ECU IN THE MEDIA
Could it be Magic?
Cormac Naughten examines how advisers could help their clients' mortgages disappear by switching between major currencies
- A number of financially sophisticated borrowers have placed their mortgages into a currency debt management programme whereby their mortgage is switched between the world's major currencies. The debt manager's objective is to manage the loan down.
- A multi-currency lending facility is arranged for the client with a private bank, and this facility is managed on a discretionary basis. The manager uses the world's largest financial market - foreign exchange (FX) - to manage the mortgage.
- The modern multi-currency lending facility is a highly sophisticated product offering a proven means of reducing the debt burden and creating considerable additional wealth for the borrower.
A Managed Approach
Since the late 1980s a number of financially sophisticated borrowers have placed their mortgages into a currency debt management programme whereby their mortgage is switched between the world's major currencies. The debt manager's objective is to manage the loan down, Justas an asset manager seeks to manage an investment up in value.
The logic certainly seems irrefutable. If you manage your assets, it seems illogical to ignore you liabilities, akin to locking your front door and leaving the back door open.
So, how does it work? A multi-currency lending facility is arranged for the client with a private bank, and this facility is managed on a discretionary basis. Usually the manager is able to arrange the facility without charge. All loans are interest-only. The manager uses the world's largest financial market - foreign exchange (FX) - to manage the mortgage. Some $1.2 trillion is traded daily in FX - a volume which dwarfs that of equity bond markets combined. The manager switches the mortgage between currencies with the objective of achieving a reduction in the size of the loan and interest rate savings over time.
After each switch the client is notified in which currency or currencies their mortgage is denominated, the exchange of their loan.
It sounds simple. Why then aren't there more advisers in tune with today's multi-currency lending products? Traditionally advisers have been deterred for three main reasons:
Who to go to?
A currency mortgage is not a retail lending product available from the high street. It is a wealth management tool available only from a select group of private banks that do not generally advertise this service. Hence finding out where to go an be frustrating.
Too risky?
Many advisers have memories of client suffering with currency mortgages in the past. In the late '80's and early '90s, there were a number of mortgage brokers selling single currency loans, predominantly in Japanese yen or Swiss francs as they seemed to offer a low interest rate compared to double-digit rates in the UK.
These were term loans without the ability to switch in and out of the foreign currency as and when conditions demanded such action.
Many borrowers also had little or no understanding of the exchange rate risks they faced. Unfortunately, some saw the pound weaken considerably against other currencies causing their borrowing to increase dramatically in size- £1 million borrowed in yen in 1980 would become £4.5 million by 1995.
Regulatory issues
Bearing in mind the two points above, it is hardly surprising many advisers became unwilling to take on the additional compliance responsibilities required of them when advising clients on a complex product with which they had little familiarity.
Client benefits
In contrast, the modern multi-currency lending facility is a highly sophisticated product offering a proven means of reducing the debt burden and creating considerable additional wealth for the borrower. Put simply, the three main benefits for the client are:
Reduction in the capital value of the loan
For example, if a £100,000 loan is moved into yen at a rate of 150 yen to the pound, the loan is now a 15 million yen loan. If the pound strengthens against a weakening yen to, say, 180 yen to the pound and the loan is then converted back to sterling at this rate, the loan has been reduced to £83,333.
Over the last five years one UK currency mortgage manager has been able to reduce client loans by nearly 3o per cent through such switches.
For UK borrowers there are considerable interest rate savings to be derived from currency borrowing - even with UK interest rates at their recent low levels
Over the last 20 years the cost of servicing loans denominated in most of the world's major currencies has been 40 - 75 percent lower than that applicable to sterling loans. The cumulative effect of building up the interest rate savings can be considerable.
Tax efficiency
For an individual borrowing against their main residence, neither the interest rate savings nor the capital reduction of their mortgage are currently liable to capital gains tax.
Advisor benefits
For clients of one UK currency mortgage manager, the benefits of their programme are now large enough to fully pay off loans taken out in the late 1980s. This performance has allowed clients to use the proceeds of endowment policies or repayment vehicles, designed to pay off the loan, in any way they wish.
Presented with the opportunity to do what they want with the proceeds of their repayment vehicles, most clients seek to invest some through their financial adviser.
Currency mortgage managers explain the product to prospective clients and screen them for suitability. This removes the compliance risk from the adviser as well as the anxiety of explaining an unfamiliar and complex product. Currency mortgages will require additional life insurance cover of 120 per cent of the value of the loan.
Currency debt management performance is not correlated to other major asset classes
It therefore provides an alternative wealth management option for advisers and their clients that can generate significant returns even in an equity or property bear market.
Last year, the UK's largest currency mortgage manager reduced its clients' loans by nearly 11 per cent. Add to this the interest rate savings and clients on such a programme benefited by over 13 per cent. In contrast, many UK asset managers reduced their clients' portfolios by more than double in the same period.
Immediate and ongoing revenue
Most currency mortgage managers pay generous procuration fees of up to 0.25 per cent of the value of the mortgage introduced. They also pay advisers a trailing percentage of the annual management fees they receive once certain thresholds have been reached for volumes of business introduced. If the benefits to both clients and advisers are so considerable, what stops advisers directing most of their clients towards currency mortgages?
Client suitability
Borrowing in currencies carries a higher risk than conventional sterling mortgages. As a result, currency mortgages will not be suitable for all clients. An acid test for advisers is if clients are unwilling or unable to withstand a potential 15 - 20 per cent permanent increase in the size of the load and the associated servicing costs, they should avoid the product.
Clients are also expected to meet rigorous financial criteria. As well as a minimum income of £75,000 and low income multiples (2.5 to 3) they are expected to be financially sophisticated as currencies can fluctuate wildly.
Risk management
There are a number of measures taken to manage the risk inherent in currency borrowing. Before a client takes out a currency loan they will agree a conversion limit with the lending bank. Conversion limits are typically set 15 - 25 per cent higher than the starting balance of the loan. If the sterling equivalent of the loan rises to that limit, the bank reserves the right to convert the loan back to sterling. Trading systems have been developed in conjunction with the lending banks that allow the manager to adopt a range of 24 - hour risk management tools for entering and exiting currency positions.
Far from being able to wave a magic wand and watch their mortgages disappear, currency borrowers must face significant risks. But for those prepared to do so, the benefits can be considerable. For the conscientious adviser, the key to these benefits lies in finding the right manager for their clients. The two most important qualifications are a long-term track record and the quality of the foreign exchange professionals involved in the managing firm. Failure to heed this advice could mean a painful experience for client and adviser.
Cormac Naughten is head of sales and marketing at The ECU Group plc ("ECU")
