The Corporate Sector and the Households

The prospects for the Danish corporate sector are good. Earnings are high in most sectors, and generally the estimated failure rate is falling, although the gap between the sound and the less sound companies is widening.

The price of owner-occupied housing has risen significantly in recent years. The increases are higher than previously seen and among the highest in the world. At the same time, the households have become more indebted. Danish households make extensive use of the opportunity to finance home purchases via adjustable-rate and deferred-amortisation loans. When opting for these loan types it is important for the households to bear in mind the risk they are incurring. On average the interest expenses of Danish homeowners will increase by 1.2 per cent of gross income if the short-term interest rate goes up by 1 percentage point. There is considerable dispersion, however, and some homeowners will see their interest expenses increase considerably if interest rates rise.

THE SIGNIFICANCE OF THE CORPORATE SECTOR AND THE households TO FINANCIAL STABILITY

Extending credit to the corporate sector and the households is one of the primary functions of the banking institutions. In doing so, the banking institutions incur a credit risk. The finances of the corporate sector and the households and their robustness to adverse developments have an impact on the banking institutions' earnings and balance sheets and thus on financial stability.

CORPORATE SECTOR

The Danish economy is in an upswing that began almost three years ago. In the initial phase, the upswing was driven primarily by private consumption, but has now become more broadly based after accelerating exports and investments during 2005.

The upturn has been most pronounced within building and construction, and the service sector. In step with the increasing growth in exports, which has taken place against the background of high growth in the global economy combined with rising market shares in 2005, manufacturing is also picking up. The higher export revenue has increased industrial output, but not sufficiently to reverse the falling trend in manufacturing employment. It should, however, be noted that part of the growth in exports comes from re-export of goods of which the primary elements are manufactured abroad. This applies to products such as mobile telephones and increasingly also to e.g. the clothing industry.

Private-sector employment has risen by around 50,000 in the last two years, and consequently the pressure on capacity has increased considerably. The tendency is most pronounced within building and construction, where the shortage of labour has reached the same high level as in the mid-1980s. In parts of the service sector, e.g. the financial sector, it is difficult to attract the required labour. Consequently, attention has been turned to foreign labour, e.g. from the new EU member states, but the influx of foreign labour is still modest in terms of the growth in employment. Even though unemployment is falling, wage increases have remained low so far.

The international economy is strong, and particularly the German economy seems to be picking up after several years' weak growth. Financial conditions have tightened a little against the background of the positive growth prospects – official interest rates have been raised in both the USA and Europe, and long-term interest rates have risen – but the level of interest rates is still low. Export opportunities are therefore good, and domestic demand is expected to continue to show sound growth. In recent years Danish companies have invested substantially in increasing their production capacity, and the ongoing introduction of new technology has led to the efficiency gains that are necessary in view of the increasing international competition. The greatest risk factor is whether the pressure on the labour market will lead to significantly higher wage increases than abroad, to the detriment of Danish competitiveness.

The soundness of Danish companies
The positive cyclical position is a major explanatory factor behind the general decline in the number of failing Danish companies, cf. Chart 21. This trend continued in the first months of 2006. However, the number of failures in the building and construction sector, in which many new companies have been established in recent years, and in the transport sector, is on the rise.

The favourable economy is reflected in the financial statements of Danish companies, cf. Chart 22 which shows the number of companies whose key financial ratios have improved, less the number of companies whose key ratios have deteriorated within the last year. This net result is calculated as a percentage of the total number of companies. Overall, Danish public and private limited liability companies achieved higher returns in 2005 than in 2004, while especially the returns in the transport sector have decreased. The companies' ability to absorb losses, measured as their solvency ratio, improved in most sectors in 2005, but deteriorated slightly in the transport sector. In several sectors, notably transport, the debt ratio (short-term debt) increased in 2005.

On the basis of published financial statements, Danmarks Nationalbank has developed a model to estimate the probability that a company will fail within the next few years, cf. Box 7. Chart 23 shows the distribution of estimated failure rates for Danish companies by sector since 1995.

MODEL TO ESTIMATE THE RISK OF COMPANIES FAILING	Box 7
Danmarks Nationalbank's failure-rate model is used to estimate the probability of a company failing within the next few years. The estimated failure rate can be seen as a weighted index of key financial ratios and other elements of the companies' financial statements. The failure-rate model does not include agriculture, etc. Variables in the model The model includes ten explanatory variables, i.e. four quantitative variables and six dummy variables. The sign in parenthesis indicates the variable's influence on the estimated failure rate. The company's return on assets adjusted for sector (-). The company's return on assets relative to the median return for the sector. Solvency (-). Equity capital as a ratio of total assets. Debt ratio (+). Short-term debt as a ratio of total assets. Reduction of the capital base (+). The dummy variable is set at 1 if the company repeats the deficit for the year, whereby the company's equity capital falls below the capital adequacy required. Size (-). Logarithm of total assets. Auditors' comment (+). The dummy variable is set at 1 if the auditors' comment in the accounts is critical. Form of ownership (+). The dummy variable is set at 1 if the company is a private limited liability company. Age (-). Dummy variable for the age of the company. Diversification (-). Dummy variables describing the number of sectors and/or subsectors in which the company operates. Municipality group (-). Dummy variables ranking the companies by municipality group with Greater Copenhagen as the reference group. Data The model is estimated on the basis of more than 400,000 financial statements presented in the period 1995-2002 by Danish public and private limited liability companies, of which just under 15,000 relate to failed companies. The latest accounts presented by an active company before it fails are regarded as coming from a failed company. The average period from the presentation of the last accounts as an active company to the time when the company fails is just under two years. A company is regarded as having failed in the following situations: compulsorily liquidated, subject to compulsory liquidation, dissolved, compulsorily dissolved, subject to compulsory dissolution, compulsory composition confirmed, compulsory composition being negotiated. This broader definition provides a better link to the time when the payment problems arose. The model's definition of company failure thus deviates from the definition applied by Statistics Denmark. In relation to the failure-rate model presented in Financial stability 2005 , a number of improvements have been made to the model's data basis. This entails that the development in the number of failures in the model is more consistent with the data from Statistics Denmark, cf. the Chart.
NUMBER OF COMPULSORY LIQUIDATIONS IN THE FAILURE-RATE MODEL AND IN THE OFFICIAL STATISTICS, 1995-2002
Source: Statistics Denmark, Experian A/S and own calculations.

In general, the median estimated failure rate for all sectors fell slightly in 2005. However, the weakest companies are struggling more. This is reflected in an increase in the 90th percentile in Chart 23 (Total) since 2003. This development should be viewed in the light of the establishment of many new companies in current years. All other things being equal, newly-established companies are relatively more likely to fail.

The largest decline in the estimated failure rate is seen for the building and construction sector, where the gap between the strongest and weakest companies has narrowed. The estimated failure rate has fallen marginally within trade, hotels and restaurants, while the gap between the companies has widened considerably within the last couple of years. The overall estimated failure rate for transport companies has remained unchanged, but again the gap between the top and bottom companies has widened. The estimated failure rate in the IT and telecom sector declined in 2005, but the level is still the highest among the sectors analysed.

One of the weaknesses of the model is that failure rates are estimated on the basis of financial statements that document the companies' past earnings. Consequently, the model only applies historical data to estimate the failure rate. If the model had been more forward-oriented, the estimated failure rates would probably have fallen more in 2005 as a result of the strong economy. This is reflected in e.g. equity prices, which reflect future expectations. Since 2003 the Danish equity-price index has more than doubled, and in 2005 alone it rose by 40 per cent. This has also been the general tendency for the individual sector indices.

Expected losses on corporate exposures
The banking institutions' largest corporate exposures are in business service, cf. Chart 24, and lending for real estate letting and administration constitutes half of the lending to this sector. The ratio of lending to business service rose from 24 per cent in 2000 to 34 per cent in 2005. The ratio of lending by banking institutions to trade, hotels and restaurants declined in the same period. The ratio of lending to other sectors has remained more or less unchanged since 2000.

The banking institutions' losses on lending to various sectors depend on the general soundness of the companies, as well as the distribution of lending on companies with different risk profiles. The banking institutions' expected and unexpected losses on corporate exposures can be simulated on the basis of data from Danmarks Nationalbank's failure-rate model, cf. Box 8.

Chart 25 shows the simulated distribution of the banking sector's loss on corporate exposures. The expected loss, given by the average, increased marginally from 2003 to 2005. Uncertainty concerning the expected loss, measured as the difference between the 95th percentile in the distribution and the average loss, was unchanged in the same period.

The expected loss on corporate exposures in 2005 has been calculated at around 0.6 per cent of total lending and is at the level of the actual losses sustained by the Danish banking sector in recent years, cf. Chart 26. Although the expected loss ratio for the building and construction sector is relatively high, lending to this sector constitutes a fairly small share of the banking institutions' total lending.

HOUSEHOLDS

The economic conditions of the Danish households have improved. Real incomes have increased, and more households have a sound income concurrently with the fact that unemployment has fallen. Combined with a low, albeit rising, level of interest rates, and a significant increase in housing wealth, this has contributed to high growth in private consumption since 2003. Consumer confidence is also at a very high level. The favourable economy has improved the households' general ability to meet their payment obligations, and the number of enforced sales is at a historically low level.

The households' positive financial situation is reflected in an ever higher rate of indebtedness, cf. Chart 27. This higher indebtedness has increased the total interest burden on the households. The households' debt and interest exposure is examined further below.

Danish households' debt in an international perspective
In an international perspective, Danish households have a high level of indebtedness in relation to the size of the economy, cf. Chart 28. Households in countries such as the Netherlands and the UK also have high levels of indebtedness.

The debt has increased during the last decade, but the development in the debt of Danish households does not differ significantly from other countries, cf. Chart 29. The level of debt is thus high, but the development during the last 10 years is not extraordinary in a European context.

In international comparisons, the Danish households' financial net worth is in the low range cf. Chart 30.

Financial net worth has increased over the past 10 years, and at a higher rate than in most other EU member states. Accumulation of wealth by households is by and large attributable to capital gains on financial assets. The statistics do not include the households' real assets, including housing. Danish housing wealth increased by kr. 500 billion in 2005 and is estimated to have been kr. 2,700 billion at end-2005, equivalent to approximately 175 per cent of GDP. Even though Danish households have positive net worth, their high gross debt makes them rather vulnerable to rising interest rates and falling income.

It is difficult to make exact cross-border comparisons of household debt and its background. The availability of home financing may e.g. have an impact on the households' rate of indebtedness. In Denmark, even low-income households can obtain mortgage-credit financing. The reason is that the mortgage-credit institutes have relatively fast and easy access to the collateral, i.e. the property. In addition, the interest payable on mortgage-credit loans is not dependent on the borrower's creditworthiness. All borrowers pay the same rate of interest, the market rate, plus a contribution to the mortgage-credit institute.

The access to finance home purchases via different types of loan also affects the level of debt. The development within home financing in Denmark, e.g. the introduction of deferred-amortisation loans and bank mortgage loans, has made mortgage equity withdrawal easier. In a European context, Denmark has a highly sophisticated mortgage-credit market in terms of the range of products.^[1] Empirical studies indicate that a well-developed mortgage-credit market with good opportunities for borrowing against the free mortgageable value of properties increases mortgage debt.^[2]

There seems to be a correlation between the completeness of the mortgage-credit markets and the households' debt. Wyman^[3] has constructed an index of the completeness of the mortgage-credit markets in a number of countries. The index considers the home-financing options available to the households (supply of loan types), the mortgaging ratio, the types of households that are able to buy homes (size of down payment, young versus elderly people, etc.), and the intended purpose of the loan (second home, rental, summer cottages overseas). Denmark, the Netherlands and the UK achieve high scores in the index. In contrast, several countries in southern Europe have a less complete mortgage-credit market according to this method.

In countries where households can raise housing loans with long maturities the level of debt tends to be higher than in countries where housing loans must be repaid at a faster rate, cf. Table 6. In e.g. the Netherlands, Denmark, the UK and the USA housing loans can be repaid over more than 25 years. In several countries in southern Europe, where the households have relatively lighter debt burdens, the maturity of a typical housing loan is around 15 years.

A high maximum mortgaging ratio makes it possible to raise larger loans, and there is a tendency for the debt to be highest in countries with high maximum mortgaging ratios, cf. Table 6.

If homeowners have the opportunity to raise supplementary mortgage loans, households can be expected to have a higher rate of indebtedness, cf. Table 6. Loans against the free mortgageable value play a significant role in the Netherlands, Denmark, the UK and the USA, where the level of debt is high, while such loans are not available in France and Italy.

The housing market
The economic conditions of homeowners are underpinned by a strong housing market, and housing prices have accelerated, cf. Chart 31. From the 1st quarter of 2005 to the 1st quarter of 2006, the prices of single-family and terraced houses have increased by 24 per cent, and owner-occupied apartments by even more.

The rising prices especially reflect improvement of the economic fundamentals. The Danish economy is growing strongly, interest rates remain low, unemployment is falling, and the Danes' disposable incomes are increasing. At the same time, the introduction of new loan types, including deferred-amortisation and adjustable-rate loans, has helped to sustain price increases. The freezing of property taxes has also affected prices, particularly in the very attractive areas, where the progressive property tax has or would have an impact. The price increases have been unevenly distributed across the country, with particularly large increases in Greater Copenhagen and the large provincial towns.

In spite of the recent increase, interest rates – nominal and real – remain low. In view of the improved economic outlook for Europe and sustained high energy prices most financial market players expect interest rates to increase further in the near future. This will entail lower housing prices than otherwise, perhaps even a slight decline, but for as long as the economy remains favourable there is no prospect of a significant general fall in housing prices.

Home financing and the households' interest burden
Homeowners increasingly opt for deferred-amortisation loans, which at the end of the 1st quarter of 2006 accounted for around 34 per cent of total lending by mortgage-credit institutes for home financing, cf. Chart 32. 64 per cent of the deferred-amortisation loans are at adjustable interest rates. Particularly in and around the large towns and cities deferred-amortisation loans account for more than 30 per cent of total mortgage-credit loans.

Deferred-amortisation loans are not equally distributed among borrower groups. For homeowners under the age of 30, deferred-amortisation loans account for 38 per cent of the total lending by that age group, while the equivalent figure for those over 60 is 45 per cent, cf. Table 7. For the remaining age groups, the share is close to 30 per cent. Deferred-amortisation loans have made it easier to achieve an intertemporal reallocation of consumption, which might explain why young and elderly homeowners choose deferred amortisation.

The new, more complex loan types have given homeowners more choice when it comes to financing. Products can be mixed to obtain a risk profile that matches the individual household's trade-off between risk and costs.

Financial stability 2005 presented an analysis of the interest-rate exposure of Danish homeowners based on data from early 2005. This analysis has been repeated on the basis of data from early 2006.^[4] Table 8 shows the change in the homeowners' interest expenses as a ratio of gross income (interest burden) in various income brackets if the short-term interest rate increases by 1 percentage point. In the analysis, the short-term interest rate is defined as the rate of interest on an adjustable-rate loan, irrespective of the fixed-interest period.

According to the database, since the beginning of 2005 more homeowners have opted for loans at variable interest rates, including many capped loans. The analysis takes into account that the interest on such loans cannot exceed the capped rate. Adjustable-rate loans, including capped loans, initially entail lower interest payments than fixed-rate loans, and from 2005 to 2006 mortgage-credit interest expenses as a ratio of gross income fell for all income brackets except the highest. On the other hand, the higher prevalence of adjustable-rate loans increases homeowners' exposure to rising interest rates.

On average, homeowners' mortgage-credit interest expenses will increase by 1.2 per cent of income before tax on a 1-percentage-point increase in the short-term interest rate, thereby bringing the homeowners' average mortgage-credit interest expenses to 10.5 per cent of gross income, against 9.3 per cent today. For a household with an income of kr. 500,000, the average increase in annual interest expenses would be kr. 6,000 before tax if the short-term interest rate increases by 1 percentage point. There is, however, considerable dispersion between and within income brackets, and the interest burden for some homeowners would increase by more than 3 percentage points, cf. Table 8.

Homeowners' increasing use of capped adjustable-rate loans dampens the effect on the average increase in the interest burden in the event of large interest-rate increases, cf. Chart 33.

The consequence of the increasing use of adjustable-rate loans in recent years is that homeowners have become more exposed to changes in the short-term interest rate. This exposure is particularly pronounced for homeowners who have also opted for deferred amortisation since they have already made use of the buffer which the deferred-amortisation option provides, unless the deferred amortisation has been used to repay other, more expensive debt. It is important that the households are aware of the risks connected with the various home-financing options and understand that no-one can say for certain how interest rates will develop.

[1] Cf. Mercer Oliver Wyman, Study on the Financial Integration of European Mortgage Markets, European Mortgage Federation, 2003.

[2] Cf. Pietro Catte, Nathalie Girouard, Robert Price and Christopher André, Housing markets, wealth and the business cycle, OECD Economics Department Working Paper No. 394, 2004.

[3] See footnote 1.

[4] The analysis is based on a database comprising a range of anonymised data about a group of Danish homeowners – choice of loan type, income, geographical location, etc. The database was made available by Nykredit and does not contain data relating to Totalkredit. The database is described in more detail in The Interest-Rate Exposure of Danish Homeowners, Danmarks Nationalbank, Financial stability 2005.