Inflation-Linked Loans May Not Be Illegal: EFTA Court

Icelandic courts must make the final decision on the fairness of an Islandsbanki inflation-linked mortgage after a European tribunal said such indexation may not be illegal in a case affecting about $12 billion of consumer debt.

European contract law doesn’t forbid inflation-linked mortgage loans, the Luxembourg-based European Free Trade Association court said in a ruling today. It said Icelandic courts must decide whether the contract was fair and was properly explained to the borrower. The EFTA court rules on points of European law for national courts.

“Price-indexation clauses do not, in and of themselves, amount to terms that may be regarded as unfair, where these clauses are lawful and the method by which prices vary is explicitly described,” the EFTA court said. It’s for the national court to decide whether specific contract terms on indexation are unfair and whether a borrower got “adequate information on a contract’s terms and consequences” before the loan was agreed.

Iceland’s banks have already forgiven $2.1 billion in debt since the country’s 2008 crisis wiped out its financial industry. The lenders were in 2010 found to have illegally linked loans to foreign exchange rates. A similar outcome now could force additional writedowns to the 1.4 trillion kronur ($12 billion) in inflation-linked loans that the central bank said Icelandic households held on March 31.

State-Created

If the Icelandic judges deem a contract term unfair, they should ensure that the entire loan contract isn’t voided as a result, the EFTA court said.

The Reykjavik District Court must now weigh a dispute between a borrower who agreed on a linked mortgage in 2007 with Glitnir Bank hf, which failed in 2008. That loan is now held by Islandsbanki hf, the state-created successor to Glitnir.

The Homes Association in Reykjavik, which represents 10 percent of Iceland’s homeowners, has urged courts to “correct the injustice” to borrowers that it says followed a 2008 krona slump that sent inflation soaring as high as 19 percent. The majority of writedowns may fall onto the shoulders of the state-owned Housing Finance Fund. The Home Association opposes linking consumer loans to inflation.

Opinion Only

“It should be noted that the opinion of the EFTA Court is an advisory opinion only,” the central bank said today in a statement published on its website. “It’s not clear when a final decision will be forthcoming from the Icelandic courts. Furthermore, the case in question pertains only to indexed consumer loans.”

The scale of writedowns to date makes Iceland a world-leader in debt relief, according to Danske Bank A/S. The government of Prime Minister Sigmundur Gunnlaugsson won elections last year in part after promising voters he would cut debt burdens further.

The island’s former banking giants -- Kaupthing Bank hf, Glitnir and Landsbanki Islands hf -- all failed within weeks of each other in October 2008, leading to an $85 billion default that dwarfed Iceland’s $15.3 billion economy.

The European Union’s top court ruled in April that Hungary’s courts can force banks to replace unfair contract terms for customers holding about $15 billion of foreign-currency loans. Spain had to change its mortgage legislation after the same court ruled that it led to unfair evictions of homeowners.

While the three members of the European Free Trade Association aren’t part of the 28-nation EU, they apply some European laws.

The case is E-25/13 Gunnar V. Engilbertsson v Íslandsbanki hf.

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