Sunday, 25 January 2015

Swiss Franc going bonkers

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…


Anonymous said...

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.

student SGH said...

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!