The Residential Housing Market in Iceland: Analysing the Effects of Mortgage Market Restructuring

In June 2004 the government-backed Housing Financing Fund eased its loan regulations in an attempt to consolidate its position in the domestic credit market. This led to a strong response from the domestic commercial banks that actively entered the mortgage market for the first time. These changes led to a substantial decline in long-term real mortgage rates, increased the access to credit, and allowed homeowners for the first time to withdraw equity from their homes without actual transactions. This paper sets up a simple model of housing demand and supply to analyse these effects. The results suggest that the structural changes led to a substantial rise in housing demand, with house prices rising by 25 per cent one year after the shock. This triggered a similar rise in housing investment approximately two years after the shock. The model predicts that the effects on house prices gradually die out as house prices return to the level that is consistent with normal profit margins in the construction sector. However, the housing stock remains approximately 5 per cent larger than in the baseline scenario.