Shocked, shocked by the contracts they signed

Croatian daily Jutarnji List ran my column today on the Swiss franc judgement in Croatia, which revisited some of the points in an earlier blog. Here's the link to the Croatian version.

And here's the English:

An Expat in Zagreb

We’re shocked, shocked that exchange rates change

By Roger Malone

In the eyes of Judge Radovan Dobronić, Croatian borrowers tempted by the favorable interest rates on loans linked to Swiss francs have a lot in common with Capt. Louis Renault. In the classic film “Casablanca,” Renault is a habitual gambler at Rick’s Café, and, after being forced to shut down the casino, he declares as he gathers his chips, “I'm shocked, shocked to find that gambling is going on in here!”

Judge Dobronić said, in essence, that Croats who took these loans were so shocked that exchange rates change that the contracts they signed with the banks are invalid and must be rewritten retroactively on terms much more favorable for the borrowers.

Now, if the borrowers were Americans, I could also understand the shock. Americans can go all their life without touching a piece of foreign currency or crossing an international border. Many couldn't tell the difference between a Swiss franc and a frankfurter, much less understand the posted rates at a money exchange office. For most, the idea of borrowing in a foreign currency would be harder to comprehend than the seven cases of Croatian grammar.

But the borrowers weren't Americans. They were Croats. And I struggle to understand what vital piece of information was withheld from them by eight reputable international banks, which the ruling suggests somehow spontaneously began deceiving their customers in the same way at the same time on the same products.

Croats routinely cross international borders and exchange money, whether to buy a bookshelf at IKEA, ski down the Alps, or collect from foreigners who rent their holiday homes. Because so many big-ticket items are priced in euros, they watch the euro-kuna rate closely. Does anyone taking out a mortgage here really not understand that the Swiss franc is not the euro?

The court noted that the banks failed to tell borrowers about an ancient IMF opinion that the franc could strengthen if the euro were introduced. The IMF and everyone in the financial industry write mountains of reports, often contradictory and speculative, and the euro went into circulation more than a decade ago. Even assuming the banks expected a general strengthening of the franc, no one expected the 2008 global financial crisis, the European credit crisis and the chaos they would bring.

Not only did the crises lead to an exceptional strengthening of the Swiss franc, they had another impact on these loans. Tightening global credit made borrowing more expensive for everyone, including banks, and since these mortgages and loans were variable-rate instruments, the banks were within their rights to pass on the increased costs.

Borrowers took these loans because the interest rates were lower, not because it was exotic to have a Swiss-franc loan. And just as if they were buying a car that’s cheaper from one dealer than another, it’s partly their responsibility to understand why. The loans were cheaper because the borrowers were taking on two elements of risk, both quite clear in the terms of the loan. First, they were linked to a foreign currency, so there was the exchange rate risk, and next they were variable-rate loans, so interest rates could change based on a formula written into the contract. Where is the nontransparency that Judge Dobronić found so heinous that thousands of contracts were invalidated?

No one expects the worst case scenario or the black swan. If it arrives, it’s only natural to look for a culprit. But I struggle to understand in this case what these eight banks did wrong in selling what at the time was seen as a legal financial instrument. (And if these loans were carried on the banks’ books in Swiss francs, they wouldn’t have even profited from the situation.)

Many, many people were hurt by the global financial crisis. I sympathize with the borrowers who took out loans linked to Swiss francs. They were squeezed from both sides during the crises. They are totally justified in throwing the dice and suing the banks. But the ruling itself is hard to comprehend, which is a fundamental problem.

While court cases must be decided on individual merits, before Croatia celebrates this great victory for the consumer, it should consider the broader implications of the decision. By legitimizing the riddle, “When is a contract not a contract,” the court sends a chilling effect on international investment as the country is trying to battle its way out of economic doldrums.

Even before the ruling, foreign companies bemoaned the uncertainties of coming to Croatia. Million-dollar projects that seemed on a clear path could suddenly face additional fees or even public referenda. Returns on investment can be delayed by populist protests. The rules of the road can be ambiguous. And while Croatia’s EU entry helped remove some of that uncertainty, the court’s ruling is a stark reminder that things—including contracts—aren’t always what they seem in this country.

Croatia’s financial system could be weakened, if not hobbled, by the immediate impact of the ruling. By invalidating these loan contracts, the court increased the risk financial institutions face in doing business in Croatia. Some banks might think twice about coming here, new instruments may not be offered, and the products that are available could be slightly more expensive to cover the higher risk. A healthy financial system is a prerequisite for economic success. Consumers—as well as banks—must be responsible for their own decisions.

Judge Dobronić’s ruling will certainly be appealed. If the higher court continues to find that the banks were at fault, based on the merits of the case, it must be compelled to answer how exactly borrowers were mislead, what reasonable and available information was withheld, and how eight banks spontaneously and simultaneously made the same mistake.

 [Follow Roger Malone on twitter at @ExpatinZagreb or at http://expatinzagreb.blogspot.com/]

How to hobble a banking system

The good news, I guess, from today's court ruling in Croatia on mortgages and other loans linked to the Swiss franc is that there is a word for "consumer protection" in Croatian. That should come as a relief to domestic and foreign property buyers alike.

Beyond that, though, there's not much good here.

In a nutshell, the court ruled that is was unacceptable for eight banks to sell variable-rate loans linked to the Swiss franc in Croatia. Most of these loans were mortgages, and as the franc strengthened in the wake of the 2008 global economic crisis and the EU credit crisis, the principal and contractual payments in kuna terms ballooned excrutiatingly. Interest rates also rose as global credit tightened. The eight international banks that offered these loans were nontransparent, the court said, and the borrowers paid the price.

The ruling and logic trouble me on many levels. To start, if the loans were unacceptable on their face--two variable elements, the principal (in kunas) and the interest rate--why did the Central Bank allow them in the first place? One of the fundamental tasks of the Central Bank is to supervise the banking system, and it was no secret that these loans were being offered. It seems nothing at the time triggered any red flags.

More fundamental to the ruling, I struggle to understand what information was hidden from borrowers. That exchange rates move around? Croatia is not like the US where people can live their whole lives and not touch another country's currency. Domestically, the kuna-euro exchange rate is watched closely because most big-purchase items was negotiated in euros, although kunas eventually change hands. Croats are accustomed to crossing national borders and exchanging money, even if it's just to IKEA to buy some bookshelves.

Or was it that the interest rates were variable? These were variable-rate loans. I would be astonished if the mortgage contracts didn't explain what would trigger a change in interest rates. In contracts I've seen--though admittedly outside Croatia--the rate is usually tied to a specific, publicly available rate outside the control of the individual bank, like a country's prime lending rate. If the contracts for the Swiss-franc loans said the banks would change the rates "whenever we darn well please," maybe there's a case. The defense would be that whoever signed such a loan should be deemed unfit to enter a legally binding contract.

Or maybe the borrowers weren't informed that a huge, global economic crisis was on the way and that a handful of European states would teeter on bankruptcy? That's a tough one. Even if the banks forecast a general strengthening of the Swiss franc against the euro, no one expected the magnitude or the longevity of the global crisis. I was hurt by it; you were hurt by it. We have to live with that.

So what vital information was withheld?

Borrowers took these loans because they had lower interest rates than other loans on the market. If they were buying a boat from one dealer that was cheaper than the same boat from another dealer, they would wonder why. The "why" on these loans was because the borrowers were taking on the risk of exchange rate fluctuations and changing credit costs (even if they didn't think about it in such terms), and they discovered risk can be expensive. It's like deciding whether to buy an extended warranty on an appliance: it's cheaper if you assume the risk of your fridge breaking down yourself.

Finally, the ruling implies the eight international banks of sound reputation spontaneously (or worse) decided to mislead their customers in the same way on the same products at the same time. That seems a little far-fetched to me.

I sympathize with anyone hurt by the global and European crises, which is most of us to some degree. But while some bank practices (particularly in the US) can be blamed for the meltdown, I fail to see what the banks did wrong in this case. And if these loans were carried on their books in Swiss francs, they wouldn't have even profited from the situation.

Court decisions should be based on the facts of an individual case and not on its wider consequences, but the broader implications of this ruling should be considered before the country celebrates too strenuously. The ruling could hobble Croatia's banking system and its attempts to restart its economy. Credit is the foundation for commercial and individual investment, and the spectre that a loan that's good today being changed dramatically by some future court is likely to dampen the willingness of banks to loan here. Banks without a presence here will think carefully about expanding into Croatia. And if a lack of transparency is the problem, the solution isn't posing the riddle: When is a contract not a contract?