The Swiss franc appreciation and the sorry saga of FX lending

Back in the 1980s Australians, many of them farmers, were offered low-interest loans, appealing in a high-interest environment. With changes in currency rates the loans in Swiss francs and Japanese yen quickly became much beyond the means of the borrowers to service with ensuing pain and suffering. Icelanders felt the pain of FX loans as the Icelandic króna depreciated in 2008 as did many Eastern-European countries. – The same story has played out in country after country with the obvious lesson reiterated: for people with income only in their domestic currency FX borrowing is far too risky. All these loans, often the result of predatory lending, follow the same pattern and it is no coincidence where they hit. There is now ample case for countries to take action: banks should be forbidden to lend in FX to private individuals with no FX income. Australia in the 1980s, New Zealand in the 1990s, Iceland and a whole raft of other European countries in the 2000s saw liberalised markets but inflation was high and so were interest rates. By taking an FX loan or even just a loan pegged to FX the high domestic interest rates could be avoided – it seemed too good to be true.

Sadly it was indeed too good to be true: currency fluctuations changed the circumstances and servicing FX loans for those with income in the domestic currency became unsustainable. For loans running over many years this was, statistically seen, almost unavoidable. FX loans have turned into a huge problem in countries such Croatia, Bosnia, Bulgaria, Montenegro, Poland and Ukraine but politicians and banks have ignored the problem.

These cases were spelled out at a conference on CHF/FX loans in Cyprus in December. Organised by Katherine Alexander-Theodotou president of the UK Anglo-Hellenic and Cypriot Law Association and various representatives of organisations fighting FX loans, the organisers have recently set up European Legal Committee for Consumer Rights to co-ordinate their work in the various countries marred by FX loans.

The recent shock of the CHF appreciation is now forcing the problem into the foreground in these countries. But more should be done: this problem should be solved once and for all because as long as banks and investors see profits in these loans this sorry saga will continue in new countries.

Australia in the 1980s

In Australia banks started offering customers, many of them farmers, yen and CHF loans in the 1980s. With Australian interest rates at around 10-16% the 7% rates of the yen and the CHF was attractive. When the Australian dollar started depreciating in 1986 the difference in interest rates was by far not enough to compensate for the new ratio between the Aussie dollar and other currencies.

As always, the borrowers first tried to keep on paying, then to negotiate new terms with the banks followed by court cases, mostly based on the banks’ negligence of warning the borrowers of the inherent risk of FX loans. To begin with, the borrowers were fighting on their own, not realising that there were so many others in the same situation.

The banks had the upper hand in court: people should have understood the risk and it was neigh impossible for the borrowers to prove what the bankers had said or not said, promised or not several years earlier. The banks claimed the loans had been issued in good faith and foreseeing the Aussie dollar depreciation had been impossible.

Westpac had been particularly successful in the FX loan market. In 1991 a former Westpac executive, John McLennan, leaked two letters from 1986 showing that the bank was well aware of the risk. What ensued was an investigation, which exposed that not only had Westpac been aware of the risk but a law firm had helped it covering its track. This turned into a classic whistle-blower case: Westpac sued McLennan but later settled.

The letters set the story straight, politicians finally turned against the banks and thus the borrowers got the upper hand and some compensation. But all of this only happened five years after the depreciation, leaving many borrowers bankrupt with all the tragedies such events bring on.

The Australian saga entails the same elements later seen in country after country: banks lend in FX to people who neither have an FX income nor are particularly well-placed to gauge the risk; politicians side with the banks – and only after much struggle and long time are borrowers able to get a write-down or other assistance. But by then, tragedies such as divorce or homes lost have already happened and things can never be the same or compensated.

Iceland: where politicians sided with borrowers

High inflation and consequently high interest rates characterised booming Iceland after the privatisation of the financial system in 2003. Banks were eager to grow by issuing loans and lend funds they borrowed internationally. With credit boom in Iceland savings were insufficient to satisfy the credit demand. Icelandic borrowers were offered so called “currency basket loans”: FX indexed loans usually based on a mixture of currency, usually US$, euro, CHF and yen.

As in Australia, things changed and fairly quickly. From October 2007 to October 2008 the króna had been depreciating drastically: €1 cost ISK85 at the beginning of this period but ISK150 in the end; by October 2009 the €1 stood at ISK185.

Borrowers complained, turned to their banks and some individual solutions were found. However, quickly borrowers were not only turning to the banks but to courts. There were no class actions but individuals sought to court, the cases were well publicised and others in the same situation followed them intently.

Already in June 2010 the first Supreme Court judgment fell regarding two such cases. According to the ruling it was against Icelandic law to tie interest rates on Icelandic loans, loans in Icelandic króna, to foreign currency but perfectly legal to lend in FX.

The result was huge uncertainty: first of all, which loans were legal and which were not, i.e. which loans were real FX loans and which were only FX indexed loans – and if some of these loans were illegal what should the interest rates be?

The banks distinguished between loans to private individuals and to companies where company loans have mostly been regarded as legal FX loans, i.e. the companies did indeed receive FX whereas loans to individuals have all been treated as illegal, i.e. not proper FX loans but only with interest rates tied to FX, no matter the form. The Supreme Court ruled that instead of the FX currency interest rates the lowest CBI rates should be used causing substantial losses to the banks.

The Supreme Court has by now ruled in around thirty FX loans’ cases. There are however still on-going FX loan cases in the courts, some of them related to consumer information such as Directive 87/102/EEC The Consumer Credit Directive, Directive 93/13/EEC The Unfair Terms Directive and Directive 2005/29/EC The Unfair Commercial Practices Directive

The peculiarity of the Icelandic FX loans saga is that the courts ruled fairly quickly in favour of borrowers, thereby gaining political support, very much contrary to other countries where FX loans have been common. This may be partly due to the fact the Icelandic households have long been highly indebted, which has to a certain degree tilted sympathy towards debtors rather than towards those who are trying to save money.

Croatia, Hungary and Poland

The fight of Croatian FX borrowers have their own organisation, the Franc Association but their fight has been arduous, as covered earlier on Icelog. Already last year, Franc won a case against eight banks, all foreign or foreign-owned subsidiaries: UniCredit – Zagreba?ka Banka, Intesa SanPaolo – Privredna Banka Zagreb, Erste & Steiermärkische Bank, Raiffeisenbank Austria, Hypo Alpe-Adria-Bank, OTP Bank, Société Générale – Splitska banka and Sberbenk.

The banks were found to have violated customer protection law by not informing clients properly. Further, the Croatian government has now decided to freeze interest rates for one year while further solutions will be sought, with banks forced to take a write-down on these loans.

In Hungary, where FX loans were among the most widespread in Eastern Europe before the 2008 crash, the government ordered banks last year to fix conversion of euro and CHF loans into Hungarian florints to a rate well below market levels. Following the recent CHF appreciation the government has said that no further action will be taken.

Polish FX loans have not been issued since the financial crisis of 2008 but the number of loans before that had been high, which means that many are still suffering their effect. Last year, governor of the Polish Central Bank Marek Belka said these loans were a ticking time-bomb. It certainly has blown up now with the CHF appreciation. The Polish government is now seeking a solution and regulators are investigating collusion on lending terms among the banks issuing the FX loans.

The underlying mechanism of FX loans

Although FX loan sagas vary in details from country to country the general mechanism is everywhere the same, always with four actors involved: international financial institutions looking for interest margins; investors, often called “Belgian dentists,” i.e. wealthy individuals looking for moderate-risk long-term investments; domestic financial institutions (often foreign subsidiaries) selling domestic currency, looking to lend in FX; domestic borrowers looking for low-interest loans.

The FX loans are normally marketed to middle or low-income earners in small or transition economies, recently been liberalised, with unstable currency or where the currency lacks credibility – and/or where interest rates are high. The banks issuing the loans are often, but not always, foreign banks, operating in a weak legal environment with weak or no customer protection.

There are certainly FX loans in other countries, such as the UK but there they have mostly been issued to wealthy borrowers often financing property deals abroad. The situation can certainly be painful for those individuals but these loans are anomalous, hitting only a very limited part of borrowers. In France, many local councils are struggling with CHF loans and fighting financial institutions in court, again clearly a major problem for the councils but now following the general pattern of FX loans listed above.

The general description above fits Australia, New Zealand, Iceland – and the countries where many borrowers have been sorely struggling with FX/CHF loans since 2008, i.a. Poland, Croatia, Hungary and other countries. With the exception of Iceland these countries have been fighting the banks for years, often with limited or only very late success. Only the recent CHF appreciation has finally managed to clearly demonstrate the calamity these loans are for normal borrowers with income only in their domestic currency.

The only sensible solution to FX (predatory) lending

For more than thirty years FX loans have periodically been causing huge harm and personal tragedy in country after country. The pattern is always the same. Banks continue this type of lending, every time minimising or ignoring the risk to unenlightened borrowers. The only new elements are a new country and new people to suffer the consequences.

Since this story has been repeating itself for decades, bankers issuing these loans cannot reasonably claim to be unaware of the risk. Instead, FX lending to private individuals with no FX hedge increasingly looks like predatory lending: the banks must have been aware of the risk and known that the risk had indeed materialised earlier in other countries.

Bankers have so far shown little aptitude of learning anything at all from the past few decades. National and international organisations working in the field of financial regulation and consumer protection should work towards making FX lending to private individuals with no FX hedge illegal. Until that happens the FX loans will continue to find new countries to wreck havoc in.

*Another side to the FX lending is whether the banks issuing the loans have properly hedged their FX exposure of their liabilities. There is indication that banks in i.a. Austria, Croatia and Hungary have held more CHF assets than liabilities. This is another interesting aspect, which I hope to cover later.

Confusion in Frankfurt or Athens

European Central Bank statement last October in reaction to a New York Times article about Emergency Liquidity Assistance management in Cyprus –

The ECB neither provides nor approves emergency liquidity assistance. It is the national central bank, in this case the Central Bank of Cyprus, that provides ELA to an institution that it judges to be solvent at its own risks and under its own terms and conditions. The ECB can object on monetary policy grounds; in order to do so at least two thirds of the Governing Council must see the provision of emergency liquidity as interfering with the tasks and objectives of euro area monetary policy.

Reuters story today based on Bank of Greece source –

Greece’s central bank has moved to protect its banks from any fallout from the coming general election, asking the European Central Bank to approve a stand-by domestic emergency funding line, a Bank of Greece official said on Saturday. The move comes after two major banks applied to be able to tap an emergency liquidity assistance (ELA) window on Friday as Greeks withdraw cash before the snap election on Jan. 25. “We have sent a request to the ECB on ELA approval for all four major banks to have a shield for the banking system,” the official said, declining to be named.

UPDATE: Karl Whelan points out that the ECB has given itself some approval authority through certain “in the event of” clauses in the ELA rules.

Swiss time was running out

The reviews are in on the Swiss National Bank (SNB) abandoning its CHF 1.2 per Euro minimum peg and they are unfavourable. It seems people are shocked that Switzerland might act in a unilateral fashion and without seeing the need to coordinate with other countries.

Anyway, the departure point for many analyses seems to be an assumption that nothing was especially wrong with the peg. Sure, the SNB was committed to buying unlimited quantities of foreign currency, and thus unlimited growth in its balance sheet, but what exactly was the constraint on that? Well, for one thing, it was producing some economic outcomes that Swiss voters — remember those people? — didn’t seem to especially like, not least rapid growth in asset prices such as housing and questions about huge holdings of foreign currency assets.

But let’s take the liquidity trap diagnosis at face value. Switzerland has been at risk of deflation, and the tendency of investors to pile into its currency at the same time forces it to appreciate, making the deflation problem even worse. The peg was supposed to solve that, but the domestic politics around that was turning sour. One way to break the deflationary cycle: get people thinking that the SNB might be just a little crazy and liable to do things at short notice which make investing in the currency not such a good idea. And furthermore, realizing that your peg is going to crack at some point in the future, acting abruptly now in a way that causes the exchange rate to, er, “overshoot” its true higher long run value so that investors expect it to depreciate over the foreseeable future, meaning rising prices and … more incentive to spend today!

Yes. it sounds crazy. But the liquidity trap is itself crazy. This particular exit option just might fit the times.

Syrian reservists

Why are hundreds of Syrians turning up in cargo ships between Italy and Greece?

It seems that the Syrian government is trying to mobilise its army reserve, and the reservists aren’t keen to go.

It’s fairly well known that the government doesn’t trust much of its army, and has relied on its spooks, some elite units, its party militia, and international volunteers. Now, it seems they’re short-handed again. Meanwhile, ferries that operated from Syria to Turkey have been shut down, probably because too many people were leaving to dodge the column.

The timing – the callout began in mid-November – is suggestive.

The AfD trolls itself.

Strangely, different extreme-right groups are falling out among themselves at the same time, in that odd synchronicity European politics occasionally has. After UKIP’s pre-Christmas train-crash over candidate selection, here’s the AfD tearing itself apart over policy.

Das Schreiben unterstellte Lucke auch, er stehe in vielen Fragen den Grundanliegen der AfD-Basis entgegen. So habe er sich geweigert, „gegen das Gender-Mainstreaming zu agitieren“, weil das Internetlexikon „Wikipedia darunter die Gleichstellung der Geschlechter definiert – und das ja eigentlich gut sei“. Außerdem habe Lucke im Europaparlament für Sanktionen gegen Russland gestimmt und er habe vorgehabt, in einer E-Mail im November allen Parteimitgliedern den Austritt nahezulegen, die „kritisch über Zins- und Zinseszins, das Geldsystem oder eine goldgedeckte Währung, über den Einfluss amerikanischer Banken auf die Politik oder die Souveränität Deutschlands nachdächten“.

It turns out Herr Lucke has been banned from responding to their own internal trolls, for fear he would cause too many resignations. Anyway, an AfD troll is obsessed by “gender mainstreaming” (perhaps they want to be like the French but copy-pasted wrong?), the gold standard, bankers, Russia, and “interest and interest on interest”. For clarity, they’re agin interest, bankers, and gender, but fer gold and Russia.

In the end at #Haiderbank, everyone who mattered got exactly what they wanted.

So I spent my Christmas reading the Hypo Alpe-Adria crash investigation, in a follow-up to this post . The point that stands out for me is that I don’t think you can blame this one on incompetence. Too many actors involved got what they wanted for that. Instead, they adopted a form of strategic incompetence that has long historical roots in Austria and its former empire, following the creases left by major historical events.

To kick off, the transition of Carinthia’s state-owned mortgage lender to a universal bank was an event conditioned by several massive historical phenomena. One of these was financial globalisation. Another was the relaunch of European integration. A third was the desire of important politicians in Austria to have alternatives to the postwar long coalition. It’s telling that Hypo Alpe-Adria, hereafter HAA, opened its first international office in 1986, about the time the extreme-right FPO was in government for the first time, in a weird alliance with the Social Democrats. Its new name, with its vaguely imperial claim to the “Alps-Adriatic”, actually appeared before the end of communism, and it began to do business in the former Yugoslavia even before it was former.

So the transformation of HAA gave its shareholders, at the time the state of Carinthia, a Steiermark mutual insurer, and some employees, a number of benefits. One of these was an economic strategy – we’re going to create a financial centre and we’re also going to invest in this new region. Another was something like having your own independent foreign policy – after all, the region was being conceptualised at the same time as the bank was being reorganised. Yet another was a source of budget revenue, from taxes and from the annual premium it paid for its state guarantee. Less legitimately, it was also a slush fund that could be used to look after important political constituencies.

And, from a very high level, it also played an important role in integrating the far right back into Austrian and European politics. The regional concept the bank embodied was one rooted in the empire and revived by the Nazis, and much loved by Austrian and German extremists. While Carinthia was an obscure collection of minor ski resorts crammed up against the iron curtain, its political elite didn’t have much to offer in exchange for rehabilitation, which they needed because their key political party had basically been invented as a lobby for old Nazis’ interests in the late 1940s. (The same thing nearly happened with the German FDP, but its liberal core and the allied oversight won out.) With a key lender in the reunification of Europe under their command, they counted for something. Wir sind wieder wer.

The European project was both a precondition of all this and also a threat to it. Without the facts of reunification and integration, it would never have gone anywhere. Without Austrian membership of the EEA and then the EU, it would never have been practical. But joining the union also made the whole deal problematic. The union didn’t, at least in principle, like state aid or special arrangements. It was especially keen to get rid of the state guarantees for German landesbanken and their equivalents. It was also keen on privatising all the things.

The owners of HAA formed a strategy to let them have it all. They would progressively sell down the shareholding, sticking at a blocking minority. They would put off unwinding the guarantee as long as possible, and load up on as much cheap funding as possible before the evil day. In the end they legislated in such a way as to let them keep guaranteeing HAA as long as it paid a market rate, which they didn’t define. The premiums were nice for the state budget and the cheap funding critical for the growth strategy. Influence would take the place of control.

Of course, people now ask “Why did they sign up to all those guarantees?” The investigation wonders why they kept guaranteeing even after they didn’t have majority control. But this is strategic incompetence for you. First of all, they relied on informal influence and personal networks to steer the bank. Second, the actors who mattered didn’t care about the risks because they well knew they weren’t meaningfully on the hook for them. Similarly, the Bavarian landesbank that bought HAA was convinced that the Austrian federal authorities were in charge, while both they and the Carinthians believed (or faked it) that the Germans were in charge.

The structure permitted all parties to get what they wanted. We don’t usually think of getting exactly what you want as being “incompetent”.

In 2006, when the Carinthians began selling down their shareholding, the accounts used for the due-diligence process dated back to 2002/2003 for the crucial South-Eastern European assets. This seems crazy. But it was just what the people who mattered wanted. There is an Austrian word, Schlamperei, which describes a sort of institutional blundering into the best course for one’s own interests. Then again, when Deutsche Telekom was ordered by its regulator to let other operators unbundle its lines, it regularly just failed to know they existed or where they were.

A poorly controlled SEE-focused landesbank was just what Jörg Haider wanted, and you can read the eventual sale to the Austrian feds as a scheme by the Carinthians and Bavarians, presumably with German federal acquiescence, to burn the other Austrians.

In practice, the strategic incompetence worked like this. In 2004, HAA engaged in a variety of transactions in derivatives that boosted its interest margins while taking risk on the absolute base rate. This worked for a while and then didn’t. They hid the losses, until they got caught. The then CEO, Kulterer, had to quit but couldn’t be questioned by financial regulators because the police wanted to talk to him. Because he wasn’t under a regulatory inquiry, that meant he could become chairman of the supervisory board. (In the changed post-crash climate, he went to jail.)

The plan had been to float HAA, but this was now out of the question. The state of Carinthia had borrowed against the IPO proceeds, which forced someone to do something. Strategic incompetence again. The solution was to do a small rights issue, and get a hedgie called Tilo Berlin to take the other end. The inquiry found that there were no named politicians on his share register but there were some companies whose beneficial owners they couldn’t trace. This was called the Austrian solution, although Berlin’s vehicle was registered as a Luxembourg SARL.

Berlin’s unique selling point was that he was willing to accept a fairness opinion that said HAA was worth what Haider wanted it to be, issued by a local tax adviser in Klagenfurt who got €12m for his trouble, although Haider then demanded half of it back as a “patriotic rebate”. HSBC and Rothschilds were asked, too, but oddly declined to agree with this valuation. HAA’s own auditors thought the due diligence was pathetic, the data room a joke, and the disclosure bordering on the fraudulent, but Berlin and his investors didn’t mind because they almost certainly already knew BayernLB would take it off their hands after a decent interval. After all, they lent them some of the money. Again, everyone with any power got just what they wanted.

Meanwhile, Haider and his circle ran the bank like they wanted. It lent enormously in the Balkans and looked after his people. When an ill-thought out airline venture was close to failure, Haider himself as chairman ordered that it get a €3m equity contribution, plus a €2.5m line of credit that was drawn down and lost within two days. The loan agreement was recorded as a “note on the file”. An Austrian senator with €9.23m in debts as a sole trader got a 50% writeoff, with more of the debt converted to an equity-kicker, permitting him to save the inheritance. Strangely, HAA never tried to collect on the land he put up as security.

Although it couldn’t be said for the man himself, Haider’s machine in Carinthia got out in time. None of the regional shareholders bothered to contribute a cent to the first bailout in 2008. With the crisis, HAA met another group of powerful people who wanted to have it all – the European Commission, which wanted stability as long as it didn’t cost anything. In order to comply with the state aid restrictions, it was necessary for the Austrian central bank, OeNB, to decide whether HAA was “distressed” or “not distressed”, and also whether it was “sound” or “not sound”. The OeNB held that it was “not distressed”, but stated that this did not mean it was “sound”. Helpful!

But then again, everyone who mattered got what they wanted. The state of being not distressed helped on interest rates, while the state of not being sound helped with regulatory clearance. If the situation was absurd, well, that was precisely what strategic incompetence was meant for, and anyway, shouldn’t the people who made the rules take some responsibility?

Then, as J.K. Galbraith said, things became more serious. As 2009 went on, a classic “slow” or “invisible” run on the bank developed, led by big-ticket depositors, often wholesale. Ironically, one of the biggest single names to move out was the state of Carinthia’s treasury.

This is where I disagree with the crash report. Concretely, BayernLB forced their hand by pulling HAA’s lines of credit with the parent company and invoking a mandatory set-off clause that effectively froze much of its cash. The inquiry argues that the Austrian government could have put HAA into insolvency and challenged this in the bankruptcy court, had they only taken more legal advice. Instead, BLB offered to maintain some of HAA’s liquidity and write off €500m of debts if the Austrian feds would buy the bank.

Interestingly, BayernLB had actually done something similar in the past, when they owned a Croatian bank. On that occasion, there was a run on the bank and BayernLB insisted on selling it back to the Croatian fisc. The circumstances of this were such that in 2007, the Croatian central bank tried to block the sale of HAA unless BLB cooperated with their inquiry, dramatically restricted its loan growth, increased its regulatory capital, and made a public apology. However, “high political pressure” was brought to bear – I think this means either the European institutions or Germany or both – and the central bank reversed itself. They didn’t even get the apology.

But I find the criticism wise after the event. It’s true that both the Bavarians (and the German feds) and the Carinthian pols got away with it at the expense of the Austrian federal budget. But nobody knew what would happen if a federal state became insolvent, or what would happen to BayernLB, or to the South-Eastern European banking system, still less what would happen if all of them happened at once. The prospect of perhaps recovering more money in insolvency in the distant future must have seemed a little remote and vague. HAA might not have been systemically important in 2008, but one of the major lessons of the great financial crisis was that it is fear that makes systemic importance.

Similarly, the inquiry rather oddly complains that the feds spent too much time and money combing the crash site for clues. The main evidence of this is that the HAA management complains a lot about how many employees are seconded to help with the special audit. But, as the late Mandy Rice-Davies would say, he would say that, wouldn’t he?

There is a good point here, though. HAA was probably the most directly and egregiously crooked of the bank failures of 2008-2009. But the problem wasn’t that Herr Marolt got let off half his debts, and treating it as if a really big forensic audit would fix it was a mistake. Although the post-crash investigation was meticulous, and quite a few HAA execs went to jail, the Austrian taxpayer is no less on the hook for the money than she was at the beginning of the process, and HAA is still stinking up the shed. It’s even paying premiums to Carinthia.

The problem, really, is that HAA’s rise and fall followed all sorts of deep features of the EMU and enlargement projects. It was bigger and more interesting than just a fraud. At every turn, you find arrangements that let various privileged groups get what they wanted, usually allowing them to have several contradictory advantages at once by dumping risks on someone else. Even the European Commission was at it – although it repeatedly badgered the Austrians to create a state-owned bad bank, it also pushed the “six pack” balanced budget amendment and insisted that the rest of the budget suffer for it. Similarly, it somehow determined that the €30-odd billion in total that BayernLB got from the Bavarian and German governments wasn’t state aid although the Austrian bailout of its subsidiary HAA kind of was.

In the end, everyone who mattered got exactly what they wanted.

488 Not Acceptable Here

We were talking about Ukraine and the proliferation of SIGINT capabilities.

Now, we’ve got some facts thanks to Adaptive Mobile and the Ukrainian telco regulator. It looks like the Russians exploited the fact that they have SS7 roaming links with the Ukrainian mobile operators, and re-routed their targets’ calls to numbers in St. Petersburg.

After this year’s CCC, expect nothing but more SS7 exploits. It’s not widely known enough that this network, the crucial one for mobile telephony, is a default-trusting system. I have a nice little handbook Tekelec gave away with a full set of commands both for SS7 and SIP – I always liked the fact the latter has an error code for Not Acceptable Here.