Denmark doesn’t need to phase out interest-only mortgages identified by the International Monetary Fund as risky and should instead ensure banks only give the loans to borrowers who can afford them, central bank Governor Lars Rohde said.
The mortgages, which both the Washington-based IMF and Standard & Poor’s have warned are adding risk to Denmark’s $500 billion mortgage market, have helped create a diversified home-loan industry, Rohde said in an interview in Copenhagen on April 5. It’s up to the banks to consider applying harsher loan-to-value requirements to prevent borrowers breaching regulatory limits, he said.
“I like that there’s a freedom of choice in the palette of mortgages available and that there are lots of different types of products that borrowers can choose between,” said Rohde, 59, who took over as central bank governor from Nils Bernstein in February. “But the mortgage lenders need to ensure that people who use these products can afford to do so.”
The IMF is urging Denmark to drop interest-only mortgages, which since their 2003 debut have offered borrowers a 10-year hiatus on principal payments. The loans, prohibited in many other countries, now threaten to weaken the stability of Denmark’s mortgage system, the IMF argues. According to Rohde, the problem isn’t the type of loan but the practice of banks handing them out to borrowers without buffers to withstand house-price declines.
“It looks like it would have been wise to be more restrictive in providing interest-only loans and that loan-to-value limits should have been considerably lower than the 80 percent that otherwise applies,” Rohde said. “But that’s a matter for the issuers to sort out. House prices can fall, we’ve seen that.”
Loan-to-value ratios on interest-only loans should probably be “significantly” lower than the 80 percent regulatory cap that applies to most of the rest of Denmark’s residential mortgage market, he said.
Rohde’s defense of interest-only loans marks a departure from the line adopted by his predecessor, Bernstein, who argued the products were inherently risky and should be phased out.
Standard & Poor’s said last month Denmark needs to find ways to encourage borrowers to repay their principal. The government has already rejected an industry plan to limit the debt pool affected by amortization requirements by splitting mortgages in breach of loan-to-value rules so that interest-only terms would still have applied to loan amounts within the 80 percent LTV cap.
Rohde has said he backs the government’s decision. “To protect the mostly AAA ratings of Denmark’s mortgage bonds, we can’t allow ourselves to introduce any changes that could weaken the market,” he said.
Since their introduction a decade ago, interest-only mortgages have grown in popularity and now make up 56 percent of outstanding mortgage debt, industry figures show.
Denmark’s house prices have lost more than 20 percent since the nation’s property bubble burst in 2008, eroding equity and leaving fewer borrowers eligible to roll over their debt into new interest-only mortgages. More than 100,000 homeowners may need help as amortization requirements start from this year, according to a February study by the University of Southern Denmark.
“The borrowers affected by amortization requirements from this year only make up a very small portion of the total,” Rohde said. “There’s no need to change the legislation” to help them, he said. “Borrowers should have known when they took the loans that they’d have to start amortizing the debt 10 years later and that time has now come.”
Rohde, whose position as central bank governor also makes him chairman of Denmark’s Systemic Risk Board, said he’s not in favor of imposing stricter regulatory requirements on mortgage banks.
“I trust enough in markets to believe that mortgage lenders should be able to administer this themselves, but it’s obviously also in their own interest to ensure that there’s no risk,” he said.
Rohde said he will use his position as head of the Systemic Risk Board to provide recommendations to the financial industry in an effort to try and avert future crises. The onus will be on the financial industry to explain itself if it doesn’t comply, he said.
Rohde said he’s also unlikely to be swayed by complaints from bankers that stricter capital requirements will stunt economic growth.
“There’s a lot of discussion about the extent to which stricter capital requirements are a growth killer,” he said. “That’s not a concern I share. It’s based on a false premise, namely that return on equity demands will remain the same. But if a bank has more equity, the risk falls, and the required return should also fall. One should also be able to fund oneself at a lower cost, so the overall cost of higher capital requirements for the bank should be close to neutral.”