Household debt and house prices

Steve Keen has an article on household debt and house prices in multiple countries, using BIS data. Since Iceland is not on the list - and we arguably had a housing bubble - I sat down and did the same (or at least similar) analysis on Icelandic data. Sources are the Central Bank of Iceland, Registers Iceland and Statistics Iceland.

First, the real (CPI deflated) house prices.

Real house prices in Iceland, monthly data.

Now let's see what happens when we add the household debt data.

Keen uses the acceleration in household debt and the change in house prices. The idea is that acceleration of household debt, which is mainly mortgages, should be like a jolt of energy into the housing market. More mortgages (increased acceleration) means more purchasing power and more purchasing power means more demand which should push up house prices. So the acceleration in the level of household debt should be correlated with the change in house prices. If the correlation is high it is a sign that changes in house prices are primarily driven by new mortgages rather than "fundamentals" of any kind.

In the case of Iceland we've got data back to 1997, limited by quarterly national accounts. We can stretch the data back to 1994 when the index for house prices is first published but I'm using quarterly data here.

Icelandic household debt acceleration and change in house prices

The second graph here above makes perfect sense until about 1Q 2008. Then we can see a great divergence between the two series and after October 2008 there is all sorts of nonsense going on.

The likely reason for the apparent non-correlation after October 2008 is that the data is all messed up. When the new banks were established they got a free book-value haircut on the existing debt of up to 30% or even more. The great profits of the banks since the collapse is to a large extent due to the banks clawing back this haircut in their books: a credit contract worth 10,000,000 ISK (nominal value) was booked, when the banks were established, at 6,000,000 ISK and then revalued, in steps, up to e.g. 9,000,000 ISK, creating a nice 3,000,000 ISK profit in the books.

It's the October 2008 haircut which is the reason for the massive drop in debt acceleration around that time. The second drop in 2010 is probably due to the fact that FX-indexed loans were deemed illegal and the banks had to write them down to a large extent. Meanwhile, the divergence in early 2008 is at least partially explained with the fact that by that time the ISK was collapsing and FX-indexed loans, the same which were later found to be illegal, were rocketing up in nominal value.

So data problems are probably the reason why the correlation doesn't make any sense after 2008. Until 3Q 2008 the correlation is as we would have expected it from Keen's idea. And the value: 0.56. If we want to be selective and skip the last three quarters of 2008 when the ISK was collapsing at the fastest pace the correlation goes up to 0.74. That's high but still lower than some of the coefficients that Keen has in the case of other countries.

And today? Well, the banks began offering non-indexed mortgages (majority of mortgages in Iceland is indexed to the CPI) in 2009 and they really took off in 4Q 2009 according to data from the CBI. A large share of new mortgages is now non-indexed but their share is fluctuating somewhat. As far as I'm aware of no official data series exists which shows their share at all times.

We could check out the correlation between household debt acceleration and house prices from e.g. October 2008 or December 2009 but we would still have to deal with the rather bizarre drop in the data in 2010, probably caused by the FX-indexed being found illegal. If we however check the correlation only from 4Q 2010 we get this:

Household debt acceleration and change in house prices since 4Q 2010. Correlation: 0.85

Now, this is guesswork and should be taken with a pinch of salt! I do not know when exactly the banks book their losses due to the illegal FX loans, I'm guessing, from the data itself, that it's before 4Q 2010. Furthermore, this is less than three years of data so we should be careful in trusting that the correlation will stay there forever. Also, since the CPI includes house prices and the CPI affects the nominal value of indexed mortgages we should expect to see correlation through that link as well. Finally, correlation is not causation and all that - and this applies to the previous graph as well.

All the same, this feels intuitively too comfortable to outright deny it. It at least seems that the current housing market in Iceland is driven first and foremost by new credit being created by the banking system. I wonder how important fundamentals, such as wages, really are.

Oh, well! Back to work!

Icelandic Pension System: Only 700 billion missing

The FSA in Iceland recently posted a new set of figures regarding the pension system back home. The bottom line: only 674 billion ISK missing (i.e. the total actuarial position is negative by 674 billion). That translates into just over 39% of GDP which is an improvement from the 2009 figure when the gap was a considerably worse 50% of GDP. So even if the current situation is bad - good luck finding money nearly equal to the whole government's, local and state, income for a whole year! - it isn't as bad as four years ago.

Or is it?

The Icelandic pension system is often held up high as one of the best ones in the world (at least in Iceland). Again, looking at other pension systems, I suppose this is true but that's not because the Icelandic system is so great but rather because most other systems are so bad! At least Iceland had the wits to store some of the pension-tax that is collected from its citizens, creating somewhat of a buffer for the public finances once the baby-boomers retired and their grandchildren entered the tax... sorry... labour force. Consequently, we have assets in the system worth around 129% of GDP (which, taking the deficit into the account, means that we, and our unborn children, have promised ourselves to pay ourselves pension worth 168% of GDP... we just don't have the money to do so... yet... but that's a problem for future generations, right?)

Not doing too bad in comparison to many others. Bankrupt by 700 billion ISK all the same.

Seemingly slowly recovering

The second graph above might give the impression that the system is recovering after the 2008 crash. What it doesn't show however is that the funds cut down the benefits of their clients by 130 billion already by year end 2011. So the majority of the improvement in their actuarial position comes from these cuts. The 2012 improvement is certainly helped by a convenient increase in domestic stock prices at the end of the year.

What's wrong?

The fundamental problem of the Icelandic pension system is that it implicitly promises a rate of return that is impossible to get in the long run. This rate of return is around 3.5%. Nobody in fact knows it for sure for it hinges on the development of factors such as wages and expected longevity. And since nobody knows for sure how exactly those factors will change, the only thing we can do is to estimate the needed rate of return to fulfil the pension promises. And the best estimate: 3.5% real rate of return per annum. Consequently, this figure is in the actuarial accounting for the pension system to try and keep balance between the future cash flows that will affect the asset side of their balance sheet on one hand and the liabilities side on the other.

But think about this: in an economy with limited resources and in fact where the annual GDP growth is already below 3% on average, is it realistic to promise a 3.5% rate of return on your pension assets?

If the impossibility of this promise doesn't immediately pop up in front of your eyes, think of it this way: would you trust a person who promises to pay you a 3.5% real rate of return on the funds you are going to lend to her when you expect that this person will only earn 3.0% real rate of return on her investments?

If I would show up at the bank with such an investment plan, I should be rightfully laughed at and tossed out!

The beauty however of macroeconomics is that we can run such an unrealistic system for quite a while by racking up gross debt - owed by the households themselves, firms and the state - in the early stages of the system. The newly created debt will act as somebody's income and spur increases in asset prices, consequently improving the balance sheets of those who hold the assets in question. So while the debt increases, the system will report a rate of return higher than the growth of GDP. In the end however, the debt burden brings the system down and it collapses. This is why I've repeatedly called the Icelandic pension system a Ponzi scheme.

That is the essential problem of the Icelandic pension system: it promises more than it can deliver. On top of that comes the very important side effects of pushing the rate of interest in the Icelandic economy upwards. This happens due to the funds' gigantic size in the economy while they demand such a high rate of return on whatever they buy: to fund an investment project, it is not unlikely that at least some of the money will come, one way or the other, from the Icelandic funds which demand a 3.5% rate of return. Consequently, the rate of interest is pushed upwards, killing the economic recovery.

I only realised this in 2010 and went public (e.g. here, here, and here) with this rather blatant truth once one just stops and thinks about it. Already in 2010 I repeatedly warned that the system needed reform to lower the dreaded 3.5% minimum rate of return. I also warned that if the pension system would not be reformed, the rate of interest would stay too high and kill off any gross investment in the economy. It wasn't done and, as expected, the level of gross investment in the economy hit a historical low! The high rate of interest, pushed upwards by the pension system, was one of the culprits.

We would have had a proper recovery if the pension system had been reformed

The Icelandic Pension Fund Association publicly replied and said I was wrong. One of the foremost specialists on the system, Bjarni Thordarson (who has now passed away), claimed my stating of the case a "nonsense" (i. dómadagsrugl). The president of the Icelandic Confederation of Labour, Gylfi Arnbjornsson, thought that my "misunderstanding" about how the system worked was becoming "awkward".

Now, finally, we have news that they are going to do something about it: the system is being reformed although it seems as if they are mainly going to reform it such that the government-backed up part and the private part will be coordinated with each other. They are going to jack up the pension age from today's 67 years though. Overall, reports are still hazy and the final plan has not been formalised.

Let's wait and see and hope that they will actually improve the system but not just reform it.

UK & Iceland GDP comparison

After the recent GDP figures from ONS, the general reaction was rather pessimistic. FT had e.g. this tweet and article:

True, this doesn't look good. In fact, after the revisions, UK GDP volume is now further below its top before the financial crisis than Iceland's GDP is. The following graph is based on data from ONS and Statistics Iceland. The top is given the value 100 (3Q07 for Iceland but 1Q08 for the UK). Chained volume measurement, seasonally adjusted (yes, the Icelandic data are SA although they don't look like it).

Back on track: Iceland is edging closer to its GDP volume top before the crisis. The momentum is also stronger.

Iceland's GDP is now 0.4% closer to its top before the crisis than UK's GDP compared to its top. Then again, Iceland had its top two quarters ahead of the UK.

But - there is always a "but" - this is a volume measurement. And although economics teach us to think in volumes and real measurements, we arguably do not rely on barter (and never did) in our commerce. We use money and money is different between economies: try paying with Queen's money in Iceland and you'll be a laughing stock (I've tried, the guy just grinned at me) just as you will be if you try using the ISK in the UK.

So what happens if we price the volume produced in the same currency, say the GBP. That comparison makes sense: we could be producing the same volume as before the crisis but is it worth the same?

The UK volume is already priced in pounds so no need to handle that in a special way. But the Icelandic volume measure uses the ISK as a measurement stick and that measurement stick has changed significantly since before the crisis. If we measure both of the volumes in GBP, the following graph is the result.

Still long way to go: measured in GBP, the Icelandic GDP volume does not seem to be edging must closer to its previous height

Notice the drop in the Iceland data in 2006. This is the "Geyser crisis", a short wake up call to the fact that we were in a bubble. But it did not last long; politicians and prominent businessmen claimed everything was peachy, the housing bubble restarted (held up with exchange-rate linked loans which have now been deemed illegal) and the banks kept on growing. Then, finally, the party ended.

To my British friends I say: sure, you're not in the best of situations. But if it makes you feel better, you're not in the worst.

How much household debt was cancelled? Update

In April last year I wrote about how much of Icelandic households' debt was cancelled. Now, we've got new info on the topic.

And the amount: 247.5 billion ISK. This figure comes from the Icelandic Financial Services Association in their comment on the new government's 10-step plan of general debt relief to Icelandic households (they don't really comment on it, they are going to wait until the government actually describes how they're going to do this).

What are the sources and the reason for the debt relief so far? The IFSA comment has a handy table to show us (my translation). The left-most column is mine as I thought it would be informative to note where the initiative for each part came from. In the cases of where I've put "Legal System" it is due to rulings regarding the illegality of certain credit contracts, first and foremost ISK denominated debt that is indexed to the exchange rate. That sort of indexation is illegal in Iceland since 2001 (though it did not stop the contracts to be created during the height of the credit party). Finally, do note that the figures due to ruling 600/2012 (a supreme court ruling regarding the illegality of certain exchange-rate indexed loans) are estimates and not entirely realised as of yet.

The total debt relief to Icelandic households, 2009-3Q2012.

Despite this nearly 250 billion ISK relief, Icelandic households are still pretty indebted. In the newest Financial Stability report, the Central Bank of Iceland estimated that the outstanding household debt amounted to around 110% of GDP. That is roughly the same ballpark as Ireland is playing in - although the Irish are not paying a 4-5% real rate of interest on their debt as Icelanders do.

From the newest Financial Stability Report (Central Bank of Iceland)

Nevertheless, the debt jubilee has of course had some effects; one should expect that when debt amounting to 15% of GDP is cancelled. But the situation is still fragile and we should not expect it to improve as easily as it did in the early 2000s when an investment boom was creating a lot of jobs and wage income.

Icelandic households' ability to live on after-tax monthly income (source: Statistics Iceland)

Minister of Finance Comments on the Housing Financing Fund

The new minister of finance, MP Bjarni Benediktsson, spoke with Bloomberg the other day. The topic was the Housing Financing Fund and its "red numbers" as Benediktsson put it.

The most notable part of the interview was when Benediktsson wished that creditors of the fund - the owners of HFF bonds - would be "flexible" if and when HFF would request discussions on changing the stipulations on the bonds. The problem with the bonds is that they aren't callable while the HFF mortgages are (in most cases) and have for the last 3 years or so been refinanced with non-indexed mortgages from the banks. The result: HFF sits behind with high-interest debts which aren't callable and truck loads of cash.

Benediktsson guessed in November 2012 that HFF would need perhaps as much as 200 billion ISK from the state but the Fund operates with an avowed state guarantee. The problem is that there is not a single word about state guarantee for HFF in laws about state guarantees. So while it is the "legal understanding" of Benediktsson (who is an educated lawyer I may add) that there is a state guarantee on the HFF bonds, one can easily argue that there is no such formal backup in Icelandic laws.

This is not the first time a politician comments on the HFF situation. In November 2012, trades with HFF bonds were halted twice. The first trigger was a stampede of sellers in the wake of an article in Viðskiptablaðið ("The Business Newspaper") where it was said that the un-callable bonds would have to be made callable to save the Fund. Not a week later, MP Sigridur Ingadottir, commented on the situation, again with Bloomberg, and said it would be necessary to enter renegotiations regarding the stipulations of HFF bonds. Another stampede followed.

In an interview with RUV (The Icelandic "BBC") in November, I pointed that while the state was regularly pumping equity into the Fund - it has gotten 46 billion ISK from the state in new equity since 2010 - the Fund would be able to pay its debts and bondholders could sleep peacefully. But this constant need to pump equity into the Fund would harm the chances of reaching a balanced fiscal budget. And the problem is that a balanced budget is something that is practically a prerequisite for abolishing the capital controls. Both the Central Bank and new minister of finance, MP Bjarni Benediktsson, know this. Abolishing the capital controls is something that is prominent on the "to do" list of the new government. Benediktsson called the capital controls "a flashing warning sign" for foreign investors, telling them to stay away from the Icelandic economy.

So there is an interesting situation brewing. The new minister of finance knows that one of the barriers that he has to cross in order to facilitate the abolishment of capital controls is to get a balanced budget. What is stopping him from doing that is a potential 200 billion ISK bill that arises due to the avowed state guarantee on the Housing Financing Fund. On top of this come a few election-promises such as lowering taxes and financing a debt jubilee to Icelandic households. Endeavouring to mitigate that problem, he wishes that creditors of HFF will be "flexible" when and if the HFF will request negotiations on the stipulations on HFF bonds.

And who are the creditors of HFF? Mainly Icelandic pension funds (64%). Foreigners hold only 4% of outstanding HFF bonds. Something tells me that Icelandic pension funds will never give back an inch when, not if, negotiations on the HFF bonds' stipulations will happen. Something else will have to give in.