No rules, no process, no strategy: Part 1, “Essentially no zoning rules”

July 29, 2015 | Boston, Boston Redevelopment Authority, BRA, Development, Government, Housing, Marty Walsh, Policy, Redevelopment authorities, Tom Menino, Urban development, Urban planning | No comments 85 views

By: David A. Smith

Even as a candidate Marty Walsh had to have known that upon becoming mayor he would have to reform the Boston Redevelopment Authority, which over the two decades of Tom Menino’s mayoralty parlayed its monopoly over all development approval in the City of Boston into a personal fiefdom that not only did the mayor’s bidding, and paid for its own operations by capturing a piece of the value it created by allowing some properties – and not others – to develop upward, but also effectively silenced all opposition.  But even he should be discouraged by the recent McKinsey report he commissioned; as reported in the Boston Globe (July 16 2015):

The agency charged with overseeing the real estate boom coursing through Boston is a dysfunctional bureaucracy, its system for reviewing projects erratic, with just a few powerful staffers deciding how new buildings will look using “unwritten rules,” according to a highly critical audit (link in pdf) being released by City Hall Thursday.


“Organizational health is bottom-quartile”

Simply put, the BRA had no rules, no process, and no strategy.

Candidate Walsh also presumably knew that the BRA was a mare’s nest of tangled reporting relationships, business processes, sub-fiefs and personal rivalries, and at the same time it would be running a pipeline of properties involving communities, neighborhoods, developers and bankers.  It would, in a word, be touchy.

The conclusions are particularly troubling given the key role the BRA plays in guiding Boston through a remarkable economic period, with the agency approving almost $5 billion in new developments citywide over the past 18 months.

Much of this development is pent-up demand that was stymied under Mayor Menino’s BRA, so simply the scale of development is itself welcome.

Organizationally, the mayor has proceeded cautiously.  From within he promoted Brian Golden to director, and messily fired former planning head Kairos Shen [Subject of a flattering Boston Globe profile, Boston Globe (June 29, 2008) profile, The Shaper of Things to Come; cobalt blue font. – Ed.] only in May:

Walsh has already broomed out key Menino holdovers.

In May, as McKinsey was finalizing its report, the mayor forced out [Fired – Ed.] Kairos Shen, the longtime planning chief under Menino. 


Over 20 years, he worked for seven directors but only one mayor.

No mere planning chief, Mr. Shen was effectively Mayor Menino’s personal architect, as illustrated by the vignette with which the Globe opened its laudatory 2008 piece:

The architect unfurled his thick stack of drawings and designs on the table in Kairos Shen’s office. Five minutes after seeing the preliminary and confidential ideas for a new public building, Shen grabbed a red felt-tip pen and began drawing his revised version of the building on one of the now-irrelevant plans the architect had arrived with.  Once finished, his new furiously sketched diagram eviscerated the architect’s design while leaving the most basic elements of the building shape intact.  “When you come back,” he ended the meeting, “please bring two different versions of the ideas that we discussed,” meaning, of course, his red diagrams.

Even then, when the piece first came out, I thought it curious that the Globe would present as admirable a gross overreach of the reviewer’s responsibility – but it was entirely representative of Mayor Menino’s late-stage BRA, with results that we all knew and only Don Chiofaro said aloud: development was haphazard, capricious, and unaccountable:

The report, by McKinsey & Co., paints the powerful Boston Redevelopment Authority as short of critical staff, beset by poor morale, and unable to manage its own property. The process to review building designs can be maddeningly slow at times, driving up costs for developers, it says.


More than merely maddening, the process was spectacularly inefficient, as illustrated by slide 57 of the report deck:

“Thirty hours actual review time”

Before the developer even files its proposal, it undergoes ‘several months (highly variable)’ of ‘pre-file discussions’ whose purpose, as far as I can tell, was to find out what the mayor would like – and often that was informed by what random people who knew the mayor would like.

“You’ll have someone who says ‘we want to see a change.’ You have to redesign, go back and forth,” said David Begelfer, chief executive of NAIOP Massachusetts, a commercial real estate trade group. “It can take months.”


You can get gray hair waiting for approval

Then, after the process began, it took 8 to 20 months to complete – and this is just design review, folks, not feasibility assessment, over which interval the BRA staff actually spend 30 hours – less than one person-week doing the review itself, with the inefficiency attributable to developers have to redo, and re-redo, their designs to respond to the taste police and the ultimate taste cop himself, Mayor Menino.  Consider this indictment from 2008:

Kremlin-watching is especially crucial in the Boston development process, which is marked by a level of flexibility –

The Globe’s editorial euphemism for ‘lack of rules or transparency’.

– that many developers find infuriating, but, if used properly –

How does one use caprice properly in a democracy?

– can help a builder legally violate nearly every zoning rule that applies to a particular parcel. And if the developer is building on a parcel larger than an acre –

Any multi-story building will need more than an acre for its footings and setback requirements, so the PDAs cover basically the entire commercial potential of downtown Boston.

also known as a Planned Development Areathere are essentially no zoning rules and the whole project can be designed from scratch, governed only by the rules imposed on a case-by-case basis by the BRA on issues ranging from size to use to height to setback from the road.

All this untrammeled authority was fostered by, used by, and wallowed in by Mayor Menino, who took glee (cf. the mayor’s now-infamous Godfather video mocking his feud-unto-death with Don Chiofaro) in stymieing and humiliating those who did not kiss his ring and call him godfather.


“What does a man have to do to get the city to use rules?”

The BRA won’t agree to anything unless it has buy-in from the mayor.  Until you have a preliminary plan that can get this support, there is no point in spending millions to get the variances and the dozens of state and local approvals from agencies and boards that hold some sway over nearly every square inch of buildable land in Boston.

This is an over-encrusted and rotten process, as McKinsey alludes:


It couldn’t have taken months to interview 56 people

“Perception is that they rubber-stamp everything.”

Nor does the board’s composition inspire confidence, for best-in-class domain expertise is lacking.

The mayor won’t give his support if the neighborhood where the building will sit is unhappy.

Define ‘unhappy neighborhood’ – does that mean a majority? 


I don’t know what I want, but I know you’re not it

A vote?  A bunch of people complaining to the mayor?  One person complaining to one consigliere of the mayor?  Nobody knew.

So developers and communities do months of dances, meetings, and revisions to preliminary plans based on feedback. Then there’s – let’s call a spade a spade here – the legalized extortion known as “linkage.”  

This is a crucial part of the community buy-in process and includes developer promises of affordable housing units above the required minimums or a new park or a new firetruck or nice street lights or new sidewalks or improvements to the local elementary school – until the community is satisfied with the package being offered. Only then is the mayor happy.

Shen makes sure the entire process has happened before the developer submits what is technically the first official proposal to the BRA.

There.  Were.  No.  Rules.  There was only mayoral power (CBS Boston, November 8, 2010): 


You won’t like me when I’m unhappy

[Continued tomorrow in Part 2.]

Bon viager: Part 2, Synthesis of family

July 28, 2015 | Annuity, Apartments, Elderly, Escheat, Homeownership, Housing, Innovations, Mortgages, Paris, Rental, Tenure | No comments 129 views

[Continued from yesterday’s Part 1.]

By: David A. Smith

In exploring the en viager model of tenure, prompted by a story on BBC News (1 July 2015), we’ve established that en viager, aside from being an antiquated legal form that survives in French law (and is enjoying a revival driven by demography), also creates a synthetic family, with the elderly seller/ tenant standing in for the auntie or mother of the buyer. 

Caring for aging parents is wired into human beings.


All of us are related, or so we say!

So is greed:

It’s a sign of the inherent tensions in the system that any death involving a viager is automatically investigated by the police, to clear up any suspicions.

Earlier this year, a man was charged with attempting to poison his 85-year-old viager tenant, by putting medication in her mineral water. He denied the charges.


Here’s to back stories

It will probably contribute to a significant change in composition of the neighborhoods in France’s best cities, like Paris – and I wouldn’t be at all surprised if some enterprising French were buying them up with a view to eventual Airbnb-ing.

“Eighty per cent of French personal wealth is held in property,” Nahon says. “Liquid assets account for very little.” So when the coffers run dry, the viager system is an appealing way out of trouble.

Given the absence of alternative hybrid-tenure models as mentioned above, it makes good sense.

Genevieve Deloche is 71 and has just agreed a viager deal on her apartment in the 20th arrondissement of Paris.


Away from the tourists but comfortably in town

It’s a peaceful, one-bedroom place, with a courtyard full of greenery, a large basement and a garage.

“It sold very quickly. Too quickly!” she says. “Within three months. It was a shock.”

If I understand things correctly, the price of an en viager house price is set by the seller or the market, but the timing of payments – the 30% bouquet, the monthly stipend based on annuitized charitable remainder trust principles – are set by formula.  So yes, Ms. Deloche, perhaps your flat did sell too quickly – or maybe you’re healthier than the market actuarially expected.

After living there for twelve years, she says it was time to consider a viager buyer because she had no children –

There’s the inheritance and escheat-avoidance motivations in a nutshell.

– and turning seventy meant there were no tax barriers to receiving a lump sum.

I presume that’s a provision of French law akin to our IRA treatments, except as applied to

She doesn’t particularly need the down-payment, she says, but the monthly stipend will go towards “having fun” – trips to the theatre, travel and eating.

That’s a wonderful use of the illiquid equity; enjoy your life while you’re still cognizant and mobile enough to do it.


I sure hope to live a long time!

With her frequent laughter, jokes and energy, Genevieve isn’t quite the image of an ailing 71-year-old that her prospective buyers might have expected.

“Typically, sellers are 70-80 years old, and female,” says Mikkael Ferrand of Viager 75, an agency based in the Paris’s smart 5th arrondissement.


Don’t get too attached to the renter, keep your eye on the property

Gender difference is real: both that for many of the older generation, women live a little longer than men (whether biology or work and life cycles is beside the point), and because if this, if an elderly man outlived his wife, he would readily be able to marry another one.

GREEDY, (background): Michael J. Fox, Nancy Travis, Colleen Camp, Joyce Hyser, Ed Begley Jr., Siobhan Fallon, Jere Burns,  (front): Kirk Douglas, Olivia d'Abo, 1994. ©Universal Pictures

GREEDY, (background): Michael J. Fox, Nancy Travis, Colleen Camp, Joyce Hyser, Ed Begley Jr., Siobhan Fallon, Jere Burns, (front): Kirk Douglas, Olivia d’Abo, 1994. ©Universal Pictures

I’m giving my money to the one who truly loves me

“They come from a generation where they haven’t worked, their husband has died and they have a tiny pension. Sometimes they get landed with a big renovation bill for the building –

That is, a condo or a co-op – and both cases illustrate the ongoing challenge of elderly aging in place in an owned multi-family building: they can be asset-rich and cash-poor – so en viager is thus likely to arise only in high-value urban environments (like Paris) because those are the places with multi-unit buildings of sufficient value that people will buy them.

– or something, and selling en viager is the only way they can pay the bills and still stay in their home.”

Ironically, though we think of family as closer than strangers, en viager transactions demonstrate that the synthetic family formed by a buyer may be more comforting than the actual serpent’s teeth of thankless adult children. 


En viager it is, then!

It’s also a way of having more control over your inheritance, says Genevieve Deloche. “You can pass on your children’s inheritance to them early, at a time when they actually need it, and avoid inheritance tax too. It’s also ideal for those who don’t get on with their kidsbecause they can take the inheritance away.”

While again implied, not stated, this suggests that under French law the adult children of an elderly decedent can overturn her will and demand their blood inheritance; if so, en viager is a revenge in life, a means of spending the inheritance on oneself, or passing the proceeds to another extra-familial relative.

In around 10% of cases, says Stanley Nahon, the first children learn about a viager deal is when their parents die – and it can leave them very disappointed. But such secrecy is rare, and many children encourage their parents to release the capital tied up in their home, as a way to support themselves in old age.


I thought I was inheriting a flat; instead I’m inheriting a burden

“Buyers, too, often see it as an ethical investment,” he says, “because it allows the elderly to stay on in their own place and avoid moving to a retirement home.”


Have I the right to sell my inheritance?

A legacy bequest is the last gift elderly parents bestow upon their children, and it does raise the question – in moral children, anyhow – what did I do to earn this?  What use of the money can honor the memory of my late mother?  An en viager stands that morality on its head and tells the living children, I spent your inheritance on myself.


And yet you incessantly stand on your head–

Do you think, at your age, it is right?”

“In my youth,” Father William replied to his son,

“I feared it might injure the brain;

But, now that I’m perfectly sure I have none,

Why, I do it again and again.”

To many an adult child, that implied rebuff from beyond the grave – a secret held until it was irreversible – must sting.

But the children of the buyers can also be in for a shock, if they inherit their parents’ viager contract. Unless they keep up the regular monthly repayments, the whole investment will be written off, and the original owner-tenant will be free to sell their property again.

Property brings out the worst in families; and sometimes the best, and it has made for great drama and black comedy, via the inheritance angle (Kind Hearts and Coronets), tontines as partnerships with no transferability (The Wrong Box):


I just need to outlive my brother by one hour … or be thought to have done so

[Side note: Tontines, originally created as a pre-corporate capital-subscription mechanism akin to limited partnerships, later evolved into microcredit and microsavings cooperatives in emerging countries and are still used for that purpose today.  – Ed.]

A film released last year focused on just these kinds of tensions, with Maggie Smith playing a dowager lady ensconced in a viager deal, and Kevin Kline the penniless son of the deceased buyer, who turns up in Paris hoping to sell his inheritance.

Propinquity can foster friendship, especially if those living in proximity have age-and-gender relationships that echo familial forms (auntie-nephew, mother-daughter).  The elderly have memories and time, and want someone with whom to share them.

Contrary to the scare stories, brokers say, positive relationships often develop over the years between buyers and sellers. They may meet for tea once a year, or send over a box of chocolates.

“It was important to like the person buying my flat,” Genevieve Deloche tells me. “To have good relations, be able to laugh a bit.”

A home is an exoskeleton around a self, a soul; when one sells it, even if one remains living in it, the buyer stands in loco filis, and it would be a rare old lady indeed who developed no maternal feelings for her eventual buyer.

Maggie Smith in My Old Lady Handout

Maggie Smith in My Old Lady

“I think of you as my son.”

I think of you as my tenant

Isn’t it strange, I ask her, to meet someone who’s gambling on how long you’ll live?

“Yes, it’s true, but I don’t care.” she says. “It’s hardly a reason to jump under a car.”

One broker told me about cases when the buyer’s gamble spectacularly failed, with sitting tenants still going strong at 102 or 103.

Something in all of us makes us root for living long and prospering in old age, so the tale of the world’s oldest viager is itself sweet:


Jeanne Calment, age 50, in 1925

In 1965 Jeanne Calment, aged 90, sold her apartment in Arles to her lawyer, Andre-Francois Raffray – a man half her age. It was a viager deal, and Raffray agreed to pay her 2,500 francs (about $500) per month.  


Ms. Calment in 1897, with a century of living before her

But Calment went on to become the world’s oldest living person, dying 32 years later at the age of 122.

Raffray himself died two years before her, on Christmas Day 1995.


Ms. Calment in 1992, age 117

“On the same day, Jeanne Calment, now listed in the Guinness Book of Records as the world’s oldest person at 120, dined on foie gras, duck thighs, cheese and chocolate cake at her nursing home near the sought-after apartment in Arles, northwest of Marseilles in the south of France,” the New York Times reported, a few days after Raffray’s death.

“She need not worry about losing income. Although the amount Mr Raffray already paid is more than twice the apartment’s current market value, his widow is obligated to keep sending that monthly check. If Mrs Calment outlives her, too, then the Raffray children and grandchildren will have to pay.

“‘In life, one sometimes makes bad deals,’ Mrs Calment said on her birthday last Feb 21.”


Ms. Calment at 120

She lived to 122, and died in August, 1997.


Vive le viager!

Bon viager: Part 1, Synthesis of tenure

July 27, 2015 | Annuity, Apartments, Elderly, Escheat, Homeownership, Housing, Innovations, Mortgages, Paris, Rental, Tenure | No comments 119 views

By: David A. Smith

Just as water and ice are two forms of the same molecules, lump sums and cash flow streams can be the same present values, one just transmuted into another. 


Over the decades, ambition transmutes into experience

We’re familiar with some of the forms:

1. Mortgage loan.  Receive cash up front, make payments over future periods.


Just hock the next three decades of your life, okay?

2. Annuity.  Pay cash up front, receive payments in the future.


Choose one, not both

3. Life insurance.  Pay cash over time, receive lump sum in the future.


To these we can now add a fourth, the life tenancy or en viager transactions:

4. En viager.  Receive payments over time, pay lump sum in the future.

As any pay-later strategy is fraught with collection risk, it can work only when the future payment can be garnished (as in payday lending) or collateralized – as in owned real estate such as a Parisian flat, and though the model has obvious benefits for both parties (the seller/ occupant and the patient eventual buyer), the incentives it sets up can be macabrely perverse, as reported in the BBC News (1 July 2015):

Buying a property with a sitting tenant and paying them to live there sounds like an odd investment, but the practice has been around in France since the Ninth Century – and bizarrely [Sic – Ed.] it’s getting more popular. Why?


If you live to be one hundred, you’ve got it made. Very few people die past that age. – George Burns

We all know what it takes to sell a home: freshly brewed coffee, the smell of baking bread in the oven – but if you’re buying under the ancient French system of viager you’d do better with a pile of medicine bottles in the bathroom cabinet and a nasty-sounding cough.


The more the buyer sees, the better your price

In a viager deal, the buyer pays a knock-down price – but only takes possession when the owner dies.

So it’s an annuity, paid by the viager buyer to the homeowner/ future estate seller: indeed, in English it’s called a reverse annuity mortgage and works like a charitable remainder trust, though those are typically used with the trust corpus, net of annuity payments, being donated to a non-profit,


I’ll give you my money corpus when my physical corpus no longer works


Give us your organs at death, and in the meantime give us your wallet

Like an annuity, it lasts as long as the person’s life does:

What complicates matters is that the buyer must pay the former owner (now the tenant) a monthly fee for the duration of their natural life – which could be months, years or even decades. And if all that sounds a bit like gambling on how long a stranger has left to live… well, it is.

As a curious exercise in consumer protection meets lottery tickets, the pricing of viagers is set entirely by the seller’s age (The Connexion, undated article):

How much must be paid is based on a rate calculated from average life expectancy in France. This is calculated on a graded scale laid down by French law.

If the seller is 70 years old, for example, the value of the property will be set at about 50%. This is called the valeur occupee or occupied value.

From this the bouquet, typically about 30% of the valeur occupee, must be paid in full at the beginning of the deal.

Thus we have a down payment (the bouquet), followed by mortgage-like payments (the monthly installments

For a 70-year-old seller the rate at which the remainder of the valeur occupee is paid is currently set at 7.24% a year. In this example the annual payment would be €5,068, and the monthly payment would be €422.33. This figure is index-linked and goes up every year with inflation.

At this initial rate the seller would recoup the remaining €70,000 over about 14 years.  However, if the seller dies within, say, two years, the property, with a market value of €200,000 would be in the buyer’s hands at the bargain price of just over €40,000.

The arithmetic of annuitized yield to the seller (or cost to the buyer) is complicated enough that I’ll decline to address it here, depending as it does on both inflation and seller’s life expectancy.  Likely, then, it’s made as an investment only by people who plan to live in the home after the seller’s death, and who have no need for interim liquidity in the quantum represented by the bouquet.


Wait long enough, and the flat could be yours

En viager thus fits neatly into the typology of financial flows to trade streams of cash for money up front.


Conversely, as the annuitized payment yield is set based on opaque actuarial tables, buyers would like to do Dial M for Murder diligence: how soon do you plan to die?


You understand you’re an inconvenience, don’t you?

Because it’s forbidden to question the seller about his or her health, it also throws up incentives to indulge in a bit of, shall we say, theatrical behaviour.

“Some of the sellers ham it up a bit,” one viager estate agent tells me in secret. “They sit on the sofa, with a blanket over their knees, and don’t move. But actually they’re in good health.”


I haven’t got long

But then, he says, the buyer often needs that kind of reassurance: “Some of them expect the residents to be 100 years old,” he says. “And they look for signs of illness when they visit the property – medicine bottles in the bathroom, that kind of thing.”


Want to underwrite these?

Viager sales are a tiny fraction of real estate deals in France – less than 1%. But the popularity of this ancient and arcane way of doing business – part of French law since 876 AD – is on the rise again, as property prices in areas such as Paris remain stubbornly high.

That’s not the reason, and it’s a classic journalistic superficiality to grab the visible thing (prices are high!) and ascribe it as the cause.  In fact, en viager is a form of synthetic family, placing the buyer in the same position as an adult child of an aging parent: the adult child will inherit the estate, will maintain the dowager duchess living in the family chateau, and will provide her with a living allowance for her personal needs.  Further, as the arrangement is non-familial, we can posit that it evolved as a device to transfer dynastic wealth when there were no legitimate heirs, and to avoid having property fall into escheat:

The term “escheat” derives ultimately from the Latin ex-cadere, to “fall-out”, via mediaeval French escheoir.  The sense is of a feudal estate in land falling-out of the possession by a family into possession by the overlord.


Escheat as defined by Dr. Samuel Johnson

For that matter, I wonder if en viager was the way a little Fitzroy born on the wrong side of the blanket was brought into the line.

For the aging elderly person, whose physical mobility is in decline and who needs help with the activities of daily life, en viager is a primitive tenure-ownership sharing model compared with (say) Accessory Dwelling Units (ADU’s) or the more modern high-tech elderly-monitoring apartments; that it is thriving and professionalized in France indicates not only that the French population is aging rapidly but also that many of them have no progeny to whom to pass their homes.


Wouldn’t you like a nice Indian or Moroccan to care for you?

Stanley Nahon is managing partner of Renee Costes Viager, which handles 40% of the viager market in France.


Formerly Booz, formerly KPMG, now an arbitrageur in viager

It’s an unusual asset class, which makes specializing worthwhile – as of today (18 Jul 15), the site claims 2,658 viagers for sale – and with France aging, the inventory will rise. 

He says the market is growing at an annual rate of 6-8%, and that his agency alone gets around 12,000 calls a year from elderly owners interested in a viager deal.

The growth in interest is due to the aging population, he says, and the fact that senior citizens’ pensions are falling in value as the cost of living rises.

Further, the model could be improved if in-home care could be added; perhaps a student or young couple who get a place to live in exchange for aiding their new auntie.  Naturally there’s potential for abuse, so it might be a three-way arrangement: en viager buyer seeking residual value, seller seeking care, and the young single or couple living in the apartment cheaply.  They are motivated to extend the owner/ seller’s healthspan and the public interest is served. 


She’s old, how long can she last?

[Continued tomorrow in Part 2.]

The unexpected hanging: Part 2, Too many banks here anyway

July 24, 2015 | Austria, Banking, Consumer protection, Currency risk, Eurozone, Global news, Homeownership, Lending, Mortgages, Risk, Swiss franc | No comments 257 views

[Continued from yesterday’s Part 1.]

By: David A. Smith

Yesterday’s Part 1 told half the story of an Austrian homeowner and acquaintance of columnist/ pundit David Frum. as described six months ago in The Atlantic (January 29, 2015), whose astonishment at being assessed a €12,000 mandatory loan prepayment demand, because though paid in Euros and living in a Eurozone country, he had chosen to borrow in  a loan denominated in the stronger and neighboring currency:

Enter mortgages denominated in Swiss francs. Interest rates in Switzerland have historically ranked among the lowest in the world. (You can get a Swiss mortgage today for a fixed rate as low as 1.5%.)  

Of course it never occurred to Mr. von Trapp that his bargain rate came with a stinger – the currency risk.  In effect, he was being paid a ‘currency risk premium’ equal to the difference between the interest rate he would have paid had he denominated the loan in Euros (his own currency, mind you!) instead of Swiss francs.


There’s a reason Euro rates are higher than Swiss franc rates

During the real-estate bubble of 2005-2007, mortgage rates in Central and Eastern Europe could cost in the double digits. Many homeowners were tempted to borrow in Swiss francs instead.

But Mr. von Trapp didn’t think about that – he just grabbed the lower ‘teaser’ rate, except that unlike US subprime borrowers, the teaser reset wasn’t a date certain, it was an unexpected hanging based on the currency and mortgage markets.

The temptation was especially acute because it was invisible. As a paper published by the Swiss central bank explained, Swiss-franc mortgages “rarely involve cash flows in Swiss francs. All loans are disbursed and all installments are paid in [local currency]. It is merely the value of the installments due and the value of the outstanding loan which are indexed to the [Swiss franc].”

That’s an awfully generous interpretation of Mr. von Trapp’s blithe ignorance.


We’re happy in our oblivion!

Typically, the lending institution was not a Swiss bank either, but the same retail bank where the customer made deposits and wrote checks.  

The loans looked extra cheap because local currencies in Central and Eastern Europe were gaining value during the real-estate bubble, as investors anticipated Poland and Hungary joining the eurozone in short order.

That makes me even less sympathetic to the borrowers; they were riding the currency game up, never expecting it could go down.

In Central and Eastern Europe, however, Swiss debt flowed into the household sector: Roughly 90% of all Swiss-franc debt in Poland was loaned to households.

As our friends the Greeks have just found out, Timeo germani praesertim dona ferentes [Translation courtesy of Matthew Healy – Ed.], or if you borrow in Danegeld, you may never get rid of th Dane. 

Altogether about 566,000 Polish households, 150,000 Romanian households, and 60,000 Croatian households bought Swiss-franc mortgages. Most astonishing of all was the Hungarian case: half of all households in Hungary contracted foreign-currency debt, almost always in the form of Swiss francs.

It was, in a word, epidemic.


We don’t want to catch a franc-loan

Foreign-currency mortgage holders suffered badly during the financial crisis of 2008. In a crisis, investors turn to the familiar and the seemingly secure—and few financial assets on earth are as familiar and secure as the Swiss franc.

This is precisely the reason Swiss franc borrowing was cheaper than euro borrowing, and it’s the same phenomenon – the Minskey moment – I reported on this blog so many years ago.


The value of Central and Eastern European currencies relative to the franc tumbled, as the monthly payments on mortgages linked to the franc proportionally spiked. Governments desperately scrambled to relieve debtors. Poland banned new Swiss-franc lending; Hungary experimented with postponing interest payments and adding them to the principal ultimately due.

As I’ve written many times, never borrow across borders, and never lend across borders.  Both sides take risks they don’t understand and can’t well hedge.  If you’re providing cross-border funding, either make it really low leverage, or make it an equity-type instrument.

Then, in 2011, an unexpected respite arrived. The euro crisis of 2010 presented Switzerland with a nasty dilemma.


Don’t borrow in Euros

The same search for safety that devalued the Polish zloty and Hungarian forint in 2008 now devalued the euro against the franc, sending the cost of doing business in Switzerland soaring. In 2011, the European Union’s statistical agency rated Switzerland’s consumer costs as the continent’s highest. Swiss exporters and service providers were in danger of being priced out of business. Responding to their complaints, the Swiss central bank pegged the franc against the euro in September 2011 at a rate of 1.2 francs to the euro.

Peg all you want; if there’s trading, you have to deal with the flows, otherwise things are overpriced or underpriced.


We can hold things in place that way

Currency pegs usually end badly, but that’s because countries typically peg in the face of downward pressure on their currency: a central bank says that one Ruritanian dinar is worth one US dollar, the markets test that claim by selling dinars back in exchange for dollars, and the Ruritanian central bank eventually runs out of dollars and has to give up.

But the situation is very different when a central bank is pegging against upward pressure. If the markets think the Swiss franc is worth more than 1.2 to the euro, they’ll keep selling euros to buy Swiss francs. The Swiss central bank, in turn, will never run out of Swiss francs. There seemed every reason to believe that the Swiss franc-euro peg would hold forever—or, at least, for as long as Geneva hotel owners wished to remain in the international conference business.

The Swiss, in short, could keep printing francs, and as long as Euro customers kept buying them, the Swiss were exporting the most intangible thing of all – their credit rating.  The Swiss central bankers must have been bewildered.


Is the Eurozone going poopie?

Everywhere in Europe, traditional modes of leadership and established institutions are unraveling.

Then, without warning, Switzerland changed its mind.

Perhaps because the Swiss had lost all confidence in the eurozone’s management, say for instance its mangling of the perpetual Greek crisis.


It’s all in the name of principle

On January 15, 2015, the Swiss central bank ended the peg—and the franc almost instantly rocketed up 20% against the euro, and even more against the currencies of Central and Eastern Europe.  


Sure looks like something happened all at once

Imagine having your mortgage indexed to the price of gasoline during a gas-price spike, and you’ll have some idea of the shock that greeted people like my breakfast companion.

Good metaphor.


Way to go, California!

It’s not clear exactly why Switzerland did this. Whatever the motive, what matters here are the consequences for Central and Eastern Europe: an even deeper plunge into a mortgage crisis, and further destabilization of already troubled democracies.

Croatia has announced that it will peg its currency, the kuna, to the Swiss franc for a year to protect mortgage holders. It’s a desperate measure, one that could cost Croatia at least 30% of its currency reserves as skeptical investors sell kuna to buy francs.


Let’s not amputate our economy, okay?

Arguably even more dangerously, if the peg to the franc does somehow hold, and if the franc continues to rise against the euro, Croatian goods and services could seem more and more expensive to German, French, and Italian customers. But Croatia’s already unpopular Social Democratic government is terrified, and terrified politicians make reckless decisions.

Reckless and shortsighted decisions, often with no endgame or exit strategy.

The Romanian parliament is debating a similar move. Poland’s populist Law and Justice Party is demanding that the government freeze Polish Swiss-franc mortgages at the January 14 exchange rate, but the government is hesitating to go that far.


Polish zlotys per Swiss franc

Instead, it’s trying to negotiate a “pain-sharing” agreement with national banks and threatening them with “social pressure” if they do not comply.  

Ominously, one regional government has gained a huge boost of prestige as a result of the crisis: Viktor Orban’s in Hungary. After all its other debt-relief measures failed, Orban’s regime in the fall of 2014 ordered all mortgage lenders in Hungary to convert their Swiss-franc loans into Hungarian forints.

Most of the press I read implies that Mr. Orban is an autocrat heading toward strongman and then dictator. 

Orban explicitly rejects the idea of “liberal democracy,” identifying Russia, Turkey, and China as more successful models for ambitious nations.


Make up your mind, then act

Perhaps he is out of the mold established by Ataturk (Turkey’s first prime minister, in office for 15 years, until his death) and emulated by Lee Kuan Yew (Singapore’s prime minister for 31 years, followed by another 14 as ‘senior minister’ and 10 after that as another special minister), but if so, he at least has the autocrat’s virtue of decisiveness:


“David, you should be more decisive.”

“Maybe … maybe not.”

This high-handed measure imposed heavy losses on the banks, which Orban shrugged off.

Hungary’s banking sector is heavily foreign-owned, and the ultra-nationalist leader has little sympathy for foreign business, especially financial business.


The forint stops here

Orban’s central bank chief sent a blunt message to the Austrian, Italian, and Belgian banks that dominate the local market: We have too many banks here anyway.  

The entire Eurozone is based on an elaborate dream – that all disputes can be settled not only without war or violence, but also without confrontation. 

After the events of January, his example may look more creditable to Europeans in search of escape from seemingly unending financial and economic crisis.

Let us not forget, Mussolini and Hitler both came to power out of national humiliation brought on by economic contraction caused by unserviceable debts.


Said simultaneously:

”Can you believe I have to work with this pompous prig?”

”Can you believe I have to work with this pompous prig?”

The unexpected hanging: Part 1, Before it was pushed

July 23, 2015 | Austria, Banking, Consumer protection, Currency risk, Eurozone, Global news, Homeownership, Lending, Mortgages, Risk, Swiss franc | No comments 166 views

By: David A. Smith

The man was sentenced on Saturday. “The hanging will take place at noon,” said the judge to the prisoner, “on one of the seven days of next week. But you will not know which day it is until you are so informed on the morning of the day of the hanging.”

Martin Gardner, The Unexpected Hanging


A man who lived (unexpectedly) to 96

To borrow is to take on risk, and risks divide into two sets of two dimensions – perception and influence – of those we cannot influence, we tend to undervalue those we poorly perceive or understand even as we overvalue the benefits of things we both perceive and control.  That, in a windy nutshell, explains why borrowers do foolish things like taking a lower rate (perceptible benefit) in exchange for an abstract uninfluenceable risk (currency fluctuation) – even sophisticated people who absolutely should have known better, as reported by David Frum (a good reporter, though no expert in finance or economics) six months ago in The Atlantic (January 29, 2015):


Pundits gotta talk, don’t they?

My breakfast companion looked gloomy.

[For what it’s worth, Mr. Frum’s column, along with a half-dozen others, appeared roughly two weeks after my blog post, Better to be franc? – Ed.]

For convenience, we’ll call the Austrian borrower Mr. von Trapp.


Why ever would you pick that name?

He’d flown into Washington from Vienna the day before. When he deplaned, he found a shocking email waiting for him: a demand from his banker for immediate payment of €12,000.  Although a resident of Austria, he had taken a home mortgage in Swiss francs, which carried a lower interest rate than mortgages in euros.

At points like this, I always wonder, What were you thinking?  Did you think lower interest was free?

Two days earlier before he had arrived in the United States, the Swiss franc had surged by 20% against the euro.

That action requires a flashback to two weeks earlier, as reported in the Economist (January 18, 2015; buff blue font):

So on January 15th, when the Swiss National Bank (SNB) suddenly announced that it would no longer hold the Swiss franc at a fixed exchange rate with the euro, there was panic.


The franc soared.


Predictable or unpredictable?

On Wednesday one euro was worth 1.2 Swiss francs; at one point on Thursday its value had fallen to just 0.85 francs. A number of hedge funds across the world made big losses. The Swiss stock market collapsed. Why did the SNB provoke such chaos?

The SNB’s action almost perfectly demonstrates the predictable- unpredictable paradox I first encountered in Martin Gardner’s The Unexpected Hanging:


This is an expected hanging

The judge was known to be a man who always kept his word. The prisoner, accompanied by his lawyer, went back to his cell. As soon as the two men were alone the lawyer broke into a grin. “Don’t you see?’ he exclaimed.  “The judge’s sentence cannot possibly be carried out.”

“I don’t see,” said the prisoner.


“Let me explain. They obviously can’t hang you next Saturday.  Saturday is the last day of the week. On Friday afternoon you would still be alive and you would know with absolute certainty that the hanging would be on Saturday. You would know this before you were told so on Saturday morning. That would violate the judge’s decree.”

“True,” said the prisoner.

“Saturday, then is positively ruled out,” continued the lawyer. “This leaves Friday as the last day they can hang you. But they can’t hang you on Friday because by Thursday afternoon only two days would remain: Friday and Saturday. Since Saturday is not a possible day, the hanging would have to be on Friday.”


“I get it,” said the prisoner, who was beginning to feel much better. “In exactly the same way I can rule out Thursday, Wednesday, Tuesday and Monday. That leaves only tomorrow. But they can’t hang me tomorrow because I know it today!”

In brief, the judge’s decree seems to be self-refuting. There is nothing logically contradictory in the two statements that make up his decree; nevertheless, it cannot be carried out in practice. That is how the paradox appeared to Donald John O’Connor, a philosopher at the University of Exeter, who was the first to discuss the paradox in print (Mind, July 1948).

Mr. von Trapp, like our imaginary prisoner, used logic to rationalize that his execution was impossible, even though sentence was passed four years earlier:

The SNB introduced the exchange-rate peg in 2011, while financial markets around the world were in turmoil.  

Investors consider the Swiss franc as a “safe haven” asset, along with American government bonds: buy them and you know your money will not be at risk.  

I’ve previously posted how the dollar’s implausible strength derives from America’s image as capital’s safe haven or bolt hole – but when one buys a currency (or invests equity in that country), one is also buying a currency-exchange risk. 


They look equal to me

Investors like the franc because they think the Swiss government is a safe pair of hands: it runs a balanced budget, for instance.

The US has the further advantages over Switzerland of (a) size, including of investable assets such as real estate, and (b) of tolerance for immigrating capital and people. 


I was wobbly there for just a minute

Having decided to hold the currency’s appreciation against the larger and wobblier Euro, the Swiss National Bank found itself in a situation not unlike AIG’s: it was the sole counterparty against a strong market tide.

As investors flocked to the franc, they dramatically pushed up its value. An expensive franc hurts Switzerland because the economy is heavily reliant on selling things abroad: exports of goods and services are worth over 70% of GDP. To bring down the franc’s value, the SNB created new francs and used them to buy euros.  Increasing the supply of francs relative to euros on foreign-exchange markets caused the franc’s value to fall (thereby ensuring a euro was worth 1.2 francs).

As a result of selling a commodity everybody wanted (Swiss francs) at a price lower than the market thought they were worth, the SNB bought a ton of the commodity that it didn’t want:

Thanks to this policy, by 2014 the SNB had amassed about $480 billion-worth of foreign currency, a sum equal to about 70% of Swiss GDP.

Most of that specie will be in Euros – and there came a point when the SNB had had enough:

The SNB suddenly dropped the cap last week for several reasons.

[1] Many Swiss are angry that the SNB has built up such large foreign-exchange reserves. Printing all those francs, they say, will eventually lead to hyperinflation. Those fears are probably unfounded: Swiss inflation is too low, not too high.


Swiss inflation is lower than the Eurozone’s, but closer

In the short run, anyhow, but in the intermediate run, who can say?

But it is a hot political issue. In November there was a referendum which, had it passed, would have made it difficult for the SNB to increase its reserves.

Elections have consequence, don’t they, Mr. Tsipras and Ms. Merkel?

BERLIN, GERMANY - MARCH 23:  German Chancellor Angela Merkel and Greek Prime Minister Alexis Tsipras depart after speaking to the media following talks at the Chancellery on March 23, 2015 in Berlin, Germany. The two leaders are meeting as relations between the Tsipras government and Germany have soured amidst contrary views between the two countries on how Greece can best work itself out of its current economic morass.  (Photo by Carsten Koall/Getty Images)

BERLIN, GERMANY – MARCH 23: German Chancellor Angela Merkel and Greek Prime Minister Alexis Tsipras depart after speaking to the media following talks at the Chancellery on March 23, 2015 in Berlin, Germany. The two leaders are meeting as relations between the Tsipras government and Germany have soured amidst contrary views between the two countries on how Greece can best work itself out of its current economic morass. (Photo by Carsten Koall/Getty Images)

“You’re a lying deadbeat.”

“You’re a self-righteous idiot.”

[2] The SNB risked irritating its critics even more, thanks to something that is happening this Thursday: many expect the European Central Bank to introduce “quantitative easing”. This entails the creation of money to buy the government debt of euro-zone countries.

In fact, the ECB did start printing more money, so the SNB was prescient:

That will push down the value of the euro, which might have required the SNB to print lots more francs to maintain the cap.

Clearly the SNB jumped before it was pushed.

[3] There is also a third reason behind the SNB’s decision. During 2014 the euro depreciated against other major currencies. As a result, the franc (being pegged to the euro) has depreciated too: in 2014 it lost about 12% of its value against the dollar and 10% against the rupee (though it appreciated against both currencies following the SNB’s decision). A cheaper franc boosts exports to America and India, which together make up about 20% of Swiss exports. If the Swiss franc is not so overvalued, the SNB argues, then it has no reason to continue trying to weaken it.

That may have been true, but I think it was cover and Reason 2 was the real one.


It’s just a cover story

The SNB should not be lambasted for removing the cap. Rather, it should be criticised for adopting it in the first place. When central banks try to manipulate exchange rates, it almost always ends in tears.

It certainly put a frown on Mr. von Trapp’s face:

Angela Merkel frowning

I get so tired of listening to Schauble

That currency appreciation had wiped out his equity in the house. His frightened banker wanted a new infusion of cash to replace the vanished equity.

Although not stated explicitly, one can deduce that the loan contained provisions requiring the borrower to maintain certain solvency ratios – probably a maximum loan-to-value (LTV) and a maximum debt-service-to-income (D2I), and if the interest rate was reset upwards (by the currency revaluation), then the monthly debt service would go up, and to keep D2I in line would have required paying down principal on the loan.

All this would have been spelled out in the loan and mortgage instruments, in clear if technical language, and Mr. von Trapp would have ignored it, as would nearly every borrower.

In small European countries, especially those that don’t use the euro, local banking markets are not very competitive and often dominated by foreign banks.


The Bank of China opening a regional hub in Budapest

As capital is increasingly global, banking efficiency tends to scale upward – it’s just cheaper for the customer. 


Hungary for your loans

Of course, it’s even better for the lender if the foreign bank can persuade local borrowers to accept a foreign-denominated instrument with foreign-bank standardized provisions:

These foreign banks, which typically borrow in euros, worry about the risk of lending in the local currency. If that currency depreciates, the lending bank could suffer severe losses. Bankers being bankers, they look instead for ways to offload that currency risk onto their customers.

While it’s understandable that banks would want to shift these risks, it’s bad policy and a bad idea for market dynamics.  Lending risks come in three basic buckets:


1. Internal risks, those within the borrower’s knowledge and control.  These include whether the borrower is telling the truth about income prospects, the borrower’s intention to keep a job, and others.

2. Future household risks, which the borrower may not fully control but at least can influence: loss of income, personal injury, divorce, children’s educational costs, and more.

3. External risks, such as interest rates rising, a sudden drop in the economy, and even a major downturn in home resale values in the neighborhood.

Sound business underwriting implies that each risk should be taken by the party best able to handle it – to evaluate it, bear it, avert it, and mitigate its downside.  So the borrowers should take their own internal risks, the bank should take the external risks, and the future household risks should fall mainly on the borrower.

(To be sure, this allocation won’t work perfectly, because borrowers are individuals, so they can’t diversify, hedge, or maintain specialized knowledge the way financial institutions can.  But it’s a good working principle.)

In those years [2005-07], cheap Swiss-denominated debt spread across Europe. In Western Europe, however, franc borrowers were concentrated in the business and financial sectors, where (one hopes) they understood the risks they were incurring—and could, if they wished, hedge against them.  

Individual borrowers shouldn’t take exogenous currency-fluctuation risks – they can’t properly evaluate them, certainly can’t hedge them, and can suffer painfully if the currency goes the wrong way.  All this is a sensible role for consumer protection (Senator Warren, take note):

United States Senator Elizabeth Warren (Democrat of Massachusetts), a member of the U.S. Senate Committee on Banking, Housing and Urban Affairs Subcommittee on Financial Institutions and Consumer Protection, listens to testimony during the hearing entitled ?Examining the GAO Report on Expectations of Government Support for Bank Holding Companies? on Capitol Hill in Washington, D.C. on Thursday, July 31, 2014. Credit: Ron Sachs / CNP / NO WIRE SERVICE Photo by: Ron Sachs/picture-alliance/dpa/AP Images

United States Senator Elizabeth Warren (Democrat of Massachusetts), a member of the U.S. Senate Committee on Banking, Housing and Urban Affairs Subcommittee on Financial Institutions and Consumer Protection, listens to testimony during the hearing entitled ?Examining the GAO Report on Expectations of Government Support for Bank Holding Companies? on Capitol Hill in Washington, D.C. on Thursday, July 31, 2014. Credit: Ron Sachs / CNP / NO WIRE SERVICE Photo by: Ron Sachs/picture-alliance/dpa/AP Images

You think I don’t know this already?

That didn’t happen in Mr. von Trapp’s case:

[Continued tomorrow in Part 2.]