20 PERSPECTIVES ON BUSINESS AND ECONOMICS | VOL 41 | 2023 From a balance sheet perspective, almost 98% of households will experience some worsening in their debt-to-assets ratio as a result of 1% rate hike. As before, households with lower bank deposits, income, and net wealth as well as those with adjustable-rate IOMs were severely sensitive to policy movements. Balance sheet sensitivity was concentrated among urban areas, particularly Copenhagen, home to a larger number of ARMs and more speculative housing assets that respond more sensitively to rate movements. With respect to age, in both the cash flow and balance sheet analysis, younger (around 30 years old) first-time home buyers were most sensitive to rate movements due to their increased leverage and limited savings (Bech et al., 2021). ARMs, leverage, and consumption Given the repeated resilience of the Danish mortgage system in times of crisis, it is unlikely that this stability will suddenly wane in the coming years of monetary tightening. However, young, highly indebted, low-net-wealth, and adjustable-rate IOM–holding borrowers stand to be substantially impacted by an increase in interest rates. Nearly 3.5 million Danes own homes (Denmark Home Ownership, 2022). Just half of households hold predictable FRMs; 40% have ARMs for all their mortgage debt, with 24% of these households using riskier IOMs (Bech et al., 2021). While rate hikes hit households’ disposable income and balance sheet at the micro level, they materialize at the macro level through a reduction in consumption, a measure many highly indebted households are forced to endure to avoid falling into arrears (Bech et al., 2021). This reduction in consumption drastically differs depending on leverage. The results of an IMF sensitivity analysis investigating the impact of a 1% increase in borrowing rates found that it would decrease average annual household consumption by nearly 1% and GDP by 0.4%. Households with a debt-to-income (DTI) ratio greater than four (over 450,000 of households) had a median consumption reaction approximately double the average amount (IMF, 2022). Concerningly, households with ARMs are considerably more indebted than the average household, having median DTI levels 1.3-times larger than their FRM-holding counterparts (IMF, 2022). Similarly, there are over 200,000 households that hold IOMs whose loans exceed a 60% LTV ratio (Systemic Risk Council, 2021). Both groups are extra sensitive to rate increases given their type and quantity of debt. Given the lump sum required to repurchase covered bonds, it is unlikely that the most vulnerable of Danes are able to repurchase their debt outright, even at reduced market prices. Additionally, the speed at which borrowing costs have risen (as outlined in the next section) complicates the refinancing process. Effects of additional rate hikes and the Danish wealth defense What makes the issue of rising interest rates even more serious is the pace and magnitude at which they have taken place. Each sensitivity analysis referenced in this article only considers the impact of a 1% increase in rates. However, from September 2022 to February 2023, the DNB has raised their benchmark rate more than 2%, with the average ARM rate increasing over 3.1% (Finance Denmark, 2023). Given the unprecedented inflation rate in the euro area, there is a significant likelihood that these rates rise even further. While it is uncertain whether the damage to household income, balance sheets, and consumption and the associated hit to GDP will materialize linearly after the first 1% hike, it can reasonably be assumed that this larger than modeled jump will magnify the previously mentioned adverse effects. One of the most common rebuttals to the charge of overindebtedness and the concern of rising interest rates revolves around exceptional Danish wealth. To evaluate this claim, not only must the absolute value of household wealth be considered but also the illiquid nature of it. Danish households are the richest in the EU, with average household net financial wealth nearly three times the EU average (McKeever, 2021). They also boast average financial assets more than double the EU average. However, roughly half of household wealth is stored in real estate. Of the remaining financial assets, 50% is stored in life insurance and pension plans, meaning just 25% of household wealth is stored in liquid financial assets (Scope, 2021). Models from the DNB indicate that interest rate increases throughout the past year will, even when considering the effects of inflation, dampen housing prices by 6% through 2023, resulting in substantial hits to household balance sheets (DNB, 2022). Rate hikes, in addition to their impact on the housing market, also affect another key aspect of Danish wealth: pensions. The state Danish pension fund ATP, covering 5.4 million members, lost $8B in the first half of 2022 alone because of interest rate spikes, wiping out the 17.9% return it earned in 2021 by more than twofold (Baker, 2022). The pension sector has lost approximately $105B in the first three quarters of 2022, around half of which stems from poor covered bond performance (DNB, 2022). Danish pension funds are one of the largest purchasers of covered
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