"Decision was rational. I put it into a model" says Hungarian Economics Professor who took Mortgage in Swiss Francs, then Clobbered on 40% Currency Move

In case you need further proof that economics professors are frequently clueless about economics, please consider Austrian Banks Facing Payback as Hungary�s $22 Billion Debt Slaves Revolt

When Hungary�s former central bank governor was buying a house two months before Lehman Brothers Holdings Inc. collapsed and the country sought an emergency bailout, he received an offer he couldn�t refuse.

Peter Akos Bod, now an economics professor at Corvinus University in Budapest, was given a choice of mortgages by his bank. The 60 year-old could select a loan in Hungary�s currency, the forint, at 13 percent interest, or one in Swiss francs at less than 6 percent. After crunching the numbers on a spreadsheet, he picked the cheaper franc loan.

�It was rational,� he said of his 2008 decision in an interview in the Hungarian capital. �I put it into a model.�

Three years later, Bod and about one million compatriots who took mortgages in francs are faced with a debt pile that has swelled to 4.9 trillion forint ($22 billion). The currency�s 40 percent slump against the franc has raised repayment costs, pushing mortgage arrears to a two-decade high and prompting Prime Minister Viktor Orban�s government to brand the loans �debt slavery.�

In Models We Trust

The decision to take out mortgages or other long-term debt in a foreign currency is not rational unless one is fully prepared for these kinds of currency fluctuations. Not only was the professor unprepared, he was silly enough to base his move on a model.

Haven't these geniuses heard about the demise of Long Term Capital Management?

The short story is future Nobel Prize winners, Myron Scholes and Robert C. Merton along with John Meriwether made leveraged bets based on a model that said bond rates would converge over time. The firm was initially successful with annualized returns of over 40%. However, LTCM blew up in 1998 following the Russian financial crisis in which bond spreads "unexpectedly" widened.

Professor Bod made a leveraged bet (that's what most mortgages are), that based on a model, Hungary's currency (the Forint) would be stable against the Swiss Franc.

Why any model would presume such a thing is beyond me. Why anyone would trust such a model is even more ridiculous. But that's just what the professor did.

Hungarian Currency Crisis

There is much more to the story including a bailout of Hungary by the IMF and debt restructurings that spilled over into Austria.

To help homeowners, [prime minister] Orban imposed currency losses on banks including Erste Group Bank AG and Raiffeisen Bank International AG (RBI) that may total 900 million euros ($1.2 billion), according to Cristina Marzea, an analyst at Barclays Capital. Faced with the risk Orban would impose further measures, lenders have offered to accept $2.2 billion of additional losses if the government promised to take no further action. If it doesn�t, banks are threatening they may withdraw from the country.

Almost 18 months after Orban was elected in April 2010, he passed a law allowing Hungarians to repay mortgages denominated in foreign currencies at discount of about 25 percent to today�s exchange rate. As long as a client applies before Dec. 31 and repays the entire loan before Feb. 28, the banks have to make up the difference.

�I paid it back last week,� Bod said. �I�m free of debt slavery,� said the former industry minister. The plan �is easy to explain from a political viewpoint. It�s cheap for the government, expensive for the banks, good for voters.�

While borrowers in Poland, Romania, Bulgaria and Croatia also took foreign currency loans, Hungary is unique because average household borrowing in overseas currencies is more than six times the region�s average, according to Barclays. In Poland, where more than half of all mortgages are franc- denominated, banks limited them to more affluent customers, and cushioned the franc�s advance against the zloty by cutting rates. Hungarian banks raised rates.

Every redeemed mortgage equates to a loss for the banks, Barclay�s Marzea said in a Nov. 17 report that banks operating in Hungary may lose 12 percent of their combined capital, or about 900 million euros, because of the early repayment plan.
�Immediate Action�

Lenders responded by suing the government in the Hungarian Constitutional Court and asking the European Union in a Nov. 14 letter to take �urgent and immediate action� against Orban, adding they will need to reassess their commitments in Hungary. Erste and Raiffeisen, which signed the letter, have said they will cut lending in the country.

By June 30, Austrian banks had lent $42 billion to Hungarian borrowers, Italians $23 billion and Germans $21 billion, according to the Bank for International Settlements.

Austria�s central bank Governor Ewald Nowotny in October described the Hungarian law as �brutal� as well as legally unworkable and �economically nonsensical.� Nowotny last month ordered the country�s lenders to limit new loans in eastern Europe to make their business �more sustainable.�

Moody�s Investors Service last week said that Austrian banks� exposure to the central and eastern European region is �the single biggest event risk for the sovereign.� Austrian banks are also the biggest lenders in the broader eastern European region. Standard & Poor�s said Dec. 5 it may downgrade Austria, one of the six remaining euro area countries rated AAA, because it may have to inject capital into its banks.

Everyone in Hungary has suffered from this mess to varying degrees. Banks made stupid mortgage loans believing they would be paid back regardless of currency fluctuations. Borrowers took out stupid mortgage loans ignoring the possibility of huge currency swings.

Worse yet, the IMF is in the picture bankrolling Hungarian banks as foreign lending has all but dried up. It's never good to be in a position of borrowing money from the IMF.

Did Bod learn anything? Of course not.

Bod explains ... The plan �is easy to explain from a political viewpoint. It�s cheap for the government, expensive for the banks, good for voters.�

The plan was not good for voters in general (at least voters who did not take out stupid loans based on models). The plan however was good for Bod, but not as good as if he had stayed away from his faulty economic model in the first place.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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