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Savers In Swiss Banks In For A Rude Awakening?

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Savers In Swiss Banks In For A Rude Awakening?

Post  TBQ on Wed Jul 07, 2010 1:15 pm

Submitted by Tyler Durden

The UBS Private Wealth Management team seems to think so. In a report titled "Franc loans might become a threat for Switzerland" the UBS economists analyze the impact of the surging EURCHF (last at 1.33, not to mention the USDCHF which is quickly going to parity), combined with the over $500 billion in Swiss franc loans lent abroad to banks and non-banks, that "The franc's rapid appreciation remains painful for foreign borrowers, as the amount of their franc-denominated debt has increased remarkably in their local currencies. The franc would receive further support if borrowers were to switch their loans into local currencies at some point in the future, as they would have to unwind their franc short positions." In other words, should a positive feedback loop be activated, the already dramatic squeeze in the covering of CHF positions will accelerate dramatically, likely pushing the CHF far beyond parity and causing major pain for both the local Swiss manufacturing industry and offshore lenders who join the unwind party late. Quote UBS: "At some point, franc borrowers might realize that the franc might stay strong for longer, which could induce them to switch their loans. While the franc is affected by many factors, should the borrowers of franc loans at some point decide to switch their loans into local currencies, it could support the franc further, as the borrowers have to unwind their franc short positions. We therefore conclude that the large amount of outstanding Swiss franc loans to foreign countries remains a threat for the Swiss economy."

The primary reason for the massive accumulation in CHF-denominated losses, primarily in Central and Eastern European countries has to do with the mult-year depreciation trend in the CHF between 2003 and 2007, a time when real estate lending was rampant in the cheapest currency:

Over the past decade, a growing number of foreign households and companies borrowed in Swiss francs to finance their local currency investments. Franc-denominated loans became popular in Austria and Eastern Europe owing to Switzerland's lower interest rates compared with their local currency loans. Moreover, the depreciation trend of the Swiss franc between 2003 and 2007 triggered demand for franc loans in Eastern Europe. As long as the franc weakened, demand for franc loans grew. And, for a time, mortgage payments denominated in francs (due to the weakening franc) became progressively less expensive. We suspect that many of these borrowers failed to anticipate the risk of rapid currency movements.

The problem, as always happens, when everyone jumps on the same side of the trade, is that sooner or later, all those people are punished for their herding mentality. Indeed this was the case here, and while the pain had been delayed, courtesy of active SNB intervention in the FX market for years, recent developments have changed all that, causing the CHF to rise to all time highs against the euro as recently as last week.

Since the start of this year, many foreign borrowers of Swiss franc loans have likely felt very uncomfortable with their loans. While the Swiss National Bank (SNB) blocked any appreciation of the Swiss franc against the euro between March and December of 2009 owing to concerns about deflation in Switzerland, this year, the SNB tolerated a gradual appreciation of the franc from the beginning of the year until mid-2010. Since June 2010, the SNB no longer manages the exchange rate with interventions as it believes deflationary risks in Switzerland have largely disappeared. Since mid-June, the Swiss franc has appreciated sharply against all major currencies, which means that servicing franc-denominated debt has becomes increasingly expensive for foreigners.

The massive amount of CHF-based lending has largely been ignored by the press, but it is time this changes. As UBS calls it, there is an "alpine level of loans" outstanding.

The total amount of Swiss franc-denominated loans outstanding outside of Switzerland remained remarkably high at the end of 1Q 2010. These franc-denominated loans peaked in the autumn of 2008 and have declined slightly since then. This dip in volume, in our view, was most likely a consequence of lower demand as the franc grew stronger, as well as the economic crisis, which reduced demand for loans, in both local and foreign currencies in a similar manner. Furthermore, it seems that maturing loans were not renewed anymore in foreign currencies. In some countries, it is now even prohibited to take out low-yielding foreign currency loans. The lending statistics suggest that existing loans are not paid back early. Many borrowers seem to hope that the franc will weaken again before their loans mature, in which case the repayment in their domestic currency would decrease again.

Of course, if it doesn't, every loan will merely become a greater drain of domestically denominated cash, until it becomes impossible to pay it off, leading to either a hufe wave of CHF-denominated defaults, or a massive rush to cover CHF shorts, both of which would be a huge hit to the Swiss economy. More on that in a second. Below is chart detail of estimated outstanding Swiss loans:

UBS puts the dramatic surge in the EURCHF in the context of existing loans:

The amount of franc loans outstanding has not kept pace with changes to the euro-franc exchange rate. When the franc appreciated for some months, and therefore the borrowing costs rose, no new loans were granted. In contrast, when the franc weakened between 2005 and 2007, the amount of loans outstanding increased rapidly. The total amount of outstanding Swiss franc loans to banks and non-banks rose from CHF 228bn in 1999 to CHF 558bn in the third quarter of 2008, before declining to CHF 488bn in 1Q 2010 (see Fig. 1). To appreciate the magnitude of these figures, consider that the sum of these loans equals around ten times the sum of all Swiss banknotes in circulation (CHF 48 bn in May 2010), and that they are nearly equivalent to Switzerland's nominal GDP of CHF 535bn in 2009. Further, the sum of franc loans abroad is equal to nearly 70% of the outstanding amount of loans in Switzerland (about CHF 723 bn in April 2010). The CHF 488bn loans are roughly double the size of the SNB's foreign currency reserves. That means there is a large franc short position outstanding, which more than counterbalances the francs that the SNB has created with its current FX interventions.

The total amount of outstanding franc loans to non-banks rose at a similar pace, from CHF 117bn in 1999 to CHF 389bn in 3Q 2008 before declining to CHF 345bn in 1Q 2010 (see Fig. 2).

Here is who will get hurt once reality finally catches up with delinquent cash flows:

There are three ways to describe the amount of franc loans outside of Switzerland: 1) the absolute amount of CHF loans outstanding; 2) CHF loans outstanding as a share of total loans; and 3) CHF loans outstanding as a share of foreign-denominated loans. According to the central bank data, we note:

* Absolute amounts of CHF loans outstanding to non-banks: In the Eurozone, Austria has the highest amount with about CHF 81bn, followed by Germany (CHF 60bn), France (CHF 30bn) and Luxembourg (CHF 25bn). Outside the euro area, Poland is the leader with about CHF 53bn, followed by Hungary (CHF 36bn), the UK (CHF 23bn), and Croatia (CHF 7bn).
* CHF loans outstanding to non-banks as a share of total loans: The highest share can be observed in Hungary (34%), followed by Poland (20%), Austria (14%), and Croatia (13%).
* CHF loans outstanding to non-banks as a share of foreign-denominated loans: the highest share can be observed in Austria
* (68%), followed by Poland (65%), Hungary (52%), and Croatia (about 18%).
* Romania and the Baltic states also have large shares of foreign currency-denominated loans, but they prefer the euro or US dollar (see Fig. 3).

Austrians have been borrowing in Swiss francs for more than 15 years (see Fig. 5), while eastern European countries started around 2004. As Hungary, Poland and Croatia have increased their Swiss franc loans aggressively in the last couple of years, the rapid appreciation of the franc and the weakness of their own currencies hurt borrowers in those three countries (see Figs. 6, 7, 8 ). New borrowers (who requested a CHF loan in 2007 and 2008), are affected more than earlier borrowers, as the latter took out Swiss-franc loans at lower exchange rates (i.e., stronger local currencies, weaker Swiss franc).

And the scary conclusion for anyone who believes that the recent ramp in the CHF is based on fundamentals, is that while the CHF can hit and pass parity with the USD in the coming weeks easily, it will have done so for all the wrong reasons. It also explains why the SNB is very much terrified by every downtick in the EURCHF and why Hildebrand was so eager to break his promise of no ongoing FX intervention: he surely realizes that should the EURCHF break below 1.30 that the Swiss economy could be next in line for bailouts.

Some foreign-currency loans allow the borrower and the bank to switch the loan to another currency. We do not expect holders of franc loans to switch to local currencies as current exchange rates are still at very unattractive levels compared with three years ago. We expect them to stick with the franc as a funding currency in the hope that their local currencies recover versus the franc before their loan matures. But the franc's rapid rise means that servicing franc-denominated debt becomes increasingly more expensive for foreigners, as they have to pay more in local currency terms. It seems that they accept these higher costs. There is some evidence that an increasing number of foreign currency debtors service their monthly payment with a delay.

We expect new franc-denominated loans are unlikely to grow in popularity in the near future owing to negative experiences. Furthermore, political authorities have started to limit or ban foreign currency loans, as they have proven to be a risk to their domestic economies. Banks will also have to double-check the loan-to-asset share. In many cases, the rise of the franc will have lifted the value of the outstanding debt above the value of the asset(s) and made the credit/mortgage shaky.

At some point, franc borrowers might realize that the franc might stay strong for longer, which could induce them to switch their loans. While the franc is affected by many factors, should the borrowers of franc loans at some point decide to switch their loans into local currencies, it could support the franc further, as the borrowers have to unwind their franc short positions. We therefore conclude that the large amount of outstanding Swiss franc loans to foreign countries remains a threat for the Swiss economy.

In other words, Switzerland is merely yet another country which is masking a huge economic hole in the form of massively underwater debt, by demonstrating that the EURCHF is surging which is traditionally an indication of strength. Alas, it is anything but. And all those Europeans who continue to plough their billions of savings in Swiss banks may be due for a very rude awakening.

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