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