Thursday, 22 November 2012

The Upcoming Problems of Housing Financing Fund

The Housing Financing Fund (HFF) in Iceland is a government sponsored entity that raises money on the capital markets and lends it onwards to Icelandic households in the form of mortgages. The total government guarantee on this fund is 950 billion ISK (58% of GDP and almost two times annual income of the State).

The problem is: the HFF is bleeding, slowly but securely. Consequently, it is a massive threat for the public finances because the government has to bridge the gap whenever its equity position runs down. And today, that position is only 1.4% of total assets.

HFF's accumulated losses since 2008 are 46.7 billion ISK. Its equity is supposed to be above 5% but as already mentioned, it is 1.4% now - down from 2.3% in June.

The government has already pumped 33 billion in new equity into the fund (in 2010) but that was swallowed whole in the fund's participation in the 110% act (you had part of your debt cancelled if your mortgage was 110% of the market value of the property). The fund has also tried to increase its net interest rate premium as we can see on the graph below. All the same, the fund now needs 12-13 extra billion ISK from the government.

The interest rate premium of HFF has increased slowly but securely since 2009. The red line is the fund's interest rate cost (the rate on HFF 44 which matures in 2044), the blue line is the rate it offers its borrowers and the green line the difference there between. The black line is 12 month moving average. 

The reasons for its demise: lack of common sense

The first reason for HFF's troubles is the fact that it is offering a rate of interest which households cannot pay in the long run!

You may have noticed on the graph above that the blue line stands at just above 4%. It stands at 4.2% to be exact. This however is not nominal rate of interest but real rate of interest!

All the mortgages from HFF are indexed - and if you want to know in more detail how Icelandic indexation on mortgages works, check this out - and carry therefore the real rate of interest. The most brilliant thing about the indexation of mortgages in Iceland is that it is not the nominal rate of interest which is upped parallel to the changes in the rate of inflation, but the principal of the loan is changed according to the annual rate of inflation.

So if you have a mortgage from HFF of, say, 1,000,000 ISK you will get it with 4.2% rate of interest. Assume that this is in November 2012. In November 2013 the annual inflation turns out to be 5%. That means that you now owe the HFF a mortgage amounting to 1,050,000 ISK which still carries the 4.2% rate of interest. You do not owe 1,000,000 at 9.2% rate of interest.

The Icelandic indexation basically postpones the full cost of the monthly payment. Instead of demanding that you as the borrower pay the original amount at 9.2% nominal rate of interest, you get a loan, automatically, amounting to 50,000 ISK and are asked to repay it later. This of course happens repeatedly, every single month to be exact (the amount changes of course depending on the rate of inflation).

Now, the trick is that this may not be so bad if the borrower can in reality pay back the loan. But that means the borrower has to find money to repay the original principal and the automatic loans as well which are so conveniently extended to him.

That is going to be a bit problematic for the average household. For even though the real rate of interest on HFF loans are 4.2%, the real wages in Iceland are not growing by that number. They are only growing by 1.1% per annum (since 1989).

So if you look at the households as a whole and consider their debts, which carry the real rate of 4.2%, and their wages, which grow by 1.1% per year, is it not likely that the ratio debt/wages will grow year by year?

Well, yes it is! And so they have! This happens not only because of new non-automatic borrowing but also because the households are given an automatic loan every single time there is inflation: inflation basically funds itself! This really smells a bit like a Ponzi-financed inflation. And that is truly what indexation, in its current form, of mortgages in Iceland is. Some day, a large chunk of this mortgage debt will have to be either refinanced at a rate of interest well below what it is today or simply straight forward cancelled. This is not sustainable!

Household debt in Iceland as a ratio of spendable income. The drop in 2011 can be explained to some extent by the illegal foreign-currency loans and the households' endeavour to use pension savings to repay debt.

The other reason for HFF's bleeding wound is the fact that it cannot pay its debts in advance: the bonds it issues have a no-early-payment clause.

This means that if households decide they want to refinance their HFF mortgages with another one, from e.g. a bank, the HFF will end up with a stack of cash it has no idea what to do with. That stack of cash will of course only yield 0-1% real rate of interest, if that, which is quite problematic for HFF because its issued bonds (the HFF 14, HFF 24, HFF 34, HFF 44 bonds) are irremediable and carry a 3.75% coupon rate.

Blatantly then, the HFF will slowly bleed out. Whatever money the government throws at it will practically be nothing else than a temporary bandage on the negative-net-interest wound which it slowly bleeds equity out of.

Truth is that the Icelandic Housing Financing Fund is in a Wile E. Coyote moment: there is nothing behind it other than the air and the Icelandic government's guarantee. The problem is that HFF cannot be allowed to go bankrupt for if it does it can be interpreted as a payment default of the Icelandic state.

It will be fun to be an Icelandic tax payer in the future! Also, if a condition for abolishing the capital controls is a deficit-free budget, good luck with that with HFF hanging around.

(Icelandic version first published on

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