Naturally, and as expected, the idea with indexation of debt contracts in Iceland is to preserve the purchasing power of the borrowed funds. The classic analogy in Iceland is that if you lend a horse, you're meant to get a horse back. If people want to think about interests as well, the lender is meant to get the horse back and a pony. Likewise, if a bank in Iceland lends out 1,000,000 ISK the indexation to the Consumer Price Index (CPI) is meant to preserve the purchasing power of the 1,000,000 until repayment. And since the bank is lending out the savers' money (which isn't true but let's skip that detail for the time being) the savers get their lent-out purchasing power back when the loan is indexed. Simple, basic stuff.
Now, of course, this is done in many countries, most notably on federal bonds. Sweden, USA, France, Iceland and plenty of other federal states index their bonds - or at least a part of them - to the CPI. This is all fine, issuing indexed treasury bonds hinders the State from being able to print itself out of debt problem and increases the fate of investors in State's finances. Also, one can argue that issuing indexed treasury bonds is cheaper for the State since real rates are, at least in theory, lower on such contracts compared to where the rates are nominal.
The way indexation is done in Iceland isn't that different from other countries. The borrower issues a bond or borrows, say, 100 ISK and if the CPI goes up by 1%, he owes 101 ISK. Most indexed government bonds are bullet loans where the whole indexed principal is repaid at the day of maturity. There can be annual, semi-annual or quarterly interest payments as well and they can also be indexed. However, not many indexed government bonds are done in such a way that the treasury repays the indexation part (it would have been 101 - 100 = 1 ISK in the simple example mentioned above) every time there is a repayment of the principal, in the case of many principal repayments. And bonds where the borrower pays part of the indexation every time there is a principal repayment are very rare.
But even though the way and the idea of indexation is similar to what goes on in other countries, the conduct is black-and-white. The major differences between the Icelandic Way of Indexation compared to other economies are two. And both of them are crucial in making the mix so economically poisonous as it is.
First, the major issuer of indexed bonds in Iceland is not the government but households, predominantly through mortgages. At year end 2007, the last year which trustful data can be found for, the value of indexed loans in the Icelandic economy was about 1,600bn. ISK (the GDP was 1,300bn. ISK in 2007). Of those 1.6tn., households were responsible for repaying about 83% and most of this was mortgages. The rest was predominantly firms (15%) while the State was hardly there (2%). (Note: I'm counting the Housing Finance Fund's bonds as the debt of households for the simple fact that they are the principal borrowers of those funds, the HFF is merely an intermediary between the households and the capital market. Some people want to count the HFF bonds as State's responsibility because they have State's backing).
The second peculiarity to notice is that most of this indexed debt is repaid according to a very uncommon formula where only a part of the indexation is repaid every single time there is a repayment of the mortgage.
When a household borrows and the principal is indexed, the household does not repay the whole cost of indexation at the day of last repayment, as is common with government bonds (bullet bonds). The household does not either repay the cost of indexation immediately - that's what Danske Bank thought in 2006 in its "Geyser Crisis" report - but only a part of it. The rest of the indexation is added onto the principal and is repaid in every single repayment that is left on the mortgage.
This sounds peculiar and it's completely normal if one doesn't get this immediately. After all, the paid specialists at Danske Bank didn't get it until some poor Icelandic household called them up and told them what was going on.
So let's take an example. A household borrows 20,000,000kr. for 40 years at 5% REAL interest rates (yes, those are extortionately high rates, but they are common in Iceland. I'll get to it in another post why they are so high, just bear with me). Repayments are monthly and lets assume average inflation is 2,5% (nominal rates are therefore roughly 7,5% on average). Monthly repayments are calculated on an annuity basis (given principal, no. of repayments and interests, the monthly repayment is meant to be nominally fixed as long as any of the assumptions, such as interests or the principal, don't change).
The monthly repayments of this mortgage is shown below in blue. In comparison, I've added another mortgage where the only difference is that the interest rates are nominal rates and the principal is not indexed. The real rates are the same on both of the mortgages at all times. Average inflation is the same in both cases but the fluctuations in the nominal mortgage's monthly payments are due to the fact that inflation fluctuates between 0% and 5%. This is of course common in nominal rates mortgages: if the inflation goes up, the nominal rates go up and squeeze the households so consumption and economic activity contract so inflation goes down again, the nominal rates do as well and consumption and the economy kickstart again. We've made a loop and the cycle begins again.
Monthly repayments for an indexed Icelandic mortgage and another that is not. Both mortgages bear the same real 5% rates at all times. 2,5% average inflation, fluctuating between 0% and 5%
This does not happen in the case of the Icelandic indexed mortgage. There are no short-term fluctuations of monthly payments but instead they grow slowly but exponentially.
The reason why there are no short-term fluctuations in the monthly payments is what I mentioned earlier: the whole cost of the inflation is not born immediately by the borrower of the indexed loan but added onto the principal of the loan. In the case of the borrower of the nominal rates mortgage however, the nominal rates go up so he must pay immediately for the cost of inflation. This has the effect that the nominal value of the principal of the indexed mortgage goes up in the beginning while it continuously shrinks in the nominal rates case.
The cost of inflation, i.e. to maintain the purchasing power of the borrowed funds, is added onto the principal of the indexed loan while it is paid in the form of higher nominal rates on the non-indexed loan. Therefore, the principal of the indexed loan grows first until the repayments get fewer and bigger share of the indexation is paid immediately.
So this is the functionality and the nature of indexation in Iceland. I've said nothing about the effects but Paul Krugman called the way of indexation in Iceland "anti-social" in an interview with Egill Helgason of the Icelandic Broadcast Corporation (IBC, not BBC) straight after the Iceland Recovery conference thrown by IMF and the Ministry of Finance in Iceland.
He has no idea how deep the rabbit hole goes! Krugman is, with those words, only touching on the poisonous nature of those loans. In very short, they completely lay waste to the influence of the monetary powers over expansion of credit, inflation and long term financial stability just to name a few horrors. But the devastating effects of the Icelandic Indexed Mortgage will be explained a bit further here on this site later and to the detail in my book, Bad Economics.
Part II can be found here