SNB: Anchors In Quicksand Can Lead To Shipwrecks

Includes: FXF, UDN, UUP
by: Stuart Staines

When asset prices are faced with intervention, one always has to look out for the unintended consequences. Unintended consequences are often the seeds for what is later identified as a black swan event, a highly improbable outcome with a major impact.

The unintended consequences of this decision to semi-peg the Swiss franc are many.

First of all, this strategy has very little chances of being reversed under the usual laws of demand and supply, as there are technically no limits to the amount of Swiss francs the SNB can print. So long that they keep this strategy, accounting wise, there will be no loss on the position, as the exchange rate will not be permitted to go under 1.20. But the real issue lies in the volatility and unsoundness of the currency they have pegged to.

As described in The Euro Endgame, the euro is bound to ultimately weaken significantly with bouts of extreme volatility as markets recognize that there is no painless remedy to the sovereign crisis under the straight jacket of the single currency. In other words, the SNB is going to run a balance sheet expansion (QE) of gigantic proportions as the crisis accelerates and it tries to protect its self-imposed ceiling.

Currently, out of the quarter trillion of foreign exchange reserves held at the SNB, over 50% is made up of euros.

As the SNB will evidently only invest these newly acquired euros in German and French government bonds, the spread between the bonds of the periphery and that of France and Germany will widen. In addition, now that the exchange rate risk is shouldered exclusively by the SNB, it should be expected that a large number of institutions take this opportunity to dump their remaining holdings of GIIPS sovereign debt onto the ECB, then sell the euros to the Swiss central bank and instead buy Swiss francs to be invested in Swiss government bonds.

What would you prefer holding? Swiss francs that you know you can buy in unlimited amounts without impacting the exchange rate or Spanish and Italian bonds you know that, for now, you can sell to the ECB at an artificially low yield? These capital flows will only accelerate the balance sheet expansion of the SNB as the risk is transferred from the institutions to the central banks. The result will be a further slide of the Swiss yield curve and a brand new highway for exciting the euro.

Is it not ironic? Whilst we were lucky enough to have avoided the Frankenstein currency we have now turned into a gigantic recycling machine for the single currency. It somewhat reminds me of UBS. They tend to avoid most rotten investments until the very last inning, when, for fear of missing out, end up being the last player to which all investments banks try to offload their toxic paper (LTCM, sub-prime mortgages…).

The very likely outcome of this whole experiment is that the SNB will have to ultimately back-out as the Eurozone debt issues deteriorate further. This will not only result in a huge loss of credibility but also a huge balance sheet loss.

But, however low the probability, let’s consider the other outcome. Suppose that, somehow, the European Union manages to kick the can down the road for longer and that the SNB continues defending its peg.

To understand what this could mean for Switzerland you have to understand a few particularities about our country. Our gross debt to GDP level at around 50% is envied by most other developed nations (for a GDP just slightly above half a trillion dollars). And yes, we did not buy into the great opportunity of joining the single currency union and abandon our monetary sovereignty so that our politicians could bolster their international presence and take their careers to the shiny shores of European institutions.

Ironically, we are one of the few successful currency unions (since 1850) and a successful federal state much inspired by America’s example. So basically, and unlike all of our neighbors, we avoided falling in the larger single currency trap. Not that we are smarter that anyone else, we just avoided making a few mistakes, pretty much the same recipe of success as with investing.

But it’s worth digging a little further if you wish to consider the Swiss Franc as the piggy bank for all your hard earned savings. Although we rank on so many aspects of wealth and well being with both Qatar and Norway, we also rank in one aspect very closely with a much less glamorous nation, Iceland.

Our banking sector’s assets to GDP is one of the largest in the world at over 8 times GDP, with Credit Suisse and UBS accounting for almost three quarters of that total. Interestingly, the three largest banks of Iceland also accounted for three quarters of the total, which happened to be also about 8 times their GDP.

Of course, having a very large banking sector is not by itself a reason for assured systemic failure. If your balance sheet is essentially composed of offshore fund deposits with no real lending activity (which is the case in Luxembourg) it’s not the same as if your principal asset is mortgage debt on inflated real estate.

At the end of the day, it all comes down to confidence (or bluff?) and short-term debt financing, the two Achilles heels of banking. Iceland had 6 times its GDP of short-term bank debt to refinance in 2008, the short-term liabilities of the Swiss banking sector is about 3 times GDP, still not an insignificant amount by any measure. This is usually the area where our national bank focuses its attention and keeps its bazooka ready if needed. Not buying a currency facing a major sovereign crisis.

In terms of exposure to peripheral European countries we have very little direct exposure but could suffer "collateral damage" if government debt restructuring leads to ratings downgrades or even bankruptcies among private-sector institutions to which the banks are creditors. And remember, a 10% balance sheet loss in the banking sector is equivalent to 80% of our GDP and about 4 years of tax receipts.

But there is yet another particularity of our small nation that is not apparent unless you live there. When I think of a typical Swiss household, the best description that comes to mind is “high earner with no assets”. Our households are somewhat similar to our banking system in the way that we have elevated earnings but a very little capital base to fall back on. In Geneva, a 100 square meter apartment is rented for over USD3’500 providing of course you can find one as we have a vacancy rate that ranges between 0.15% and 0.25%. I can’t remember a time where vacancy has not been officially considered as in “crisis”. Finding an apartment in Geneva can take anywhere between a year and, well, never.

What’s the usual asset of all households in developed nations? Home sweet home. In Switzerland, the home ownership rate is below 40%, the lowest of any non-communist country. In Geneva, it’s below 15%, fifteen percent, not a typo. The reason? Suppose that you are in your thirties and you wish to buy an apartment. The average price in Geneva is anywhere between CHF10’000 and CHF15’000 per square meter meaning that if you plan to have any children, its going to be impossible to find anything below at least one million. The minimum down payment in Switzerland is 20%, so if you add taxes and other legal fees you need to have aside a good quarter million and generally more .

Needless to say, few have that kind of money aside in there 30’s. To somewhat “promote” home ownership, we are allowed to take out all our retirement savings (somewhat similar to a 401k in the US) for the purchase of our primary residence. Of course, before your 40’s, retirement savings are nowhere sufficient so you will eventually have to ask your family for a “little” help. If you are amongst the lucky few that have managed to put together this down payment you will be the proud owner of your home.

Now when I say owner, I mean the proud owner of a very big mortgage, which is generally amortized by only 1% a year and for tax reasons is transferred into a special retirement savings account. Anything above one percent, even with the current record low 2.3% annual interest (with 10 year Swiss rates at 0.85%, now below even Japanese rates) and you might have to choose between paying the mortgage and eating a steak now and again. In addition, it’s precisely for the tax benefits of this gigantic liability that anyone still tries buying at these extravagant prices.

Real estate prices in the “big” cities of Geneva and Zurich have risen by 7.6% every year since 2000 and by almost 11% in 2010 alone (Switzerland’s real estate prices as a whole have risen by 4% yearly since 2000). Another interesting aspect is that real estate value to GDP is the highest in the world at about 100% of our GDP.

But there is yet another most important particularity that goes too often unnoticed. Switzerland has one of the largest foreign resident population in the world, 20% of the population. They work essentially in international organizations, corporations and financial institutions, which happen to all be relatively well-paid jobs. Given that homes are mostly unaffordable for residents, you can guess who is boosting demand for housing.

Switzerland experienced a real estate crash 20 years ago that took many local financial institutions, particularly cantonal banks, years to recover from. It was in 1993, following double digit gain in prices in the late 80’s and early 90’s for the exact same reason as today: extremely low long rates, but still twice as high as today. A significant recession followed and real estate prices fell 6% annually until 2000. At the time, 76% of mortgages were variable rate mortgages, so when the SNB took up interest rates above 7% to reign in inflation, the impact was severe.

You might have guessed by now why I have described in length this Swiss home ownership structure. All the ingredients of a huge real estate bubble are brought together in our small safe haven. In a small real estate market, where demand is mostly from foreigners, the friction point between supply and demand is extremely thin. Although you have an initial sizable down payment, many buyers can simply not support any rise in interest rates let alone try to amortize their mortgage. In such a configuration, if prices start falling they will fall hard and fast. You don’t need much for the pendulum to start swinging the other way.

By offering a free exit out of euros thereby artificially increasing the demand for Swiss government bonds (and more than doubling the money supply in the process), the SNB might have dug itself in a hole. Whether it’s the uncontrolled real estate bubble or the free falling euro, the SNB will be on the hook.

My two cents is either go to New York to do some shopping or sell the swissie short against dollar. And then go do your shopping.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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