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Iceland Sees Mortgage Bubble Threat From Foreign Cash

November 06, 2012

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Residential housing and rooftops are seen in this skyline view of Reykjavik, Iceland. Photographer: Paul Taggart/Bloomberg

Iceland’s lawmakers are searching for ways to keep their economy from lurching into another asset bubble as offshore investors forced to keep their money in the country channel it into the housing market.

Apartment prices have soared 17 percent since April 2010 and are now just 1.7 percent below the pre-crisis peak in March 2008, Statistics Iceland estimates. The boom stems from currency restrictions imposed in 2008 to prevent the collapse of the Krona after the country’s biggest banks defaulted on $85 billion of debt.

While those controls helped cauterize a capital exodus and propel a recovery, it left about $8 billion in offshore kronur that can only flow into Icelandic assets, inflating demand for housing and mortgage bonds. The government is now seeking to correct the imbalances, which risk plunging the island into yet another boom-bust cycle just four years after the banking industry dragged the economy through its worst recession since World War II.

“There’s every reason to look into whether parliament should pass legislation to limit the investment options for offshore kronur holders,” Sigridur Ingibjorg Ingadottir, chairman of the Parliament’s welfare committee in Reykjavik, said in an interview. This should include “preventing investors from using offshore funds to invest in the real estate market,” she said.

Economic Recovery

The capital controls and Iceland’s decision to allow its banks to renege on their obligations to bondholders underpinned the country’s economic recovery after the 2008 meltdown triggered a recession that lasted into the first quarter of 2010, according to the International Monetary Fund and economists including Nobel laureate Paul Krugman.

The island’s gross domestic product will expand 3.1 percent this year and 2.2 percent in 2013, the central bank estimates, after contracting as much as 6.8 percent in 2009 and another 4 percent the following year. The krona plunged as much as 80 percent against the euro in the offshore market in October 2008 and the island was forced to seek an aid package led by the IMF to avoid national bankruptcy.

The capital controls now pose the biggest threat to Iceland’s recovery, according to rating companies Standard & Poor’s, Moody’s Investors Service, Fitch Ratings and the Washington-based IMF. The central bank estimates the measures, which are being phased out in steps, won’t be gone until 2015. Finance Minister Katrin Juliusdottir said in an interview published Oct. 1 that some form of currency control will stay in place until Iceland adopts the euro even though the island has yet to complete European Union accession talks, started in 2010.

‘Abnormal Situation’

“The capital controls have created an abnormal situation and they lead us to believe that the economic situation is better than it really is,” Ingadottir said. “We’re living in an artificial world with the Icelandic krona, which isn’t a real currency. We just prop the krona up like a real currency with legislation which protects her for the time being.”

Offshore kronur investors have pumped money into housing, helping inflate prices. According to Registers Iceland, the average house price was 34.2 million kronur ($270,000) last week.

Property sales in Iceland rose 88 percent in the week through Nov. 1 to 139, from a year earlier, according to Registers Iceland. The aggregate value of homes sold doubled to 4.8 billion kronur ($38 million), the office said.

Losing Customers

Housing bonds have also become a preferred target for offshore krona investors because Iceland’s $7.9 billion mortgage market dwarfs its other asset classes. The investors have put their money into bonds issued by the state-backed mortgage provider, the Housing Finance Fund, which has about 60 percent of Iceland’s home-loan market. HFF is now struggling to stay afloat as it loses ground to commercial banks expanding their product range to grab a bigger share of the mortgage market.

HFF, which has been required by law to sell loans linked to the consumer price index, is losing customers to banks selling regular mortgages as inflation exceeds 4 percent. HFF is now at risk of missing payments to creditors as it relies on the state for support, according to Moody’s.

“The risk is that there may potentially be a default at the HFF level, which is not paid for in time by the government,” Oscar Heemskerk, a senior analyst at Moody’s, said by phone on Oct. 12. “At the same time, the government has strong reasons to fulfill their implicit guarantee. So we expect that investors get their money back.”

Cash-Flow Gap

Since Iceland’s 2008 banking meltdown, in which Kaupthing Bank hf, Glitnir Bank hf and Landsbanki Islands hf together defaulted on $85 billion, policy makers have struggled to rebuild the island’s financial markets. Proposed legal changes include a motion still being discussed in parliament to split retail and investment banking.

Iceland’s capital controls have made life harder for HFF, according to Styrmir Gudmundsson, a fund manager at Jupiter Capital Management hf. The restrictions have kept yields low, helping Icelanders to take out cheap loans at commercial banks and prepay their mortgages at HFF. Yet the state-backed mortgage provider doesn’t have the same prepayment option toward its creditors, creating a cash-flow gap, Gudmundsson said.

“As the yield on HFF bonds keeps declining, and the fund’s duration gap becomes wider, HFF’s financial position becomes more difficult,” he said. “The capital controls have had a considerable impact on the Housing Finance Fund.”

‘Asset Bubble’

“We can assume that there’s an asset bubble expanding now,” said Ingadottir, whose committee oversees HFF. “The development in the real estate market is abnormal.”

Parliamentary elections in April are likely to make matters worse for HFF, as politicians shy away from passing any costs on to taxpayers, according to Gudmundsson.

Iceland needs to decide whether it wants to rescue HFF “through the tax system or the pension system,” he said. “So in fact this is a question on which generation should suffer the losses. The silver bullet solution is probably a mix of these two alternatives.”

To contact the reporter on this story: Omar R. Valdimarsson in Reykjavik valdimarsson@bloomberg.net.

To contact the editor responsible for this story: Jonas Bergman at jbergman@bloomberg.net; Rob Urban at robprag@bloomberg.net


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