Regulation of Foreign Currency Mortgage Loans. - the case of transition countries in Central and Eastern Europe

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1 Regulation of Foreign Currency Mortgage Loans - the case of transition countries in Central and Eastern Europe 4 th World Bank conference on Housing Finance in Emerging Markets Washington, D.C., May 26-27, 2010 Hans-Joachim Dübel (Finpolconsult), Simon Walley (World Bank) 1

2 Questions to be answered What is the scope, features and drivers of FX mortgage lending? What happened to FX mortgage portfolios in turbulence? How (and why) did regulators respond and how effective were their responses? Some recommendations Study covers Poland as Hungary both users of Swiss Franc lending Latvia using currency peg Ukraine classic dollarization case Austria as Eurozone comparator, source of cross-border lending 2

3 Scope and features of FX mortgage lending Most transition countries started with some FX lending. Only few did without (Czech rep). Loan amount indexed to foreign currency implying negative amortization risk in local currency: Depreciating exchange rate in the long-term (PPP) However, appreciation may occur in the short-term! Interest rates indexed to foreign benchmark rates or reviewable by lender, usually short-term. Some risk layering (IO & repayment vehicle loans, subprime). Share of forex lending in the outstanding mortgage portfolio in selected transition countries 2002 and Dec '02 Sept '09 Austria Hungary Poland Latvia Romania Ukraine Bulgaria 3

4 Demand and supply drivers of FX lending Interest rate differentials: standard argument (IMF), but in many cases too small to explain size of market. Nominal interest rate level or Tilt effect: absolute affordability limit specific to long-term lending, relevant in high-inflation countries. General dollarization of the economy (property market) Failure to establish (subsidized) local currency funding base Cross-border capital flows & home country matching regulations Foreign Currency as an entry/competition tool using non-risk adjusted pricing 4

5 Demand drivers case study Hungary House price to income ratio, 1994 loan cohort Debt service to income ratio, 1994 loan cohort CHF standard loan (bullet) 8 6 CHF standard loan (bullet) Jun-09 HUF standard loan (bullet) Market share of FC in mortgage and consumer lending Mortgage loans for consumption purposes Car loans % 2 15% Jun-09 HUF standard loan (bullet) Market and subsidized HUF rates, market CHF rates HUF market rates for housing loans 4 2 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Personal loans Consumer goods purchase loans & other consumer lending 1 5% Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 CHF market rates for housing loans HUF subsidized rates for housing loans 5

6 Supply drivers funding market structure Share of foreign bank ownership Latvia Ukraine Hungary Poland Net foreign debt position of the banking system Latvia Hungary Ukraine Poland Cumulative Eurobond issuance, % of GDP 4 35% 3 25% 2 15% 1 5% Hungary Ukraine Poland Latvia Structure of deposits and dollarization proxy for 5 65% Latvia 45% 4 35% 3 25% 2 15% 1 5% Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul % 5 45% 4 35% 3 Resident MFI Non-resident MFI Resident non- MFI Non-resident non-mfi Foreign currency share of residents' deposits, r.h.s. 6

7 Risk realizations: NPL and mortgage payment shock USD/EUR markets Ukraine / Latvia CHF markets Hungary / Poland 18% 200 8% 200 Non-performing loan ratio, % 16% 14% 12% 1 8% 6% 4% 2% QI QII QIII QIV 2009QI 2009QII 2009QIII 2009QIV Debt service index NPL ratio (total loans), l.h.s. Mortgage debt service index, Jan = 100, r.h.s. Non-performing loan ratio, % 7% 6% 5% 4% 3% 2% 1% QI QII QIII QIV 2009QI 2009QII 2009QIII 2009QIV Debt service index NPL ratio (loans to households), l.h.s. Mortgage debt service, January = 100, r.h.s. 18% 200 8% 200 Provisions to total loans, % 16% 14% 12% 1 8% 6% 4% 2% QI QII QIII QIV 2009QI 2009QII 2009QIII 2009QIV Debt service index NPL ratio (loans to invididuals), l.h.s. Mortgage debt service index, Jan 07 =100, r.h.s. Non-performing loan ratio, % 7% 6% 5% 4% 3% 2% 1% Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov Debt service index NPL ratio (loans to individuals), l.h.s. Mortgage debt service index, Jan = 100, r.h.s. 7

8 Hungary vs. Poland payment shock and relative delinquency rate detail Interest rate and installment differentials cohort CHF vs. local currency delinquency rates 4.5% % % % 1. Hungary CHF Poland PLN Hungary HUF Poland CHF 0.5% 0. IV I II III IV 2009 I 2009 II 2009 III 2009 IV Polish banks mostly tie CHF rates to a CHF money market index; this creates what one could dub policy hedging, i.e. a bet on Swiss central bank action. Hungarian banks practice reviewable CHF rates, i.e. pass through funding cost changes; result is lower cost of funds risk bought by higher default risk. 8

9 Negative equity shock esp in house price bubble markets Ukraine / Latvia Hungary / Poland

10 Danger zones FX is only one factor Cumulation of exchange rate and interest rate shock generates cash flow risk. Cumulation of cross-border flows and tight urban markets (Riga, Kiev) generate negative equity risk. Follow-on effects (unemployment, economic crisis) Risk mitigants (historical): Contractual features (Poland, Hungary and Ukraine failure) Early deflation attempts (Poland) Risk transparency (Hungary, Austria ag. JPY loans) Stress testing (Poland) Land and housing supply policies (Latvia, Ukraine failures) Timing and policy lags essential. Stylized facts, four transition countries Apartment price inflation in Warsaw and Riga, regulatory interve Polish Recommendation - April Warsaw Riga Latvian Recommendation - April

11 Evaluation of regulators responses Hungary No response to boom in FX lending following discontinuation of Forint subsidies recently very tight underwriting requirements and capital requirements making FX loans uneconomic and unaffordable. Poland One of first to react with strong rules on under-writing but not well applied. Latvia No response to FX lending, although some anti-bubble measures. Euro loans now encouraged as part of debt restructuring package and FX share still rising. Ukraine Very late response post devaluation, and outcome was a unilateral ban on FX loans Austria Some good steps on consumer information, but slow to spot and react to carry trade problem with borrowers using investment vehicles to repay loans. 11

12 Conclusions FX lending not all bad can fill a gap caused by no affordable domestic alternative or constrained access to domestic long term funds, but need to consider when is could be appropriate: Liquid currency (swap market, access to liquidity lines, long term funds) Stable exchange rate no exotics Risk sharing mechanism (Polish indexed rates) or even caps Not used for speculative purposes carry trade motive Avoid risk layering 12

13 Recommendations Clarification of the role of foreign currency mortgages Need to understand why? before acting Developing the domestic currency alternative Targeted use of subsidy mechanisms Consider inflation proof loans Optimizing FX lending bank regulation Liquidity Management Greater Cross-border cooperation Underwriting rules Capital Rules Optimizing FX lending consumer protection More than just tick-box disclosure Stress-testing and scenarios Some protection eg caps on negative amortization 13

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