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The Polish CHF Mortgage Saga

Kalim Aziz
December 17, 2015

For better or for worse, the issue of CHF mortgages is blown out of proportion and has become a tri-party football match between the banks, the borrowers and the regulator.

The problem of the CHF mortgages for the banks and the borrowers is a stock/value (collateral) problem and not a flow (i.e. debt servicing problem) per se. CHF borrowers, at the initiation of the mortgage loans, were ‘over-extending’ themselves by choosing a ‘product’ which could get them the maximum level of loan for a given level of annual (monthly instalment).

Polish economy has performed better than most European economies during this crisis that has prevailed during recent financial crisis and income levels have increased (solid Wage Price Inflation) and for working loans, affordability has not deteriorated in any measureable way (i.e. it’s not a flow problem). Cumulative wage price inflation (i.e. increase in wages in nominal terms) from 2009 to 2014 has been around 26%, since 2006 to 2014, this number is around 35%. So the ‘affordability’ in terms of cash flow, is not, and cannot be considered the real issue.
So, in our view, comprehending the more relevant factors requires to looking into why, where and what of the CHF mortgage borrowing and lending activity.
As in any market/economy, a systemic decline in interest rate from a significantly high level to moderate to low level plants the seeds for mortgage market. This in turn results in first movers to take advantage of the opportunity and move into this market to capitalise on the opportunity. The rapidness of ‘market capturing’ quickly exhausts the ‘near term/existing’ pool of clients. This requires a me-too lemming like behaviour of followers who seek client base from the second pool. The pull of first pool of client also results in positive movement of prices in real estate (initial supply of real estate, lags the demand create by the mortgage market)

So two things happen:

  • Property prices go up making the first mover look even more clever and profitable, and
  • The followers chase to expand the market by getting into second, third and potentially fourth pool of borrowers.

The potential third and fourth pool borrowers now see real estate price moves and want to latch on to this property ladder before the it moves out took much out of reach and they look for (and scrape for) the largest real estate ticket they could get hold of based on their cash flow affordability.

"Trapped in a Flat"
This is what has happened, more or less, to the Polish residential real estate market, price growth has stalled and the ‘home equity’ content of higher leverage buyers where the liability has increased to f/x developments are way out of money.

These borrowers, have now outgrown their property size and are desirous to move into a bigger space (young couple who bought the first property now wants to move into a bigger space with expanding family), due to lack of equity (i.e. underwater) cannot move out and/or upgrade. This is where the primary source of noise on CHF mortgage is coming out.

Headache from the CHF doses

So, we have stalled residential real estate market, real estate developers over extended, and the CHF mortgagees wage increases not going into other spending or increased consumption sentiment but used to pay for the short position on CHF. So, despite, positive GDP growth dynamics, solid wage price inflation, there is delta negative sentiment for consumption and a contribution towards deflation (from the demand side in addition to supply side feed stock cost declines). The unintended consequences of policy mistake is not just what is the cost of bail-out and who will pay for it. It also includes, dynamic wide-ranging market mechanism based affects to wide variety of segments in the society.

So what are the considerations to work out this CHF (and other f/x mortgage issue) with minimum damage to the system and dis-location?

Whatever anyone says or a takes a position, the cost of the mistake, today has be borne by three parties: the banks for being aggressive, the regulator/government for not monitoring and the CHF borrowers who benefited from this. Care has to be taken on how this is resolved with the following areas to be considered quite carefully:

  1. the impact on capital on the bank
  2. moral hazard and its associated consequences, and
  3. workability of the solution for CHF borrowers.

The problem from the banking system perspective is not the absolute size even on the high end cost, it is the impact on the capital of the system. Regardless of the flow impact, which, albeit meaningful buy small in relation to the capital of the banking system, the IFRS and other regulatory accounting treatment of the ‘loss over the life of the plan’ would result in a measureable hit to the capital and may result in a wobble to the financial stability of the system.

One of the conditions which is positive for conversion of CHF mortgages into PLN mortgages is already in place now after the latest interest rate cut. The gap between PLN mortgage rate and CHF mortgage rate has halved from a level of 4% to 2%. To limit the negative consequence of moral hazard, the borrowers have to be asked to contribute back (albeit less in present value terms) the benefit back to the system in a separate category. This would at least allow the CHF borrowers to draw a line in the sand and move forward and would also signal to the PLN mortgage borrowers that they are not fully out of pocket for being prudent.

On the other hand, there has to be sufficient incentive and room for the CHF borrowers to convert the mortgage in PLN and resolve this issue once and for all which would allow them to rebuild home equity in a the near foreseeable future so that it has a meaningful impact, albeit, a bit more deferred, restarting the residential real estate market in Poland. In addition, a meaningful resolution could change consumer confidence levels which is a significant contributory towards the ‘deflationary’ environment.

The task of the Regulator

The policy error on the regulatory part and therefore the government should be the ‘balancing’ mechanism, i.e. its contribution towards the solution not only in monetary terms but also in the form of allowing the banking system to mirror the unwinding of the CHF position.

The banking system on the whole should not be more than 10% of existing capital. This is large enough to punish the system to behave in the future but not so much that it would lead to financial instability in any shape or form.

Whatever the level of conversion of CHF mortgages into PLN by the borrowers, it would necessitate the banking system to also mirror the action. Polish banks through direct borrowing or swaps would have more or less matched CHF mortgage book with CHF liability to not have a net long/short exposure of significant level. When the PLN mortgage is converted by the borrowers, the Polish banks would be required (in order to not go short) convert its CHF liability into local currency, i.e. it will buy CHF by supplying PLN. This could create pressure in the F/x market and this is where the Polish government should be there to provide f/x support.

What we think is that neither party (i.e. banking community, the regulator/government, and the borrower) can afford not to have a workable solution in place. The banking community knows that it should have known better, the government has elections, and the borrowers, are looking for any help they can get to move on and get out of this depressing state (they also know that it is their decision which got them here).

What we also know that the price action on banking stock with exposure to CHF mortgage saga is of the order of the high-end of the proposed burden to the banking system. This issue is already in the price action of the market.

The article was written in January 2015.

Kalim Aziz
Kalim Aziz
Senior Analyst at Duet Asset Management LLP, London
Mr. Kalim Aziz spent more than 20 years analysing companies in the global emerging markets. Kalim served as a Head of EMEA Research managing over 30 analysts at ING Groep in London and later headed Equity Research of the EMEA Region at UniCredit Banca Mobiliare in London together with Centralny Dom Maklerski Pekao in Warsaw and Koc Yatirim in Turkey, altogether covering more than 100 companies in the region. In 2006, he moved to the buyside as a Co-fund Manager of Kairos Eurasian Fund with Guido Brera. Kalim now helps managing equity fund at Duet Asset Management in London. Besides, he owns a consultuancy company Kiradvisory Limited, an affiliate of Helgi Library on various analytical work.