Back in the 1980s, quite a few Australian borrowers took on mortgages denominated in Swiss francs and/or Japanese yen, usually egged on by their banker. Aussie dollar mortgages had sky high interest rates at the time, whereas rates were lower in Switzerland and Japan. If those overseas rates stayed low, and if the Australian dollar didn’t weaken, borrowers would save a fortune.
Want to know how it turned out? Well, it is now referred to as the foreign currency loan scandal for a reason. Thanks to large fall in the Australian dollar’s value, more affordable interest repayments soon became extremely expensive, outstanding debts ballooned in local currency terms and people’s homes and farms were quickly imperilled or lost.
One problem with foreign currency loans is that the risk is binary – if they go right, you save a few bob (or francs, or yen) on interest. If they go wrong, you blow up. Another is that interest rate parity suggests, at least in theory, that there is no free lunch there anyway, except maybe for your friendly banker. It’s a mirage, with fees (a country with higher interest rates should see its exchange rate depreciate by an amount equivalent to the differential with a lower rate country).
Unfortunately, and all too predictably, it’s a situation that has played out time and again. It seems national mortgage and other financial markets are incapable of learning vicariously.
Each geography and each generation wants to make its own mistakes. So does each banker. Around the time Baby Boomer Aussie foreign currency borrowers and banks were learning their lesson, so too were Germans, Austrians and many others.
A few decades later, some of those same central European banks caught up in the 1980s and 1990s scandals in their home lending markets were up to it again in Eastern Europe.
Behind the Financial Times paywall is an article describing how Polish borrowers were sold Swiss franc mortgages by Austrian, Italian, Spanish and Dutch banks in the mid-2000s, which subsequently went bad. Poland is looking to follow in the footsteps of Hungary (where similar practices were present) in helping claw back some of the mortgagees’ losses from the banks.
I’m not writing to comment on that political/legal hot potato, nor to analyse how it might affect those European banks (which we’ve avoided). Rather, it is to make the general and obvious reminder that all free lunches are worthy of great suspicion.
Just a few years ago, a European friend of mine was discussing taking out some part of his mortgage in francs rather than euros. He’s a trained engineer—so he understands the margin of safety concept intuitively. He also wears a helmet on the ski slopes. And yet he still found the concept enticing. I discussed with him the binary nature of the risk. Fortunately he passed, as the EUR/CHF is down at least 25% since then. His wariness meant his annual interest bill cost more in Euro, but he avoided a ballooning principal balance a few years later.
Unbelievably, the same Austrian banks were having yet another crack at selling foreign currency loans.
As the forever erudite James Grant once opined:
“Progress is cumulative in science and engineering, but cyclical in finance.”
7 thoughts on “A Zloty Trouble in Foreign Currency Loans”
Great article, and an important reminder that the size and likelihood of the risks as well as the benefits need to be evaluated in any investment.
Just wanted to point out a typo in this sentence: “His *weariness* meant his annual interest bill cost more in Euro, but he avoided a ballooning principal balance a few years later.” Should be ‘wariness’ .
Corrected. Well-spotted Sean, although he might well have been weary too given he had a young baby around that time.
Back in the pre-online days at Intelligent Investor, I used to spend every second Tuesday with Greg and the analytical team editing the print edition, usually well into the a.m. You would have been a most useful asset to have around!
Yes, why don’t people simply match assets and liabilities and take out loans with the same currency and economic life of the corresponding asset? Of course, with fixed interest, if your asset does increase in value 100% of the times interest rates rise.
Not disagreeing with your point in the slightest. Mad to take the risk. But is it quite as binary as you make out? Couldn’t the currency also move in your favour?
Valid point Ben – binary is the wrong word indeed.
Let me restate. The risks are asymmetrical – profiting to the tune of, say, A$200,000 won’t feel as good as losing A$200,000 and being homeless will feel bad.
More technically, in addition to being an unnecessary and mostly unaffordable risk to take, the downside is convex and the upside concave. So if you take a CHF loan and the CHF depreciates towards zero, you end up with a free mortgage in AUD terms. If the AUD depreciates towards zero instead, you end up owing many multiples of your original mortgage (so the upside is 100% of your mortgage, the downside technically infinite). It’s a similar profile to shorting stocks. Agreed, you’d be mad to take the risk.
Ben – there is also the issue that usually interest rates are higher in one currency than another for good reason. Particularly in less developed economies, interest rates in local currency are often higher because inflation is much higher. In addition, in some instances, higher interest rates have also attracted speculative capital inflows and caused the currency to be overvalued relative to lower-interest-rate peers.
Consequently, in most instances, the risk of currency losses on lower-interest-rate foreign currency borrowing exceeds the risk of currency gains. There is, unfortunately, very seldom a genuine ‘free lunch’.
There are lots of wrinkles in capital markets that can be profitably exploited in theory but just don’t offer anything to the retail buyer in practice.
Unfortunately, when some pack of financial know-nothings get themselves into trouble and then start whingeing about the unfairness of it all (of course there wouldn’t be any whingeing if the currency movement was in their favour), politicians often stick their noses into the matter. The resultant new laws (i.e. bureaucracy) stifle capitalism, and make it harder for the sensible majority to act freely.
An example: I recently had the opportunity to buy a flat in London from a family friend at an 8% discount to its market value. I had about half of the purchase price available as cash and I wanted to borrow the balance in GBP so as to be able to fund the loan with matching cash flows from the property. I was told by my UK bank that the Australian government actually prohibits lending to Australian residents in foreign currencies – presumably as a result of the foreign loan scandal. As usual for an Aussie bank, the fees that the ANZ bank wanted to charge to fund the purchase were a punch-line. So as a result of being unable to reasonably fund the purchase, I had to let it slide, thereby costing myself and the Federal Treasury a substantial amount in forgone profit and tax respectively.