Disclaimers:
1. I am employed by one of financial institutions involved in mortgage
lending denominated in CHF, my financial well-being might be negatively
affected by aftermaths of sudden appreciation of CHF.
2. I do not possess any substantial (in equivalent of more than 1,000
PLN) liabilities nor assets in or denominated to any foreign currency.
With hindsight it sinks in to me the decision of Swiss monetary
authorities from 15 January 2015 deserve some more attention. The Swiss
National Bank, apart from discontinuing its policy of warding off appreciation
of the country’s currency, decided also to slash interest rates by 50 basis
points, pushing policy rate further down into negative territory…
This move calls into questions one of economic paradigms I would take
for granted during five years of studies and four years of banking career.
Until recently in the economic theory the “floor” for interest rates was zero.
Whenever the range of a central bank’s instruments in monetary loosening was
described, one mentioned decreasing interest rates to zero and if this turned
out to be insufficient, enlarging monetary base. Whenever I asked chaps from
market risk department to estimate maximum negative valuation of an interest rate swap, it went without saying the scenario to analyse was an overnight drop
in interest rate in a given currency to zero. Time and central bankers proved
us wrong…
Interest rate is cost of money. Because as a matter of principle money
cannot be bought or sold, the price is paid for temporary transfer of money,
i.e. for borrowing or lending it. Theoretically, the cost of money can be
negative, but in practice it seemed irrational. Recent goings-on have disproved
economic theory. Thus we witness theory of economics is still in the making.
Negative interest rates have serious implications for stability of
financial system. We already see the first apparently eerie effects of SNB’s
move. Yields of Swiss governments bonds have entered negative territory, not
only on secondary market, but also on debt auctions. In practice if yield on a10-year bond is –0.09%, you pay now 100.91 units of a currency to be paid back
100.00 units in ten years. At first glance it such investment makes little
sense and the negative yield can be interpreted as safekeeping fee.
Nonetheless, investors snap up on such bonds. Why? “The Economist” has beaten
it to me in providing a comprehensive answer.
Government bond market naturally crops up as the first illustration of
how central bank’s policy impinges on financial system. Let’s examine the
outcomes for other economic actors.
Interest rates at which commercial banks lend or borrow money are
strongly tied to rates set by a central bank shaping monetary policy of a
currency in which those banks lend and borrow. On the lending side the
situation is at first sight straight-forward. Components of cost of credit are
a variable rate taken from inter-bank market (LIBOR) which is the cost of
funding for a bank and the bank’s margin over LIBOR, standing for reward for
credit risk borne by the bank. Whenever positive margin is higher than negative
LIBOR, the cost of credit remains positive. If the margin, however, was low
enough not to fully cover negative LIBOR, we would be faced with a situation
when a borrower would have to repay less than they had borrowed. Consider a 1Y
10,000,000 CHF overdraft with cost of 1M LIBOR + 100 bps a Swiss company takes
out. The principal is to be repaid at maturity, interest to be paid monthly.
But if 1M LIBOR is –1.12%, then what? My first answer would be that no interest
payments would occur, but how to handle loan principal? Should the net cost of
–0.12% per annum be amortised over time and decrease outstanding loan by 1,000
CHF? If so, what if within a year 1M LIBOR rises above –1.00%? Loan
administration staff and finance staff at some banks should begin to scratch
their heads now!
From the borrowers’ (no matter if talk of individuals or enterprises)
perspective the loan with negative cost is a veritable bargain. Probably the
SNB intended to spur borrowing, thus increase monetary base and trigger
inflation that would result in currency depreciation. The side effect of this
action is that the break-even point for borrowers has been set too low, i.e.
some entities that would not be eligible for a loan if LIBOR ran at 1% are now
creditworthy. This pool of borrowers will likely default on their debts when
interest rates increase, threatening economic growth in the future.
From the depositors’ perspective negative interest rates make horrible
news. If commercial banks are to get funding on market conditions, they should
pay depositors LIBOR. Businesses have no choice and will need to accept the
negative rate. No one would imagine companies switching from bank transfer to handling
payments in cash. Individuals, however, might choose to withdraw money from
banks and decide to keep their savings in cash in a piggy bank / in a drawer /
under the carpet. Of course if you keep cash at home, you are exposed to risk
of physical damage or theft, but I presume some depositors would be willing to
take those risks. A sudden outflow of cash from the banking system could pose a
threat to banks’ liquidity. The effects could be comparable to a regular bank run.
In Poland, the Banks’ association and the Ministry of finance have
worked out and agreed on measures to ease the pain of over half a million
CHF mortgage borrowers. The proposals are modest and require banks to make some
concessions that will somewhat decrease their profits, but in return should
fend off provisions for past due debts. The measures will include:
1. lower or no FX spread on instalments – directly hits banks’ earnings,
however gives a relief of up to 4% to borrowers,
2. using negative LIBOR as a base rate, however the total sum of base
rate and margin might not fall below zero – at best a borrower would not pay
any interest on the loan,
3. banks will refrain from calling for additional collateral – it has to
be underlined in extreme cases LTV ratio, measure relation of outstanding debt
to property market value, might be reaching even 200% (e.g. a borrower owns a
flat which could be sold for 500,000 PLN but their debt in PLN is 1,000,000
PLN), the concession is a violation of one of Financial Supervision’s
recommendations on mortgage lending, but given the current market situation, it
is the best possible solution,
4. extension of lending periods, which would result in lower monthly
instalments – given record-low credit cost in CHF and prospects of CHF/PLN
returning to levels seen before 15 January 2015, it is a reasonable to wait out
the period of ultra-strong CHF.
The compromise is very wise, since both banks and borrowers will share
responsibility for the event which has taken both sides aback. That being said,
one must not forget during the lending spree which reached in climax between
2006 and 2008 banks aggressively foisted upon their customers loans denominated
in foreign currencies, particularly to those mortgage applicants who could not
afford to service mortgage loans in PLN, but in CHF, in which interest rates
were lower, were creditworthy.
For those with shorter memory, a short reminder, how in July 2006 the
same politicians who today bleat how evil CHF lending was, expressed their
disapproval of Financial Watchdog’s efforts to curb mortgage lending in foreign
currencies.
The Polish Financial Supervision has also come out with another proposal
that seems to hold water. The distressed borrowers could be given the option to
convert their loans into PLN at the CHF/PLN rate from the day the loan was
taken out, however they would need to return to banks difference between lower
interest paid in CHF and PLN. The CHF appreciated rapidly in late 2008 and
despite staying around or above 3.00 since then, a monthly instalment of a rate
in CHF was lower than a monthly instalment in PLN until the first quarter of
2013. This was due to interest rate differential between CHF and PLN that
offset CHF appreciation. This proposal should remind CHF borrowers for many
years they benefited from their decision, however the reward was accompanied by
FX risk… Impact for banks is very hard to estimate, in depends on so many
technical assumption of the operation that any attempts to give a ballpark
figure are doomed to fail.
The proposal, apart from questions of legal nature, gives rise to
several technical / mathematical questions, e.g.:
1. how the current outstanding debt in PLN would be determined (not only
FX rate but also loan amortisation needs to be taken into account),
2. how the difference is interest base and effects of loan amortization
and changing time value of money would be accounted for,
3. would the borrowers have to return the difference in interest paid in
cash, or would banks be willing to add it to the outstanding debt, if yes,
would breach of currently binding Recommendation S in terms of max. LTV ratio
be allowed,
and many other, proving this idea makes sense, but is on account a quick
fix.
Many accuse banks of reaping profits from CHF appreciation. Had it
worked like this, we would see enormous profits of institutions involved in
CHF-denominated lending in their 1Q2015 financial reports. But we will not.
CHF-denominated loans are banks’ assets, but they are effectively funded by
liabilities. Because Polish banks do not take deposits in CHF, rarely issue
bonds in CHF and generally do not take out loans in CHF (there are exceptions
when funding is secured by parent companies), they have to replace funding in
PLN by funding in CHF. This is done with use of FX swaps, derivatives which
compose of FX spot and FX forward. For example, in order to replace a 3M
deposit in PLN with a 3M deposit in CHF, a Polish bank sells PLN and buys CHF
at a current date at spot CHF/PLN rate and agrees to conclude a reserve
transaction in 3 months, at pre-agreed CHF/PLN rate which reflects interest
rate differential between PLN and CHF. Thus effective cost of funding is LIBOR
rather than WIBOR. Such operations are risky, because long-term assets are
matched by short-term liabilities which needs to rolled over frequently. The
roll-over risk materialised in late 2008 when access to FX swap virtually dried
out and intermediation of Polish and Swiss central banks was requisite to match
positions on Polish banks’ balance sheets.
Banks’ earnings on loans denominated in foreign currencies are made up
of spreads. When such loan was disbursed, a bank earned profit on a spread
between market FX rate and bid rate (i.e. if NBP CHF/PLN rate was 2.30 PLN, a
bank would convert CHF into PLN at 2.20). Then banks earned on spread between
market FX rate and ask rate each time an instalment was repaid. This practice
was curbed in 2011 thanks to anti-spread law. I dare to claim as of today
portfolios of FX-denominated loans, after costs of hedging and provisions for bad
debts, generate negative income for the banks.
My own guess is that the period of negative interest rates and
ultra-high CHF will not last long. Negative cost of money will lead to
distortions in financial system, while strong CHF will send the Swiss economy
into deep recession. Bright future is not ahead though. Just three days ago ECB
announced it would launch out into quantitative easing. If without near-zero
interest rate and expanding money supply economies of the Euro zone are unable
to grow, it means they are still on their knees, almost seven years since the
outbreak of full-blown crisis in early autumn of 2008. This time there will be
more than seven lean years…
2 comments:
Thanks for the detailed explanation Bartek. Since the events of January 15, I have been watching the story develop in the press. The fact that more than 550,000 families have CHF denominated mortgages boggles the mind.
The Canadian dollar is essentially a petro-currency...its fortunes generally rise and fall with the price of oil. The CAD is currently at a 6-year low against the U.S. dollar and will likely stay at depressed levels until the oil price rebounds.
The CAD is a volatile currency...I have seen it dip as low as 0.65 cents and increase to $1.15 in my adult life.
The notion of introducing currency risk into an individual's largest debt (mortgage) is simply madness for me....particularly against the CHF (Europe's strongest currency). Yes, I understand there was an attractive interest rate differential (against PL denominated mortgages), but what were these people thinking? One of these "people" is a family member in PL. It is difficult to be sympathetic with his undertaking such a short-sighted and risk laden strategy, but I'm trying.
Best,
Basia
Thank you Basia!
Those people were thinking they would outwit the system. Having run a blog for almost six year, I have the comfort of referring you to another post, Enraged, dated 9 December 2012 which might give the answer. If we can afford little we save on quality and accept lousy deals to get what we want. Besides, in 2006 pessimism was scarce in Poland. Imagine an equity analyst saying in early 2007 stock prices will soon decline by 50%. Everyone would laugh them off!
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