The Swiss Franc (CHF) was the talk of the financial world last week. We feel compelled to write something about it, but our response will be measured because we know someone directly affected by the situation. You see, we have this colleague…

You don’t need to know him to know him. All you have to do is look in the mirror and see your own reflection: married, kids, house. By all measures, he’s a smart and creative man following a well-traveled path towards personal and professional fulfillment. And though it was never relevant prior to last week, it seems necessary now to also mention that he lives in Romania.

Without knowing this colleague personally, it would have been easy to pump out a mindless hot take – an opinion piece based on simplistic moralizing rather than actual thought. It would have been no problem whatsoever to demonize the Swiss National Bank (SNB) for their lack of communication with global markets on a policy that is, not for nothing, a complete reversal of one initiated as recently as late 2011. Nor would it have been any trouble to demonize SNB for initiating the policy in the first place, intervening in a highly liquid and fully functional currency market whose nascent level represented the best estimates of economic equivalence. Truth be told, we didn’t have to talk about the SNB at all. Like so many hit-pieces from 2008-2010, we could have gone after the vicious and greedy investors – from the exchanges themselves to global hedge funds to individuals – made vulnerable to exogenous financial shocks by risk-neglecting, over-leveraged, and unhedged positions.

All of these would have been easy pieces to write. But you see, we have this colleague…

In many places around the globe a common practice over the past decade has been to borrow money denominated in foreign currencies. For individuals whose primary liability is a mortgage, this was because the mortgages carried the interest rate of the foreign currency. And while the concept may seem odd to borrowers in the US and Canada, it was quite attractive to countries where domestic rates were high. For reasons beyond the scope of this article, CHF was the go-to currency for these types of loans. And there were massive – MASSIVE – amounts of loans written that were pegged to CHF. One report (which you can read fully in the embed below) found that in the 3rd quarter of 2011, 62% of all loans made to the Romanian non-banking sector were denominated in CHF, and of those, fully 96% were made to households.

Ironically, when an economic issue rises to the level of “systematic risk,” it is largely ignored by investment markets. The perverse incentives are simple: systematic risks will be contained by any and all interventionist policies required. Fiscal and monetary policy will win the day; the ostriches will triumph.

Of course, this doesn’t mean that vigilant analysts aren’t scouring the globe, attempting to shine light on rising threats to global prosperity. During both the Tech and Housing Booms, judicious researchers were talking about the potential – not the certainty, but the potential – that the booms were actually bubbles, and that they might burst. And this case is no different. Nothing less than a Senior Economist at the SNB named Pinar Yesin wrote in 2013:

 Foreign currency loans to the unhedged non-banking sector are remarkably prevalent in Europe and create a significant exchange-rate-induced credit risk to European banking sectors. In particular, Swiss franc (CHF)-denominated loans, popular in Eastern European countries, could trigger simultaneous bank failures if depreciation of the domestic currencies prevents unhedged borrowers from servicing the loans. Foreign currency loans thus pose a systemic risk from a “common market shock” perspective.

You can find the full report in the Scribd embed following this post, but essentially, the risk was foreseeable. And in the world of blogging, where I envision myself writing to a faceless mass of global readers, this is an easy stance to take. But, you see, we have this colleague…

The last time I bought a house, a tremendous amount of thought went into what mortgage would be best for me. In the US, this generally entails looking at two factors.

First, what type of mortgage best suits the situation? This is a matter of personal preference, but the two big variations are fixed and variable mortgages. Variable mortgages “float” with changes in the prevailing interest rates, and tend to have lower initial rates since the borrower takes the risk of rising rates. Fixed mortgages, on the other hand, lock in somewhat higher rates, since the bank carries the interest rate risk. Given the historical context of rates, and our perceived preferences at the time, my wife and I opted for a 30-year fixed. The second choice is: Who to borrow from? That’s generally a function of an individual’s credit-worthiness, but I scoured the country and engaged multiple brokers whose job it was to eke out an extra 1/8% discount in my favor. Anyone who’s been through the process knows the drama, analysis and complexity involved in making a mortgage decision. But in the context of the global mortgage market, what we endure in North America is downright simple. I searched long and hard for the best deal, sure, but what I went through was nothing compared to my foreign brethren.

As a US borrower, there is no reason whatsoever for me to even consider a foreign currency mortgage. As the USD is (at least for the moment) still the reserve currency of the world, and my nation’s credit-worthiness is (kinda sorta) beyond reproach, there was virtually no chance I would be able to obtain a better rate from a foreign market. I didn’t even look, but thinking about it now, if I had, it would have added an extremely complex layer to the analysis. This is because when you engage in a foreign currency mortgage, the borrower bears the foreign currency risk.

What does the average mortgage borrower know about the complexities of currency markets? Nothing, that’s what.

I may be going out on a limb here, but my guess is that when the masses of European – and primarily Eastern European – borrowers went in search of a mortgage, all they were looking at were rates. Just like me. The lowest rate translated into the lowest payment, and little if any thought went into the foreign currency risks that were lurking silently in the background. Until now.

Imagine that you borrow $300,000 on a 15-year fixed loan in the US. Your monthly P&I at 4% would be $2,219. Now imagine the same situation, except that instead of borrowing USD, you borrowed in Swiss Francs and overnight the US dollar depreciated 30%. Your mortgage principal is reset to $390,000 and your payment jumps to $2,884. Now this is just a single theoretical example, but imagine for a moment the hardship you and your family might endure if your monthly mortgage payment suddenly jumped 20-40%. See, we have this colleague…

We can’t help at times like these but to think about Nassim Taleb’s “black swans.” Over time the term has become synonymous with “exogenous event,” particularly those that have materially adverse impacts on financial markets. Yet this is a vast oversimplification that fails to communicate a much broader idea: That it is far more difficult to prove a truth than it is to disprove it. The term itself is derived from a simple thought experiment where we start with the assumption that all swans are white. This belief is easy to accept since it is predicated on our real-world experience. And yet, it is virtually impossible to prove it since doing so would require the location and inspection of every swan in the world. On the other hand, if we wanted to disprove it, we need only find a single, solitary black swan.

And so here we are, operating under the notion that a set of central planning institutions have everything under control. The markets have a backstop, volatility will be controlled, inflation targets hit, currency pegs honored. It’s easy to accept given our experience since 2008; all the swans we’ve seen since then have been white. That is, until the SNB – our black swan – comes along to fundamentally shake our confidence.

This may be a good thing in the long run, but right now it’s just plain painful.

Generally speaking, free markets are a necessary condition for human progress. We know this. Everyone knows this. Furthermore, in a perfectly rational world the best way to make people cognizant of the risks inherent in their decisions is to allow the infliction of carnage resulting from the bad ones. But we don’t live in a perfect world. Rather, we live in a world dominated by asymmetric information, where one party to a transaction invariably knows more than the other. Especially in the case of mortgages, it appears that in the last 10 years the market has been dominated by bad ideas and bad people.

Now we have another very personal example. You see, we have this colleague…

At the time when many are suffering, it seems schadenfreude to bask in the warming glow of “I told you so.” And yet, when Mr. Yessin was talking about this exact issue in 2013, nobody cared specifically because nobody was yet suffering. In a larger sense, when are we supposed to talk about personal responsibility? When you’re suffering and don’t want to hear it, or when you’re doing fine and won’t care?

We don’t know the answer, which is why we are constantly telling our stories about high valuations, and volatility squeezing sustainable retirement income, and the importance of asset allocation strategies to contain risk, just to name a few. If we constantly beat the drum, odds are that we’ll catch you at the right time. We just hope that you’ll be motivated to talk to us the day before you see your first black swan, rather than the day after.

As for our colleague…he’s going to struggle through this. As a result of making a long series of judicious financial decisions, he’ll keep his head above water. Many of his family, friends and associates won’t be so lucky. Many will experience capital impairments with enduring, potentially life changing effects.

There’s little else we can say, except that our hearts go out to them.

Yesin – Foreign Currency Loans & Systematic Risk in Europe


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