Creating an Asset out of a Liability - Multi-Currency Mortgages
In an age where investors are spending increasing amounts of time managing their investments, it is perhaps strange that the management of 
liabilities is an area that remains frequently overlooked.
A pound is a pound whether it has a plus or minus sign in front of it and so it should be professionally and skilfully managed whether it is an investment or a debt.
The objectives of multi-currency debt management programmes are:
• To reduce the size of your debt by borrowing in currencies which fall in value against sterling; and
• To reduce the cost of servicing debt by borrowing in currencies which have a lower interest rate than sterling.
The foreign exchange market is the world’s largest and most transparent financial market. Some US $1.9 trillion is traded daily in this highly liquid, 24 hour market – a volume that often dwarfs that of the global stock and bond markets combined. As such, foreign exchange has traditionally been the area that has offered major banks and financial institutions their greatest source of revenue. It has also tended to exclude most non-institutional investors except those prepared to engage in high risk margined trading. The potential of this dynamic market can provide a means of profiting from the management of debt. For UK clients the combined benefits of debt reduction and cumulative interest savings since 1988 are now large enough not only to fully pay off any loans taken out in 1988 but also to have generated a considerable cash surplus.
Clearly, any product that demonstrates a proven ability to turn a liability into an asset should be taken seriously.
Borrowing in Foreign Currencies
The Basics
Historically, UK borrowers have been subject to some of the highest interest rates of any of the major world economies. Borrowing in foreign currencies with interest rates which are lower than those applicable to sterling, is therefore an attractive proposition, offering the possibility of sizeable reductions in both monthly interest payments and the capital sum borrowed.
Interest Savings: There are significant variations in the interest rates applicable to loans denominated in different world currencies. For instance, over the past twenty years, the costs of servicing loans denominated in Swiss francs and Japanese yen have been some 40% to 75% lower than those applicable to loans in sterling. The cash flow benefits of compounding such savings over two decades will be readily apparent to any corporation or individual.
Example: Assume the inter-bank cost of funds stands at 5% in sterling and 0.25% in Japanese yen. While the monthly interest cost on a traditional sterling loan of £1 million would be £5,208.33, the monthly interest cost on a loan denominated in Japanese yen for the same amount would only be £1,250 (allowing for a 1.25% bank margin).
Capital Reduction of Debt: Debt reduction may also be considerable if the loan is denominated in currencies which then depreciate against sterling. All major currencies have fluctuated against one another over the years, thereby generating opportunities for debt reduction.
The Reality
Whilst it is tempting to look only at the cash flow benefit of borrowing in a low interest rate currency this should not be the primary consideration when assessing the suitability of a foreign currency loan facility. Instead the focus should be upon the effects of fluctuations in the exchange rate, as these directly affect the size of the borrower’s outstanding loan.
The sterling equivalent of a foreign currency loan will increase or decrease according to the exchange rate of that currency against sterling. If the chosen currency weakens against the pound, the sterling value of your loan will be reduced. If the currency strengthens against the pound, then the sterling equivalent of your loan will increase. There is therefore, considerable potential for either profit or loss at the time of redemption of a foreign currency loan.
Example: Assume a £1 million loan is taken out in Japanese yen and that the exchange rate a the time of borrowing is 270 yen to the pound. The £1 million loan will equal 270 million yen. If the yen then strengthens against sterling and, five years later, stands at 13 to the pound – although the lower interest in Japan would have produced substantial interest rate savings – the sterling value of the loan would have doubled to £2 million.
Interest rate savings aside, the value of your collateral (whether a property or a portfolio of investments) would have had to have also grown by at least that amount for you to be able to redeem your loan without suffering a net erosion in you wealth.
Single Currency Loans
The perils of single foreign currency loans
In recent years, many borrowers who adopted a “single” foreign currency loan, without the ability to switch into other currencies, have experience a sizeable increase in their debt. In the nineteen eighties and nineties, this fate befell many UK borrowers who looked to escape double digit interest rates by taking out “low cost” foreign currency loans without adequately considering the exchange rate risks.
Many such borrowers suffered heavy losses caused by the weakening of sterling against other currencies. This was particularly apparent during sterling’s withdrawal from the Exchange Rate Mechanism in 1992, an there are even more dramatic examples:
Example: A borrower who took out a Japanese yen loan equivalent to £1 million in 1980 would find himself fifteen years later in the alarming position of having an outstanding loan of some £4.3 million – over four and a quarter times the original amount. Clearly, the aggregate interest rate savings over the same time period pale into insignificance with such a dramatic increase in the sterling equivalent of the loan.
Such events clearly demonstrate the dangers of being locking into inflexible lending arrangements. It is our opinion that single foreign currency loans are only justifiable if the borrower has a source of income or capital in the same foreign currency. Even in this context one must consider the implication of adverse fluctuations during the term of the loan if the bank’s security is valued in sterling (i.e. a UK property).
Hedging
In general, it is unwise to create a market risk exposure only then to seek to eliminate all or part of the potential gain by “hedging” it. If the risks inherent in a currency loan are unacceptable, one should either reduce the exposure to an acceptable level, or not enter into a foreign currency loan facility.
Hedging is generally used by those who feel that they are exposed to unacceptable risks and have therefore decided to pay a premium to eliminate or control that risk.
This is readily understandable in the case of importers who pay for their imports in a currency other than their own. After all, between the dates when they strike their deals and the payments dates, the importers are exposed to the risk that their own currencies may fall in value against the currencies in which their payments are due. As they are importers, not currency traders, they may prefer to pay a premium and hedge this risk in order to protect their profit margin rather than risk losing it to adverse currency fluctuations.
In general, we do not feel that most hedging techniques available for limiting foreign exchange exposure are either appropriate or keenly priced enough for the amounts and periods relevant to most individual foreign currency borrowers.
In practice, it is not possible to fully hedge out the risk of borrowing in a low interest rate currency for less than the amount of interest saved. On top of this there are dealing costs. The combined cost of a total hedge will therefore exceed any interest rate saving.
Multi-Currency Loans
Flexibility is Key
It is important to remember that world events can quickly alter the outlook for any currency. What may seem a perfectly appropriate strategy one minute may not be the next.
The invasion of Kuwait, sterling’s withdrawal from the ERM, the Asian crisis and the destruction of the twin towers of New York’s World Trade Centre have all caused major dislocations in the currency markets.
It is imperative, therefore, that one obtains a loan facility that offers that flexibility of denominating the loan in a range of currencies and the freedom to switch between them, as and when deemed appropriate.
After more than a decade of refinement – hand in hand with the evolution of technological systems – we recommend one of the most versatile multi-currency lending products in the international banking arena. This has been developed in conjunction with major banks that are fully committed to the development of the programme and appreciate the need for flexibility.
These facilities now afford borrowers the opportunity of using the world’s largest financial market to their advantage without the considerable time and expense of refinancing their loans regularly from one banks product to another. The result is a significant development in the range of wealth management tools available to private banking clients.
Main Features
A multi currency loan offers borrowers the flexibility of denominating their loans in the currencies of their choice. Naturally, the interest rates payable will reflect those applicable to the currencies chosen.
Currency loan facilities are typically offered on a five-year interest only basis. Some may extend up to twenty years and beyond with an endowment policy, pension plan, ISA or any other acceptable repayment vehicle in place to pay off the loan at maturity. Should the loan be reduced as a result of successful management, his would leave a greater cash surplus from the policy proceeds than would otherwise have the case.
It may be a requirement of a lending bank offering a currency mortgage that life insurance cover for the term of the loan be put in place at around 120% of the loan. This is to allow for the possibility of adverse exchange rate movements increasing the size of the loan.
Interest is charged at the inter-bank rate applicable to the chosen currencies plus the banks margin of typically between 1.25% and 2%. The widely adopted benchmark for the cost of funds to banks in foreign currencies is the London Inter-Bank Offered rate (“LIBOR”), details of which can be found in the Financial Times on a daily basis.
Multi-currency loan facilities are usually extended against investment portfolios and/or residential property. Prime commercial property may also be considered by some banks. Full details of banks’ current lending criteria may be obtained, upon request.
We are also involved in Corporate and Institutional debt on terms that are tailored to the Corporate or Institutional borrower.
The Need for Professional Management
Balancing risk against reward
No lending bank will tolerate too great an increase in the sterling equivalent value of a multi-currency loan resulting from adverse currency moves and may opt to convert the loan back into sterling at a predetermined level. This would leave the borrower paying UK interest rates on a larger debt. Foreign currency loans would not, therefore, be considered by anyone who is unable to afford the financial implication of a permanent increase in their loan and the resultant higher sterling interest rate payments.
Within the terms of a multi-currency loan facility, banks typically allow for an increase of at least 15% in the sterling equivalent of the loan. Notwithstanding the ability to stop the currency loan programme at any given point, it is our belief that anyone considering a multi-currency loan facility should be able to withstand at least a 20% capital increase in the value of their loan without breaching any predetermined conversion limits imposed by their lending bank. Clearly, this product is unsuitable for those with borrowings that are already highly leveraged against their assets.
Whilst the interest savings that one can generate from borrowing in some foreign currencies are indeed significant, such savings should not be treated as disposable income. It is strongly recommended that these savings be reinvested, with the aim of producing a growing capital base, from which funds could be used to counteract any unwelcome increase in the size of the loan or to pay off the entire loan earlier than planned. In our opinion foreign currency loans are unsuitable for those who are merely looking for a reduction in monthly interest rate payments.
Bridging the gap between borrowers’ needs and their capabilities
It must be pointed out that achieving interest rate savings and debt reductions and, more importantly, maintaining them over the term of a loan is much more complex than any simplified example may suggest.
For most private individuals, the reality of trading the many available currencies coupled with the need for extensive analysis and monitoring has meant that controlling foreign exchange risk extends beyond the scope of their resources.
To ensure that interest rate differentials and exchange rates can be used to the borrower’s best advantage, a professional currency management company is strongly recommended. Indeed many lending banks will not extend a multi-currency loan facility unless an approved currency management company has been engaged.
A currency debt manager’s role is to seek to maintain debt in currencies that are expected to weaken against (or at least, remain stable against) sterling, whilst achieving an interest rate advantage. Given sterling’s long-term propensity for weakness, this is not a simple task.
The Multi-Currency Debt Management Programme
Client reporting
Reconciliations of all currency loan balances with the lending banks will be on a regular basis so that the switching process is effected efficiently and swiftly for all of the parties concerned.
Whenever a switch is effected clients are informed of all relevant switch details together with the current balance of their loans in terms of their reference currency and the applicable interest rate data.
Tax Issues
The tax treatment given to our debt management programme will differ according to the country in which our clients reside for tax purposes. There are also different tax regimes for private individuals, corporate clients, trusts or institutions.
Under current UK legislation we are advised that the Inland Revenue does not regard reductions in the sterling equivalent of a mortgage (as opposed to gains on assets) to be liable to Capital Gains tax, if such gains are made by individuals in the context of borrowings secured on their main residence.
However, clients should obtain independent advice on their individual tax position from their tax adviser.
Lending Criteria
From 1st November 2004, arranging and/or advising upon some mortgages became a regulated activity in the UK.
Borrowing terms vary from one lender to another. However it is usually possible for us to arrange funding for our currency debt management programme subject to the following criteria:
• Minimum loan size of £250,000
• Residential property, although some commercial property may be considered
• Debt/Equity ratio must not exceed 65% of the value of your property.
• Income multiple of three times the principal earner’s income or 2.5 times joint incomes (in the case of joint applicants), subject to a minimum principal earner’s income of £100,000
• You must be able – and prepared – to tolerate sizeable adverse foreign currency movements
• Terms are up to 20 years
• All loans are interest only
• The bank’s spread over the London Inter-Bank Offered Rate (“LIBOR”) is typically between 1.25% and 2%
Suitability and Eligibility
Clearly, multi-currency debt management is not suitable for everyone. It is important that you do not enter into such an arrangement without fully appreciating and accepting all the associated risks and implications.
Multi-currency debt management is suitable only for those who can afford to absorb comfortably the possibility of an increase in the size of their loan.
Unlike many other investment products where a firm can tailor the risk profile to the individual investor, our management style is fixed and clients must have the financial resources and temperament to tolerate the risks associated with it.
For those who are able to afford to take this risk and have the temperament to accept potential losses, then the potential gains in terms of cash flow and debt reduction over time can be substantial. However, before committing themselves, potential clients should discuss all the implications with their financial adviser.
We will use our experience to assist potential clients in determining their suitability.
For further information regarding multi-currency loans, the management thereof or any other services provided please contact us.
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Your home may be repossessed if you do not keep up repayments on your mortgage. The Financial Services Authority does not regulate foreign currency mortgages. Changes in exchange rate may increase the sterling equivalent of your debt.