The impacts of Hungary’s future foreign currency mortgage ‘fix’ could be milder than feared, Morgan Stanley said in a research note on Hungary this week, before the 6 April election. London-based analysts at MS, said the government, after a verdict by the Supreme Court, is likely to put together a package by restructuring the exchange rate cap scheme that will cause banks only limited losses. He also thinks that a radical package, e.g. a permanent, compulsory FX rate cap scheme, would still be better than doing nothing, leaving a persistent overhang on the banks.
Read Morgan Stanley’s recent opinion on OTP at the link below:
Last summer, Prime Minister Viktor Orbán moved the FX mortgage issue up the political agenda, telling the banks that a definitive solution to FX mortgage debt had to be found. “With the highly costly early repayment scheme of 2011-12 fresh in minds, many investors understandably feared the worst. These concerns are overdone, in our view," Daniel Cowan and Laura Sisson said in a research note on 2 April.
They think that “multiple, significant economic limitations mean that the costs of any new scheme are likely to be milder than currently feared."
Morgan Stanley’s CE3 economist, Pasquale Diana, sees “a higher likelihood of a constructive outcome post elections".
Cowan and Sisson think that an extension of the existing rate cap scheme is possible, either making it compulsory for all FX mortgage borrowers (cc. 50% have so far signed up) and/or making it permanent.
They estimate that the worst of the two scenarios - a compulsory and permanent FX rate cap scheme - would cost OTP HUF 97 billion after tax, equivalent to 6% of book value. “This, though, assumes no potential government assistance," the analysts added.
The MS economists expect the government to wait for the verdict from the Hungarian Supreme Court, which is likely to follow shortly after the European Court of Justice’s final ruling on April 30. “Now that the prospect of legislative intervention has been raised, the worst-case scenario, in our view, would be if nothing were done, leaving a persistent overhang on the banks."
Limitations on any scheme
In order to analyse the likely impact of any scheme the analysts put the spotlight on the limitations, if any, for the government. They identified the following key issues:
1) One important detail on which the government and banks seem to agree is that FX mortgage holders should not be better off than equivalent HUF mortgage holders as result of the scheme. “This will necessarily limit the cost for the banks," Cowan and Sisson said.
2) The analysts think that the focus of the next government following the April general election will move to promoting growth in the economy from repairing it, which was the primary task of the last term. “PM Orbán has recognised that the economy needs a functioning banking system. We think that this factor will ultimately prompt the government to limit the cost of the scheme to the banks either through its scope and/or through sharing the burden."
3) The banking system is stable The current capital of the Hungarian banks is HUF 2.4 trillion, giving a healthy Basel II CAR of 17.4% (minimum 8%) at 4Q13, according to central bank (NBH) data. There are HUF 3.4 trillion outstanding FX mortgages. “If we assume the same 25% effective haircut implied by the 2011-12 early repayment scheme (HUF:CHF 180 versus cc. 240 market rate), this would imply a post-tax cost of HUF 470 billion, impacting sector CAR by 340bp on our estimates."
4) “The short-term conversion of the entire FX mortgage stock would most likely place prohibitively high pressure on the exchange rate and currency reserves. There are outstanding FX housing and home equity loans equivalent to around EUR 12 billion, roughly one-third of Hungary’s reserves of EUR 34 billion. This would argue for either a limited scheme or one phased in over an extended period in order to reduce the currency impact."
5) The analysts also noted that the government did not consult the judiciary on previous measures, but it has now said that it will wait for the Supreme Court’s verdict. “Ultimately, the court’s decision cannot stop new legislation, although having waited, it would be difficult for the new government to ignore it completely."
What did the courts say?
In November 2013, the government requested the Supreme (Curia) and Constitutional Courts to examine the legality and constitutionality of the FX mortgage contracts. Subsequently the Curia requested the European Court of Justice to rule on the issue. The ECJ provided a non-binding initial opinion on February 12. The Constitutional Court ruled on March 17. The ECJ will issue its final ruling on April 30. So far, the main points are:
1) Certain parts of the mortgage contracts may be ‘unfair’: The European Court of Justice has said that there are grounds for the Hungarian Curia to investigate the fairness of clauses allowing a) the imposition of an additional FX funding margin by the banks and b) the unilateral change of interest/FX rates by the banks.
2) The ECJ’s initial opinion states that the ultimate decision whether to investigate if FX mortgage contract clauses were unfair lies with the Hungarian courts.
3) Unfair clauses do not invalidate the contract Both the Hungarian Curia and the ECJ have stated that invalid/unfair clauses do not provide grounds to void the entire contract and that the first priority should be repair of any offending clauses.
4) Legislation can amend contracts, but must be fair: The Constitutional Court ruled that, while FX mortgage contracts do not contravene the constitution, new legislation may amend contracts retroactively in exceptional circumstances. The court also ruled that any changes must be fair to both parties.
“For now, the courts’ insistence on the preservation of the contract is a positive for the banks as it removes a potential key driver of government intervention. The stipulation that invalid contract clauses can be repaired with existing legislation is also helpful for the banks as legislation passed since the crisis dictates that FX loans be translated at the prevailing mid-rate. The insistence on fairness to both parties, i.e., borrower and lender, is also important," the analysts commented.
Exchange rate cap scheme may be reshaped
Among the most likely scenarios Cowan and Sisson mentioned a revamped exchange rate cap scheme, which has attracted HUF 1.3 trillion mortgages, 52% of eligible loans by value, after 18 months. In total, 173,000 mortgage holders had taken up the scheme out of total 446,000 FX mortgage contracts. The relatively low take-up has been explained mainly by perceptions of the scheme’s unfavourable structure, the analsyts noted.
Cowan and Sisson examined three possible scenarios for the government’s planned FX mortgage fix. They think these remain the most likely potential outcomes within the current sphere of debate. The two key scenarios are based on the existing fixing scheme and most likely represent the two ends of the range of possible costs, they think. The third examines possible outcomes for the FX margin, which is central to the current legal debate.
1. Make the existing scheme compulsory
OTP has said that the current scheme costs it HUF 2-3 billion in forgone interest income. The take-up of the scheme has been roughly 50% by value of outstanding contracts, implying that full take-up of the scheme would cost the bank HUF 5-6 billion per year for the length of the five-year fixing period, the analysts estimated.
2. Make the existing scheme permanent
“This would involve conversion of the FX mortgage into a new HUF mortgage but at a rate favourable to the borrower. The costs would be significantly higher than the current FX fixing scheme as it would imply a ‘haircut’ on the loan. One important limiting factor, however, would be the condition that the scheme should not leave FX borrowers better off than HUF borrowers, which would potentially put a floor under how generous the conversion rate might be."
“The disadvantage of this scheme would be that the associated costs would be so high that the government would need to share some of the burden to avoid undermining banking system stability. There is a precedent for this: under the current rate-fixing scheme, the cost of the interest portion of deferred debt is borne 50:50 between the government and the banks."
The analysts estimate that converting OTP’s entire stock of FX housing and home equity loans would lead to gross losses of roughly HUF 115-175 billion depending on the exchange rate used (HUF:CHF185-210). This would be offset against the tax and special bank levy burdens, reducing the net burden to roughly HUF 65-95 billion, before any government share, roughly equivalent to haircuts of 15-22.5%.
3. Funding margin
The FX funding margin clauses have been the subject of much of the current legal debate. “One possibility remains that banks may be required to compensate borrowers for the margin if the contract clauses are found to be unfair," Cowan and Sisson said.
From 2008 OTP doubled the FX funding margin from 1% to 2%: In 2010, new legislation was introduced, which effectively removed the margin by fixing the currency translation at the prevailing mid-rate for household FX loans. From this year, OTP has also removed the margin from its home equity loans. On this basis, the FX margin is no longer charged by the bank.
“The question is whether the banks will be obliged to repay the surcharge. We think the forward-looking loss would be zero as OTP has phased out FX funding surcharges. If OTP were required to compensate borrowers retrospectively for the additional 1% surcharge after 2008, we estimate that the cost would be HUF 2-3 billion. If it were required to repay the entire FX funding margin on all FX mortgages since 2004, we estimate that the impact would be HUF 10 billion."
The analysts would expect a relatively low overall margin impact of any FX mortgage conversion or cap. Average HUF mortgage spreads have recovered to levels similar to FX mortgages, they noted.
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