Tuesday, September 18, 2012

Stress-Test The Economy, Not Just Individual Households?

When individuals apply for a mortgage, the bank "stress-tests" their ability to service the loan in a possible future environment of higher interest rates. In Norwegian terms this would mean that, instead of current 3,5-4,0 % rates, what if the mortgage rate doubles up to 7-8 % - can the household still make the monthly payments? I have never been present at a meeting like this, but I would assume (and some logic supports this) that many of the responses follow a similar pattern: "I don't see a problem with higher interest payments, we just X a bit less then...", where X can be replaced by "travel", "eat out" or plainly "consume".

The logic I referred to above is this: paying down the mortgage is one of the few, and in many cases the only relevant way of saving for many households. So instead of saving less (includes tapping your savings account), the households need to curb their spending if a bigger share of their income goes into paying interest on a mortgage. For a household this drag on spending caused by 7 % mortgage rate would amount to 50000+ NOK per year with a typical mortgage of 2-3 million NOK.

So, yes, most of the individuals would be able to tackle a doubling of the interest rate. Stress test performed, loan granted, everyone should be happy? Perhaps not if you look at the "macro" level. Someone more provocative would even say that if you look at this from the viewpoint of the Norwegian economy as a whole, the worry is that these households would be doing just what the banks expect them to do: working hard and spending less to be able to service their loans. I don't have the time and energy to do the math now, lazy as I am (and as a non-economist, I'm more interested in "folksy" story-telling), but my hunch is that this kind of drag would amount to some percentages of the Norwegian GDP. (If you have done the math, feel free to share it in the comments section.) Mildly put, at least many of the restaurants in Oslo would notice this.

In the end, the economy is a sum of our actions, and fairly small changes percentage-wise may lead to big consequences. If households with mortgages curb their spending by 10-30 %, everyone will notice it. This is why I call for stress tests for the Norwegian economy - not just individual households - when the nation continues to build this debt colossus. Debt-to-income ratio of 200 % was passed some years ago and for 11 % of households the ratio is already above 500 %.

The smart homeowner-debtors will now state that the interest rates will not rise but remain extremely low for years to come. I'm not sure how they know it, but they might even be right. I will come to that in my next post.

1 comment:

  1. The average Norwegian household has a historically high dept due to an immense increase in home prizes the last two decades. The dept already gives problems for the private consume even with the current law interest rates and high vages. But the interest rates will surely increase, Due to challenges Norway has on the export market, the average houshold income vil decrease, with a freeze in consume and cracking home prizes as a consequence.. As I see it, an economical breakdown in the Norwegian society is inevitable due to the current bouble.