I’ve thought a lot about theory economist Gudmundur Olafsson’s attempts to divert the public’s attention from the injustice of price-indexation of loans. He uses the analogy of when a man borrows ten horses from him, he expects ten horses back.
He makes no mention of the responsibility bestowed upon him as the lender to provide the borrower with healthy horses instead of limpering and diseased ones. If he fullfills that obligation then it is easy to return the ten horses. If not then the borrower is at a terribly unfair disadvantage.
In civilized societies, consumers are guaranteed the right to return faulty products in exchange for money back or products that work. Seeing the capital of a mortgage grow by 25% in three years, in spite of 25% of the original amount being paid onto it, indicates that the product is faulty, even dangerous.
It should be the right of consumers to return the product or at least get one that works.
Related posts:
Bromley86
2 years ago
Bearing in mind that I don’t like the idea of price indexation, I’ve got to ask again does it actually matter?
If I go to a UK bank to borrow money, then inflation is worked into the rate that I borrow at. So if you get rid of indexation, won’t the rate just change to compensate?
Returning goods is a different story. All of the reward of increasing house prices belongs to the borrower, so likewise all of the risk does too. Of course, with FC loans so prevalent, the situation is going a little beyond the normal. IMO the Icelandic state really should assume responsibility for these if asked (at the “right” price mind), but I can see why that’d be a problem.
Easy
2 years ago
I’m totally against this indexation, it is just criminal and plain stupid, but why didn’t anybody say something before, why were we taking and taking so happy loan after loan, didn’t everybody know that the loans they we were taking were indexed to inflation? well, when you accept it and you go voluntarely and take a loan that is indexed to inflation just because there is no other kind of loand and you(in general) don’t want to get behind and get the same things everybody is getting…(and we think that luxory pruducts are first need prudocts) well, it will grow with inflation, isn’t it? and don’t get me wrong I definitely think this indexation has to go, but lets not play the total victims here, because just 10 months ago we were so happy with everything, “Iceland is paradise…, It’s the place to be…, we have the best houses…, the best life…, we are the happiest people on earth…, etc, etc” yes, there was a terrible misshandeling of the economy, yes we were missinformed, but we were not totaly ignorant.
we can not expect to live and spend like kings for the last 10 years and now because everything went wrong, well get all of our debts forgiven and written off. By the way the analogy of retuning a pruduct doesn’t really feet in here. I think a solution has to be found and the goberment has to do something, but write off everybodys debt and nothing happened here, is just not possible, unfortunatelly our system is so corrupted that some companies and corporations and even few individual are acctually getting it just because they know the right people or are in the so called inner circle, and I think thats what boders people m ore than anything the fact thet otrhers get it and I don’t.
nn
2 years ago
To answer Bromley86 – it does matter when all the risk is on one side of the table. You wouldn’t accept a UK loan with variable interest determined by the bank each month, would you?
The price indexation (plus the neat Icelandic law that the borrower is stuck with the loan even after he defaults and loses the house) means that the bank has both suspenders and a belt while the homeowner has nothing. This leads to bankers thinking they are “invincible” and do the stupid things that got them bankrupt.
When inflation is bad for both parties it is mutually beneficial to keep it down. If the banks don’t need to worry about it, there’s no incentive to keep it low.
BTW: Increased loan availability was one of the main things that caused the housing prices to rise, which was part of the price index – and one increased housing prices of the main parts of the inflation during 2004-2007.
nn
2 years ago
Last parts hould be:
– and increased housing prices was one of the main parts of the inflation during 2004-2007.
C.A.K
2 years ago
C´mon – if we follow your analogy, then the debitor of the horses ALSO got the rights to tjeck if the horses he borrows is in a good condition. The responsibility goes both ways and is definitely not solely the creditors.
If you cannot see that the one who bears most responsible for his/hers life is the person himself, well.. Then it is to no ones wonder why you fell robbed.
Wally
2 years ago
I think the system is obviously flawed but noone forces us to take loans. It is up to us to make our own decisions. The obvious and smart thing to do is to save up more money, and actually wait until you have done the work before you buy the things you want.
Its the same thing our parents did and their parents before them.
Bromley86
2 years ago
Thanks Nn.
You said, “You wouldn’t accept a UK loan with variable interest determined by the bank each month, would you?”
I’d agree with that, but my point was that most variable rates in the UK are either directly linked to the BoE base rate (with a margin added on) or something called a Standard Variable Rate, which is set by the lender and often (although there’s no requirement for this) roughly tracks the BoE rate.
The BoE rate roughly and on average is higher than inflation. If inflation is high, the rate might be expected to increase & vice versa. Or at least that’s my understanding of it.
So I think that most people in the UK do accept loans where the rate is determined by a bank, although not usually on a monthly basis, and I think those banks usually make sure that inflation is priced into that rate. Otherwise they’d go out of business (and I appreciate the irony there
).
What would be interesting would be if someone could post the rough average variable interest that people are paying on mortgages in Iceland now.
Mike (UK Nordic analyst)
2 years ago
nn writes:
“You wouldn’t accept a UK loan with variable interest determined by the bank each month, would you?”
That’s exactly how a normal UK mortgage works, the rate of interest that you pay rises and falls as determined by the bank. The actual rate charged is usually computed from a combination of factors including LIBOR, market wholesale rates, overnight rates, gilt yields and the rate of interest the lender needs to attract depositors.
Daði
2 years ago
C.A.K., most people and that includes myself some years ago have had faith in their system.
When we accepted our mortgage we got a printout of projected payments and increase in capital from the bank, attached to the papers. I had attended seminars held by top Icelandic economists projecting a future I thought I could sign for.
I am the first to hold up my hand and say I was wrong to trust the system and not criticize it earlier. All the risk is with the borrower, not the financial institution. It is not right.
Bromley 86, examining interest rates in Iceland can only lead to one conclusion, the problem is the ISK. Its volatility skews everything.
Dadi
2 years ago
Wally, you are not getting it are you. You epitomise the misunderstanding Icelanders have regarding price indexation.
A couple I know in their late twenties lived at home with their parents for years and saved up to 4-5 million ISK to purchase a home with 20-30% down. This is three years ago.
They now owe more than 4-5 million ISK in their apartment. So applying good financial practises from abroad where they have a more stable currency and no price indexation doesn’t work.
Of course no one forced them to take a loan but they did the responsible thing and saved up and bought a small sized apartment. The only loans available though were both broken, the price indexed and the currency loans.
And do talk to the parents of many who have paid their loans back many times over.
If we followed your logic then no one would ever buy a home in Iceland.
Wally
2 years ago
thanks Daði
but…..I too saved up 4-5 millions. We took out a loan for a very modest sized apartment but our deposit was 50% of the house. I will have mine paid off by June next year.
The system is definately broken as I said before but….we all have a choice on how we play the game.
Your friends didnt do their homework. They saved too little, they bought too expensively, and they obviously didnt see the bigger picture. Not that many people could actually claim to have seen the bigger picture.
I know this sounds harsh, and I do have sympathy for them, but we make our own decisions.
I think it is disgusting that businesses get their loans reduced and not the private citizens. Alot of what is happening in Iceland today sickens me.
It seems like everybody from the top down is incapable of taking any sort of responsibility for their actions.
Bert Pachetta
2 years ago
Indexed loans can be offered but non-indexed must be offered as well. To do otherwise is to declare yourself an underdeveloped country.
Daði
2 years ago
Wally, my friends bought a three bedroom place in the newest area of Hafnarfjordur, not exactly an expensive location. It was not a case of buying something they could not afford. It was simply a case of grown up people with jobs wanting to move out from their parents. You could argue that they bought at the peak and that the apartment was to expensive but neither one of them is a housing market expert. The way they went about it was as mature and responsible as you could expect from normal people.
Having 50% to pay on your first apartment is quite an achievement which I don’t think you can ask of most people. It might have been possible if you bought it ten years ago, factoring in that you rode the bubble without taking a second mortgage.
If you are paying off your mortgage soon then I assume that you haven’t lost your job like the couple above.
This week Frettabladid wrote that 20% of mortgage holders in Iceland are paying late or not at all. While I am not in that situation, I can surely empathize with those who are because they are my friends, co-workers and family. And most of them did not live a champagne existence in the last few years or play reckless with their finances.
Blubber
2 years ago
The horse analogy is dumb no matter what, but even so, Guðmundur Ólafsson forgets the simple fact that if you lend someone ten horses for 35 years, you are an idiot if you really think you are going to get the exact same ten horses back.
Horses have a lifespan of about 17 years.
If you are that stupid, you deserve a dead horse.
Indexing is such a fabulous system that it is pretty much only in use in Iceland, we are special.
The interest is all the bank should need to make sure the payment is valuable within the market.
However, if the banks are making bad decisions regarding their lending policies and handing out money like it’s candy to feed an inflated housing market, then that is a risk the bank is taking.
The government should not under any circumstances condone crappy bank practices by penalizing homeowners.
Michael Hudson explains this very well:
http://www.globalresearch.ca/index.php?context=va&aid=13055
“In Iceland – but nowhere else – home mortgages have a uniquely bad twist. Creditors have managed to protect the weight of their claims on debtors by indexing mortgage loans to the nation’s consumer price inflation (CPI) rate. Each month the debt principal is increased by the CPI increase – and so is the interest charge. During 2008 that index rose by 14.2%, so a 100,000-euro mortgage at the start of 2008 would have grown to 114,230 euros by yearend. These monthly adjustments also would added an entire percentage point onto the interest payment – an extra 100 euros to be paid to creditors monthly, in addition to the growing principal to be amortized. Talk about making money without effort …!
Such heavy debt charges would shrink any economy, and that is what is happening in Iceland. Prices for real estate declined by an estimated 21 percent for housing in 2008. So in the above example, the market price of the house worth 100,000 euros at the beginning of the year would have been worth only 79,000 at yearend, while the mortgage would have grown by 14% to 114,230. This would have plunged the homeowner 35,000 euros into negative equity – a remarkable 35% change.
In every other country, investors lose out when prices decline for real estate, stocks and bonds, while creditors find the purchasing power of their loans eroded by inflation. That is how most countries have “inflated their way out of debt” for many centuries. But Iceland’s creditors have created a system in which their position actually is improved as the rest of the economy suffers inflationary price erosion. Their claims rise in proportion to the rate at which consumer-price inflation eats away at wages and business profits. Where is the sense in this?”
Paul H
2 years ago
I am sure I will be corrected if in error with my limited understanding…
If you buy a house in Iceland with a mortgage and its value is X…
Then its value on the market increases over time to 2X…
Don’t you then owe the bank 2X and not just the original X?
Like I said, please correct me on this, its not something I have studied because I choose not to get caught in anything like such a trap.
In fact, I refuse to get caught in debt at all right now, which is how we have avoided a lot of the hurt put on the world by recent events.
[I watched the entire Shock Doctrine video, btw, thanks.]
If this is true, it is grossly unfair.
If the bank wants to buy property and assume the risk with doing so, then it ought to just go ahead and do that.
Allowing a borrower to take the risk with the bank protected from it, and getting all the benefit from increased value of the property is just so flawed and wrong it boggles the mind.
And for the debt to stay with the borrower even if they default and the property is then taken by the bank boggles the mind beyond even that.
This type of system is so prone to going horribly wrong, and it has.
Like I said, please correct my understanding where it is in error.
(I am really enjoying the posts, btw.)
Mike (UK Nordic analyst)
2 years ago
The indexed mortgages in Iceland are indexed using a “factor” (called, as always in Iceland, “stig”) which operates on the averaged inflation index. The cost of housing contributes a small amount of this index. So if all other prices remained the same and the cost of housing (calculated using imputed rents, current prices etc) doubled then the indexing would NOT double the mortgage. This is one of the weaknesses in the system – the indexing factor has nothing to do with house price inflation. Equally, they are not indexed to salaries, which should play a part in this system.
However, non-Icelandic readers should take the complaints against the system with a pinch of salt. The interest rate charged on these mortgages has always been very low, typically 4-5% – and that is fixed. They were originally only supplied by the Housing Finance Fund, a state sponsored organisation that was set up to provide cheap mortgages as a social service. The trouble was that they continued to supply “cheap money” as the house boom took hold. The HFF began to fund financial speculation by Icelandic consumers rather than helping poor or young people get a roof over their head. Equally, the commercial banks entered the system in about 2004. They too poured cheap money into the housing market – they matched the interest rate of HFF and were prepared to lose money to gain market share. The beneficiary in all this was the Icelandic mortgage holder – they enjoyed a boom fueled by cheap money. Some, but not many, Icelanders took advantage of the “good years” (basically 2000-2008) to pay down their loans, but most of them just blew the excess money on consumer goods and international travel. Indeed, they took on more and more debt creating a huge current account deficit – ironically creating inflation which began to bite them back. So understand that when you hear Icelanders complain about indexed-link mortgages – the inflation was itself a result of their own actions.
To many outside observers the years 2005-2008 were bizarre. The Central Bank had only one tool at its disposal to curb inflation and the deficit – interest rates. These went up and up. But at the same time the HFF continued to flood Iceland with low interest rates. At the same time the government introduced tax cuts. The country was in financial chaos from 2005 onwards. If you read any reports from the time you will see such statements as “the transmission of monetary policy is very poor in Iceland” or “fiscal and monetary policy are working against each other in Iceland” or “the HFF needs to be reformed” – this is what is being referred to in such statements.
(There are other problems with these mortgages. Here are two. First they are effectively “back loaded”. Any increase in capital now is spread over the entire length of the mortgage – the effect is that although the capital outstanding might go up by a large amount, the corresponding immediate payment doesn’t go up at the same rate. Secondly, Icelandic mortgages are incredibly long. I’ve seen mortgages of 40 and 45 years. This length and the backloading means people can take out stupidly high mortgages which are quite affordable at the start. As indexing kicks in and the time left gets left the repayments go up exponentially. Stupid, stupid, stupid. The way a mortgage holder should work the system is to use the “cheap money” to save quickly in the early years and then pay down the mortgage very early. Many financiaky astute people did this – the rest didn’t bother to read the contract, and if they did then they didn’t understand it. Or if they did understand it then they didn’t get out a claculator and work what would happen.
Any sensible person would know that you would, at some point have a very rough ride. Economists have trouble predicting inflation over the next two years, never mind 40 years!! And Iceland has a history of high inflation caused by a small currency and a reliance on commodity prices – fish and latterly aluminium.)
Dadi
2 years ago
Paul, you are understanding this correctly. Like Blubber says, the loans here are tied to the consumer price index. So a rise in say the price of cigarettes or milk is going to affect your mortgage and monthly payment.
Bromley86
2 years ago
Yet again, thanks Mike.
nn
2 years ago
Interesting discussion here. I admit I don’t know much about these things as I do not have a loan myself. I entered the job market in 2004 after getting my M.Sc. degree, and have been renting and saving up for a good down payment on an apartment ever since. In 2007 I was kicking myself for not getting a 100% loan right away but now it seems to have been the right choice.
I’ll probably use the money to settle down abroad if the situation stays as it is.
Paul H. points out that when inflation soars, so does the value of the house, but if that was the case – why not tie at least part of the loan to the housing market value? A 2 year old loan for a house priced at X is now 2-3X for a currency loan, probably 1.5X for a price indexed loan while the house itself will probably not sell for more than 0.8X – if you can even find a buyer. So all the risk is on the borrower.
And as said before: you can’t use the US way of defaulting on the loan and handing in your keys because the loan is tied to the owner as well as the equity.
C.A.K
2 years ago
PLS correct me if wrong: The whole idea behind the price-index-loans, was it not that the loans would be cheaper, cheaper and cheaper and in the end pay themselves off?
nn
2 years ago
C.A.K.: Im not a historian/economist/etc. but here’s my view:
In Iceland we had the problem that high inflation* would eat up loans and savings, so fixed-% money lending was done at a loss.
Imagine lending someone one month minimum wage (let’s say €1000). and getting €90 a month for the next 12 months (total €1080). If inflation is raging and minimum wage becomes €2000, you’re only getting back a fraction of the “value of money” you put out. If you arrange to get 9% of minimum wage instead, inflation is removed from the equation and neither party gains/loses from big inflation (assuming minimum wage is adjusted for inflation each month).
So in 1982 people came up with a system of price-indexing loans AND salaries to neutralize the effect of inflation. But then nothing was holding back inflation**, and to hold it back they stopped price-indexing salaries (but not loans, as “it’s trivial when inflation is low”).
There’s a good writeup on the Icelandic price-index absurdity at http://blog.eyjan.is/bjorn/2009/05/20/hallo-heimur/ – in Icelandic.
*) In 1930 ISK was on par with the Danish Krona (DKK). In 1980 the exchange rate was 1:100, so we chopped off 2 zeros, and the new ISK:DKK exchange rate was 1:1 again. Now it’s around 1:24 (http://www.google.com/finance?q=DKKISK). That’s a total of 2400:1 in 80 years.
**) from August 1982 to August 1983, 1-year inflation was 103% (http://visindavefur.hi.is/svar.php?id=2998).
Blubber
2 years ago
C.A.K: Yes, that was the idea. Instead of pursuing a steady currency managing policy, the government dumped the entire risk on the borrower.
That said, people still voted for the government and never did anything about it until now.
Blubber
2 years ago
C.A.K: This is a carry over from the old days when Íbúðalánasjóður was the sole loan provider, a government agency supposedly protecting the government’s lending practices.