Friday, June 19, 2009

A cautionary tale about mixing mortgages with currency risk

So we got our housing market wrong?

One of the key reasons for the decline in the UK economy is the correction currently going on in the housing and commercial property markets. Britain, like a number of other countries, borrowed hundreds, if not trillions, of dollars and euros to bid up the prices of assets that already existed. However in the main, the foreign exchange borrowing was done at an institutional level. This was not always the case in eastern and central Europe. For instance, in March 2007 Linda Pasztor bought a flat in Budapest (FT, 21 March 2007). She needed a mortgage for the equivalent of $71,500. Did she borrow Hungarian forint at 5.5%? No – she went to the Austrian Erste Bank and borrowed 87,000 Swiss francs at 4%.

Posted by jack c @ 12:19 PM (1296 views)
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3 thoughts on “A cautionary tale about mixing mortgages with currency risk

  • Looks like the link wont work so here is the article

    So we got our housing market wrong?
    Dr Tony Gandy tells a cautionary tale about mixing mortgages with currency risk

    One of the key reasons for the decline in the UK economy is the correction currently going on in the housing and commercial property markets. Britain, like a number of other countries, borrowed hundreds, if not trillions, of dollars and euros to bid up the prices of assets that already existed. However in the main, the foreign exchange borrowing was done at an institutional level. This was not always the case in eastern and central Europe. For instance, in March 2007 Linda Pasztor bought a flat in Budapest (FT, 21 March 2007). She needed a mortgage for the equivalent of $71,500. Did she borrow Hungarian forint at 5.5%? No – she went to the Austrian Erste Bank and borrowed 87,000 Swiss francs at 4%.

    This type of transaction was rife across the whole region. People would borrow for mortgages in “Save” currencies. This allowed those people buying assets in higher-yielding currencies an opportunity to fund themselves at a lower rate – an approach that was seen as logical, if short term. Hundreds of thousands of people did it, and Austrian banks led the way. Their home market has for a long time used what are known as currency “carry trades”, and 12% of Austrians borrow in Swiss francs or even Japanese yen (Swiss National Bank Working Papers 2008-19).

    The big Austrian-based banks Raiffaisen Bank, Erste Bank and Bank Austria (owned by Italian bank Unicredito) lent the equivalent of 70% of Austrian GDP in the form of mortgages to eastern Europeans.

    Since these mortgages were taken out, the highly leveraged customers have had to face up to the reality of currency risk. Countries such as Hungary and those in the Balkans have seen a rapid fall in the value of their currencies, in part because of the high leverage their citizens have taken on to purchase their houses and fund a consumer spending boom.

    For citizens in most countries, a fall in the value of the currency has no immediate impact; to quote Prime Minister Harold Wilson in 1967: ‘It [a devaluation] does not mean that the pound here in Britain, in your pocket or purse or in your bank, has been devalued”. The impact tends to be longer term, as imports rise in price and exports become more competitive.

    However, if you are highly leveraged in a foreign currency, a devaluation most certainly does matter. If you get paid in forint and the value of that currency has fallen by 40% compared to the Swiss franc, it means that interest payments due in Swiss francs have nearly doubled and the loan is nearly twice the size. Meanwhile, to the lender, the value of the asset that backs up this loan has also fallen by 40%. Add to that the rapid fall in property values in some countries (close to 50% in Latvia), and a bank that has funded a loan in Swiss francs in a country like Latvia or Hungary finds that the value of the asset is only a small proportion of the value of the loan. For the borrower, the amount owed has rapidly grown, making paying it off a rather distant dream.

    The consequences are severe pressure. Citigroup has commented on the problems facing eastern Europeans and the impossibility for many of paying off these loans. Citigroup estimates that 15% of mortgages in Hungary could default. This is not great for banks that originally lent at 4%; the loss of capital is likely to be very large. But Ukraine is worst, where the expectation is that 30% of mortgages will not be paid back.

    However, this is not just a problem for central and eastern European countries; it also leaves the Austrian banking sector – indeed the whole country – in crisis. It puts enormous pressure, too, on the Swiss National Bank to try to drive down the value of its currency. Switzerland became the first western country to experience full deflation and is finding it almost impossible to export because of the high value of its currency. It is slowly starting to sell its francs and buy euros to help address the exchange problems it has – however, it will not be buying forint or Ukrainian hryvnia. The fact that people in Hungary and Ukraine borrowed in Swiss francs was not Switzerland’s fault, and why would the Swiss now want to buy assets in countries that would be bust if not for the IMF?

    The situation in central and eastern Europe puts the crisis facing the likes of the UK, Ireland, Denmark, Spain and many other western economies into context. At least western Europeans have not been so foolhardy as to add currency risk to all the other challenges and dangers of entering the housing market.

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  • mark wadsworth says:

    Well, hurray for borrowing in your own free-floating currency. The US and the UK (the worst offenders in the credit binge) have had a retrospective 25% discount on what they have to repay in future.

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  • Why did the Austrian banks lend to the Hungarians then? This seems incredibly foolish of the banks. It’s almost as if the bankers cared more about earning short-term bonuses rather than caring about the longevity of the banks themselves. At least that could never happen here…

    No doubt the conspiraloons will accuse Austria of trying to take over Hungary through debt-slavery; ultimately leading to the resurrection of the Austro-Hungarian Empire. Those cunning, cunning Austrians….

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