Challenge 3 - The effect of balance sheet adjustments In the wake of the fall in share prices, we have thus far seen the effects on housing finance in the form of low interest rates, which have enabled households to increase their indebtedness at a slowly rising interest ratio. As the interest ratio has risen marginally, this in turn has led to a continued increase in residential property prices in several countries, including Sweden. The lower expectations of future earnings that have resulted from the stock market decline has so far not markedly reduced housing finance demand in Sweden. Thus far, the effect of the low interest rates appears to be the dominant factor. As the balance sheet adjustments come to an end, the geopolitical uncertainty abates and the economy continues to recover, risk aversion will decrease, which in turn will lead to a normalisation of market rates. Consequently, this will dampen household demand for housing finance. On the other hand, expected earnings flows will rise in tandem with the rise in economic activity. The ability of mortgage institutions to find "cheap" financing will also be affected by the normalisation of interest rates. Investors will return to riskier investments as risk aversion declines. Furthermore, rises in long-term interest rates will reduce the value of the bond holdings that were acquired by investors during the current risk aversion period. Consequently, mortgage institutions will face challenges in the time to come on both the demand and supply sides.
In the light of high  BIS Review 15/2003  1  expectations of future growth, households financed their consumption, and companies their investment, by increasing their indebtedness in the belief that these debts would be easy to repay due to high future earnings and income. Moreover, a large proportion of the companies' financing was obtained via the stock market. Balance sheets became inflated, as did the actual growth in the economy. When earnings prospects later proved to be lower than expected, there was a fall in both share prices and the value of assets. Debt levels appeared high, particularly in the corporate sector. In order to lower their debts, companies had to increase their income and reduce their costs, which resulted in weaker demand in the economy. Furthermore, the declining share prices prompted households and the financial institutions that invest households' money to seek out investment alternatives that appeared safer. The downward adjustment of the future outlook itself also resulted in uncertainty. This in turn was compounded by the uncertainty caused by international terrorism and the attempts to deal with this by putting pressure on Iraq. This contributed to an increase in the spreads between corporate and treasury bonds as well as to greater volatility in the markets. To counteract the effects of balance sheet and income statement adjustments on the real economy, monetary policy was eased in several countries around the world. At the same time, fiscal policy became more expansionary.