By Jason Voss, CFA
The European sovereign debt crisis has been occupying a disproportionate amount of investor mindshare over these past many months. Yet there is another potential debt crisis in Europe that is receiving almost no attention from financial analysts or the press.
During the global real estate bubble €6,123 billion worth of mortgages were issued in Europe. Many of these borrowers are paid salaries or wages in their local currency yet must repay their loans in euro. Mortgages taken on by homeowners in the European Union (EU) who live outside the eurozone are known as “FX mortgages.” The declining value of the euro has thus proved a boon to FX mortgage holders who saw their property values fall when the bubble burst — but, if the euro regains its value, European banks could face a sea of defaults.
Why FX Mortgages Are A Potential Problem
As a condition of joining the EU, a nation is obligated to eventually adopt the euro as its currency. EU members that have adopted the euro are collectively known as the eurozone. Of the 27 EU nations, 10 currently do not use the euro. Of these ten non-euro nations, three nations (Denmark, Sweden, and the United Kingdom) have been exempted from ever having to adopt the euro.
Of the remaining non-eurozone countries, two of them, Latvia and Lithuania, have pegged their currencies to the euro. So, in effect, Latvia and Lithuania are de facto members of the eurozone.
The remaining five nations (Bulgaria, the Czech Republic, Hungary, Poland, and Romania) are all members of the EU but not yet members of the eurozone. Borrowers in these nations had difficulty getting home loans in their local currencies during the global real estate bubble. Consequently many homeowners in these five nations entered into mortgages denominated in either euro or in Swiss francs — the aforementioned foreign exchange (FX) mortgages.
Unfortunately, when the euro and the Swiss franc appreciate, borrowing costs for consumers in each of the five non-eurozone nations also rises. It puts borrowers at a distinct disadvantage as they are earning paychecks in a currency that is depreciating relative to the currency used to pay their largest monthly expense. Effectively, these borrowers have adjustable rate mortgages — but with interest payments that adjust on a daily basis as currencies fluctuate in value.
The Size of the Potential FX Mortgage Crisis
Total FX mortgages in the five non-eurozone nations as of the end of 2009 were €32.5 billion, according to the European Mortgage Federation. (Note: Unfortunately more current data are not available.) This compares to total 2009 GDP in the five nations of €691.5 billion, according to figures from the International Monetary Fund and CFA Institute. So FX mortgages are 4.7% of the economy in these five nations. Additionally, the €32.5 billion of FX mortgages represented 0.28% of the total EU-wide economy in 2009.
While these figures may seem insignificant, consider the fact that the EU is, at the time of this writing, teetering on the brink of recession. Consequently, a loss of 0.28% of GDP would be significant and could further threaten the capital ratios and solvency of European banks.
Here is an overview of each of the five nations’ exposures:
|2009 GDP (in Millions)||% of EU GDP||Total Value of Mortgages (in Millions)||% of EU GDP||FX Mortgages||% of EU GDP|
Risk of FX Mortgage Defaults is Increasing
Each percentage point of depreciation in local currencies results in a percentage point increase in a monthly mortgage payment. Doubtless the many borrowers in the five non-eurozone nations are tracking currency fluctuations with great interest.
As a way of measuring the risks inherent in FX mortgages it is helpful to look at the volatility in exchange rates between the local currencies of the five non-eurozone nations and both the euro and Swiss franc.
As of 16 September, 2011 here are the volatilities of the five non-eurozone nations’ currencies on a rolling monthly basis:
|Relative to the €||Relative to the Swiss Franc|
|Rolling 30-day FX σ for Qtr.||Rolling Monthly FX σ for Yr.||Rolling Monthly FX σ for 5 Yrs.||Rolling 30-day FX σ for Qtr.||Rolling Monthly FX σ for Yr.||Rolling Monthly FX σ for 5 Yrs.|
Sources: OANDA and CFA Institute. Note: Monthly periods were utilized because mortgagees pay on a monthly basis. Rolling periods were chosen to help smooth data from volatile currency markets.
Clearly those unfortunate borrowers who have mortgages denominated in Swiss francs are having a harder go of it than those whose mortgages are denominated in euros. Not only have each of the five nations experienced dramatically increasing volatility between their home currencies and the Swiss franc, the magnitude of the volatility is a full 5.714% higher for the franc over the euro.
By comparison the volatility in the euro exchange rates has actually decreased in both the Czech Republic and Romania in the last year, and over the past five years only Bulgaria’s exchange rate with the euro has experienced higher volatility.
So if the EU manages to solve its sovereign debt crisis it is likely that the euro will recapture some of the value it has lost in 2011. In rising, the euro may increase the borrowing costs in the five non-eurozone nations with big FX mortgages, thus increasing mortgage delinquencies.
Though the potential FX mortgage crisis in Europe is dwarfed by the sovereign debt crisis, it still has the possibility of sending Europe into a recession. Furthermore, as a potential crisis receiving very little attention its impact could be disproportionate.