The Journal’s front page story, “Homeowners Abroad Take Currency Gamble in Loans,” had numerous anecdotes about how Eastern Europeans are active in the carry trade, borrowing in cheaper currencies, gambling that the interest rate savings won’t be offset by currency appreciation.
Some have compared the carry trade to picking up nickels in front of a steamroller. Retail players are the group least equipped to play this game, which until recently has been the province of professionals.
It’s one thing to have Japanese investing in foreign currencies for higher yield. Prevailing interest rates in Japan are so low as to be microscopic. With yen interest rates at 50 basis points versus foreign interest rates of 5-6%, they are getting 10 to 12 times more in income by going overseas. True, the yen is undervalued, but there is some debate as to what degree. Also recall that most Japanese are investing via multicurrency savings accounts, which are liquid (although in a rapidly moving market, they won’t be able to trade anywhere near as quickly as professional investors). If they are observant, the downside risk might be 30%. So for them, the trade is risky, but as practiced, not nuts. They are gambling with their savings, but if not done to excess, this as prudent currency diversification. Reports indicate that most investors are doing so only with a manageable porition of their assets. Indeed, senior Japanese financial executives I know who are close to regulators say the authorities think this sort of investing, within proper bounds, is sound policy.
By contrast, a adverse currency movement could literally put Eastern European borrowers out on the street, since they are putting what is almost certain to be their biggest asset at risk. The Wall Street Journal suggests that the yield differential is roughly 50%. In addition, these mortgages are illiquid. Borrowers cannot easily or quickly refinance, so if their currency bet moves against them, many will be stuck. In addition, with an adverse currency move, the principal will have gone up too, so even if they could refinance, they might not get enough to retire the initial mortgage, plus the new mortgage would probably be at higher interest rates (that’s why they traded out of their currency in the first place). It would take a massive currency moves to offset undo the yield differential at the time of borrowing, which would mean the gain in principal balance would be even greater.
)Yet this chart, shows the strategy is wildly popular. And despite the very large risks, regulators are permitting this sort of foolishness to occur (one would think it should at least be restricted to commercial borrowers).
Why are these regulators casting a blind eye? The Journal unwittingly gives the answer:
In Hungary, the foreclosure rate is only about 1%, and banks are able to hedge against currency risk. “We have extremely fat margins,” says Peter Kisbenedek, former CEO of Erste Bank Hungary, soon to be chief financial officer of Erste Holding, parent company of Austria’s Erste bank, with branches throughout Eastern Europe. “We can fund the risk.”
Put simply, this business is extremely lucrative for the intermediaries, and to hell with the customer (wait and see where that 1% foreclosure rate goes if you have a sharp movement in currencies). Regulators have to decide how to balance the interests of the organizations they oversee versus the public, and here there is no doubt here as to whose interest they favor.
Financial institutions used to be in the business of helping investors and borrowers find suitable vehicles for their needs. Increasingly, it has become an exercise in finding a chump.