a fixed rate of interest combined with an inflation derivative and secured by residential real estate collateral. This kind of financial contract is what's known as an index-linked loan, which Icelandic law requires to be linked to the official consumer price index, hence the term CPI-indexation. While rampant inflation would ordinarily cause inflation linked mortgage payments to rise sharply, these loans have additionally been engineered with graduating payments and negative amortization schedules, leading to compounding interest accrual and in the long run exponential growth of monthly payments. The ever increasing costs inevitably lead to a variety of economic calamities and human tragedy.
Since originally introduced, such contracts have become so widespread as to currently represent 85% of the Icelandic mortgage market or around 75% of GDP, one third being accumulated cost of inflation or around 25% of GDP. Through the years this risk transfer mechanism has imposed enormous liabilities on the homes which for many has turned out to be an impossible burden to bear, resulting in thousands of families defaulting on their payments and facing foreclosure. Additionally in the years 2005-2008 some 10-15% of the market moved into loans linked to foreign exchange rates, which has since then doubled in price forcing many families into bankruptcy.
These lending practices have repeatedly sparked protests, even riots in the streets, and 15% of registered voters signed a petition for abolishment but have gone ignored by authorities despite polls indicating 80% support of the public at large. In 2010 a supreme court ruling the FX-indexation turned out to be illegal since an amendment was made to the law in 2001. As it turns out less than a year earlier in 2000 an amendment was also made to the law regarding consumer credit, including residential mortgages. Latest research seems to indicate this amendment may in fact also have outlawed the aforementioned usurious CPI-indexation of consumer credit. The Homes Association has prepared a case which has now been filed in court to have this conundrum resolved once and for all.
The Central bank of Iceland on indexation:
Annual report 1992
Page 32: "Third, the indexation of financial assets as well as higher and positive interest rates have had the impact that household debt has accumulated instead of being eroded through inflation."
Working paper no. 59 - Households' position in the financial crisis in Iceland
Page 10: "Another salient (and more problematic) feature distinguishing Icelandic households from those in many other advanced countries is the composition of their liabilities. The majority of mortgages are indexed to consumer price inflation with fixed real interest rates, so that households are insulated from fluctuations in nominal interest rates to a large extent but are instead exposed to increases in nominal debt levels when inflation rises."
Page 44: "Icelandic households are relatively more likely to end up in negative housing equity than households in many other countries due to the characteristics of Icelandic mortgage contracts. The first factor is the extensive indexation to consumer price inflation and exchange rate developments, which exposes the debt position to exchange rate and inflation risks."
Page 46: "The incidence of negative housing equity increased considerably in the run-up to and aftermath of the crisis, as house prices declined and mortgage debt levels rose due to the currency depreciation and accompanying inflation on top of the rapid debt accumulation. The share of households with negative housing equity increased gradually from about 6 to 13 per cent from January 2007 to April 2008 and then rose at a more rapid pace thereafter. Almost 22 per cent of indebted homeowners were underwater at the time of the banking sector collapse, and by February 2009, when the currency had more or less stabilised, it had reached 28 per cent. The inflation spike and further house price declines made the share in negative housing equity continue to escalate even further (see Figures 4.6a and 4.6b). It peaked at almost 39 per cent before the court ruling and new legislation on foreign-denominated loans reduced it slightly, to 37 per cent. This corresponds to an increase from roughly 4,000 households in negative housing equity at the start of the period to roughly 26,000 households by December 2010. Hence, roughly 27 per cent of all homeowners (indebted and debt-free) were in negative housing equity at the end of the four-year period."
The Incredible Loan Machine
An example from a model constructed in 2013 by The Homes Association, showing the projected development and cost of a typical inflation index-linked mortgage over time, compared with other types of loans and specifically with nominal rate loans which are ordinary for most other countries. The example is calculated given prevailing inflation of 4,83% in april 2013, but as shown the historical average is as high as 5,84%.
The problem only gets worse by refinancing inflation indexed loans, because that locks the accumulated undpaid indexation component into a new starting capital amount. This amount then starts rising even more because of price inflation which subsequently compounds on this new and higher loan capital. The refinancing rate of mortgage loans in Iceland has been estimated at 8 years on average. As shown here, the inevitable result is that under such conditions, the average mortgage loan will always keep rising and can in fact never be repaid: