Credit-supply conditions

Wider capital market regulations, technological change and reductions in the cost of information technology, developments in the sharing of information on credit histories, and the deepening of markets for securitized contracts and derivatives, new types of mortgage contracts (Muellbauer, 2008), improved credit scoring systems (Avery, 2009; Green and Wachter, 2007), easer access to mortgages, improved mortgage system, relaxation in mortgage restriction, longer loan terms, lower payments (Lunde, 2008b), credit liberalization, financial innovation (Nesvetailova, 2007), these are some of the explanatory factors of improved access to credit. They all shaped improved credit supply conditions leading to credit expansion. That is to say, the developments of the credit supply conditions made credits cheaper and more affordable.

54 In addition, changed dynamics within housing finance market in Denmark are believed to have significant effect on the households’ ability to service the debt burden. For example, the introduction of adjustable interest rate mortgages (ARM) in 1996 and of interest-only mortgages (IO) in 2003 made it possible for owner-occupiers to reduce payments considerably when re-mortgaging (Lunde, 2007b).

The market share of ARMs has risen quickly after 2000, especially in periods when interest rates were falling from 2003 to 2005. In 2000, only 6% of the total mortgage value was ARM, while 83% were fixed-rate mortgages (FRM). In 2006, the share of ARMs had risen to 50%, while the share of FRMs had shrunk to 45% (see appendix 23 A and table 11 in appendix B). Thus, the mortgage developments had positively affected households’ cost payments when new choices were introduced. It contributed to a perception that: “In Denmark, while mortgage debt burden has been rising, the ability to service that debt has either been relatively stable or has improved slightly” (Girouard et al., 2006a, p.130).

Also, the option of repayment provided new flexibility for home occupiers. With the option of repayment, households cut their interest payments.

In addition, improved credit scoring systems made credit granting decisions more efficient.

In the US, the automation of many of the steps in the lending process resulted in a decrease of the cost of originating a mortgage lending from 2, 5% to 1, 5 % (Benett, 2001, in Maullbauer, 2008) Avery, Brevoort and Canner (2009), and a group of researchers for the Federal Reserve System Board analyzed how credit scoring contributed to improved credit affordability. They concluded that the credit scoring system had increased the availability and affordability of credit thanks to new and improved methods of establishing prices on credit (Avery, 2009), which, according to Green and Wachter (2007) lead to an acceleration of the sub-prime market.

Thus, the contribution from financial sector developments resulted in easier credits- both globally and in Denmark- which attracted more first-time buyers. The growing appetite for credits has raised households’ debt level, contributing to further house price appreciation (Muellbauer, 2008).

However, as prices, debt level and financial innovation had grown, so did the risks. The growth in credit (indebtedness) posed higher risk than ever before (Case and Quigly, 2008; Lunde et al., 2008a; Ynesta, 2008). Also, the rise in ARM is associated with increased risk exposure and housing boom. So, despite the housing tangible value, the investment in housing is not as safe as it was believed. The associated risk from housing markets will be presented in the following.

55 3.3.5 Risks

In boom times, the financial markets were characterized by ample liquidity, low risk premiums and positive economic developments (Danmarks Nationalbank, 2008). However, a range of risk factors were under-estimated, or even neglected.

First of all, the risks of housing to wider economy were neglected- the risk of housing downturn was under-estimated or even rejected. For example, Danmarks Nationalbank’s assessment of financial stability in 2007 stated that even on the housing downturn, there were no immediate risks to financial stability and wider economy. “There is no reason to expect a general housing price dive for as long as the economy remains strong” (Danmarks Nationalbank, 2007, p.6). Also, some economists stated that if there were a housing downturn, it should be a “soft landing” because the increase in interest rate was expected to be relatively mild (Rae and van den Noord, 2006). Also, a prevailing belief among people that “this time is different” resulted in risk misunderstanding (Reinhart and Rogoff, 2009).

However, because the significance of the housing market to the wider economy is so substantial (Leamer, 2007; Goodhart, Hofmann, 2007), the risk of a housing downturn can be harmful to construction, financial and real estate sectors.

Secondly, another very important risk to financial stability and housing market was neglected: the risk of over-indebtedness. Already in 2005, in Denmark, 6% of all households from a survey were in a burden problem of housing-related cost, of whom 10% were households with a main income earner of 25-29-year-old, 8%- single persons with children (see appendix 24A and 25 A for the analysis and figures).

The involvement of an “enormous” debt in housing makes housing investment dangerous. When housing prices fall, many owners are pushed into negative equity, which makes households reluctant to sell their property, or move to another place of living in order to get a new job.

This also exacerbates the problem of unemployment.

Thus, the effect of negative equity risk on economy was also under-estimated.

The adjustable- rate (ARM) and interest only loans (OIM) seemed to decrease households’ interest payments- the ability to service the debt thus improved. However, the increase in ARM and decline in FMR may in itself pose a risk if the interest rate suddenly increases and if those mortgage holders face a tight budget situation. Therefore, the increased proportion of IOM and ARM is associated with higher risks (Lunde, 2008c). In addition, the high proportion of “risky” ARM and IOM is compared to American subprime loans (Lunde, 2008c), which is associated with irrational subprime

56 lending (Mortensen and Seabrook, 2008). However, the risk of interest rate increase was under-estimated under the assumption that interest rate increase was expected to be mild (Rae, van den Noord, 2006).

Furthermore, the increased ability of households to extract or borrow against their home equity has altered consumer spending (Muellbauer, 2008) and created more indebtedness (Lunde, 2010). It increases further the possibility of a default (here increased spending and indebtedness are associated with higher credit risk, if income and other factors are constant).

In addition, the volatility in lending activities since 1993 has increased (see in figure 43 in appendix 20A). Volatility in mortgage lending increases housing volatility and economic cycles, which in turn, can sometimes trigger financial instability.

So, the combination of all above mentioned risks makes households and economy more vulnerable if housing prices fall or interest rates rise. Increased households’ vulnerability to default means that the possibility of not being able to repay a loan is increased in spite of increased earnings and decreased interest payment.

Under rational lending, this means that improvements in credit conditions (liberalization, easier access to mortgages, new types of loans with lower mortgage payments) should have been neutralized by higher risk perceptions. So to say, because of increased volatility/pro-cyclicality on housing and credit markets, banks should have diminished the lending activities.

However, in reality we experienced the opposite: as housing price deviated from its long term equilibrium, the credit demand and supply growth continued (measured by total lending on the balance sheets of Danish banks), reaching its peak in 2006.

Only in 2008, after the collapse of Lehman Brothers, the decline in lending activities had begun.

However, this decline was explained by increased business uncertainty. It has become more difficult for banks to valuate profitable projects (Danmarks Nationabank, 2007). Therefore, banks cut on lending and households cut on borrowing. This happened when housing price already were declining. However, when banks cut on corporate and household lending and tighten credit standards in a crisis period, this poses even greater risk to a wider economy, and to a housing market.

57 To conclude, lending was based on general favourable economic conditions for households.

However, taking risks factors into account, the households’ risk exposure (measured by debt-to- income; debt-to-GDP and increased volume of IO mortgages) increased as well, making them more vulnerable to default. Also, because housing prices were far away from equilibrium, the risk of price decline, housing wealth loss, negative equity and foreclosures increased significantly.

So, can those imbalances be explained by an improved ability to service the loan? I address this issue by the credit affordability concept in the following section.

3.4 What is credit affordability? - Concept definition based on literature