Austrian Bank Carry Trade Mortgages, What A Way To Leverage Real Estate

Austrian bank downgrades show a unique real estate funding bubble

Last week Moody's downgraded Austrian banks' Erste Group Bank AG, Raiffeisen Bank International AG and Italian bank UniCredit's Bank Austria, while also cutting several German banks.  Overall causes of downgrades were attributed to exposure to Central and Easter Europe (CEE).

A peculiar lending activity occurred among the named banks and the CEE countries. This lending amounted to Austrian banks transforming mortgages into a carry trade proposition funded with Swiss francs. In fact, Hungary’s former central bank governor, Peter Akos Bod, obtained such a mortgage prior to the Lehman collapse in 2008. In a Bloomberg report dated December 14, 2011, reporters Boris Groendal and Edith Balazs explained that the former Hungarian central banker called the loan rational at the time.

Currently, however, with the course of Swiss franc appreciation over years, and depreciation of some CEE currencies, CEE residents have been strained to make their mortgage payments. Hungarian leaders have revolted against Austrian banks and Polish borrowers struggle while underwater on their loans.

To explain unique dynamics between Austrian banks and CEE countries which spawned the carry trade mortgage, history provides a foundation.

Austria’s present relationship with CEE countries emerged naturally from history

Historical background, briefly stated, provides perspective. Austria when an empire was once joined in a duel monarchy with the Hungarian empire starting in 1867. This combination included the Czech Republic, Slovakia, Slovenia, Bosnia and parts of Serbia and Romania. When “balance of power” politics developed in the “Age of Metternich” countries sought territory.

The world aside from an isolationist U.S. was divided between the Triple Alliance powers of Austria-Hungary, Germany and Italy versus the Triple Entente of Britain, France and Russia. WWI eventually started out of the global dynamics experienced by global divisions. Henry Kissinger's book “Diplomacy” (1994) provides an outstanding analysis of this period.

From Austria's historical connection with CEE countries, imaginable was shock in seeing the U.S.S.R.’s descent of its Iron Curtain shutting off Austria from Eastern Europe. But Perestroika and Glasnost brought a new openness which allowed Western European and especially Austrian banks to renew relations. Seeing historical interaction and economic opportunity, Austrian banks started to merge with CEE banks.

Once the Soviet demise occurred, developing nations of the CEE offered existing infrastructure and wider demand relationships among former Soviet nations. What also existed for these unique countries was unstable currency rates and typically high interest, combined with a want of home ownership.

When the global housing boom started last decade, Austrian banks were in a position to put more CEE residents into private home ownership, despite high interest rates of CEE countries. Austrian banks found the carry trade.....only for mortgages this time.

Essence of the carry trade

Carry trades are a good and standard operating procedure, when used right. Essentially, a carry trade occurs anytime an entity sells a cheaper interest bearing instrument to buy returns on a higher interest bearing instrument; or, sells a depreciating instrument to finance an appreciating instrument's purchase. What is difficult with a carry trade is that an entity will have to buy back the sold instrument one day.

Borrowing cheap to loan high is the fundamental concept of the carry trade. Banks function off of borrowing at cheaper rates, which are for the most part short term, and lending at higher rates longer term. They then collect the spread in interest rates as profit.

Currency trading is the same thing. Ultimate goal in currency trading is to find a currency that is cheap, and has a low interest rate, to then take the funds and lend to or buy a currency that is appreciating in value with a high interest rate. An example of such a trade has been the AUD/USD (not so much currently).

Because currencies can dramatically fluctuate given a variety of variables, any carry trade position must have the flexibility of rapid liquidation should the cheap become expensive, or the paradigm of the position reverse. So why not give this a try with 15 to 30 year mortgages?

Where carry trades are subject to potential reversal in their expected patterns at any time, mortgages are long term contracts. If fundamental propositions of the mortgage fail to manifest, obvious default can be a consequence.

Austrian carry trade mortgages to CEE countries

Austrian banks sought to make real estate mortgages cheaper given high interest rates in CEE countries, but with such countries also experiencing appreciating real estate values. To do this, Austrian banks used the euro currency against the franc to make interest rates cheaper. Austrian banks would use their euros to buy francs, or otherwise loan euros in exchange for francs. When it was time for Austrian banks to close out the loan of euros for franks, they needed the exchange rate to be the same, or optimally show franc depreciation. In this way, Austrian banks would either not lose money on the currency swap, or would make money by having to use fewer euros to close the swap.

Once having obtained francs, Austrian banks issued franc denominated mortgages to CEE residents at franc based interest rates, which were much lower than alternatives. To repay the loans, CEE residents must convert their local currency into francs.

Such propositions could have worked well, and did finance housing where otherwise housing might have been unattainable. However, the Swiss franc appreciated substantially following the Lehman collapse of 2008. Carry trade mortgages, and their foundational propositions reversed.

Austrian banks had to use ever increasing amounts of euros to close their franc swaps, leading to losses. CEE residents are paying more than ever to convert their local depreciating currency into highly appreciated francs. Homes are now underwater given currency reversals, compounded by economic circumstances.

A real estate market was created out of alternative and unorthodox funding mechanisms, in so doing long term contracts were put to the volatility of FX exchange rates. Swiss franc is now pegged at 1.20 euro. Still highly appreciated compared with when the mortgages were created.