ECU IN THE MEDIA
Professional Adviser - November 2002
Financial alchemy
Financial alchemy
The ECU Group's Cormac Naughten considers managed currency borrowing - a way for clients' to pay off their mortgages years early, saving thousands of pounds in interest.
Over the last years an increasing number of financially sophisticated borrowers have been doing something similar- changing their mortgage from one currency to another until it too disappears. The logic certainly seems irrefutable. If you manage your assets then it seems illogical to ignore your liabilities, akin to locking your front door and leaving the back door wide open.
But to many, the idea seems incredible, more financial alchemy than financial management. That somehow you can reduce your mortgage to zero without paying any more than with a normal interest-only mortgage offends those who believe you don't get something for nothing. If it is so good, they say, then why isn't everyone doing it?
Many people did get involved in currency borrowing in the late 1980s and early 1990s - some with disastrous consequences. The preferred vehicles for many were single-currency loans in either Japanese yen of Swiss francs, as they seemed to offer a low interest rate compared to double-digit rates in the UK.
Unfortunately, these borrowers saw the pound weaken considerably against other currencies causing the sterling equivalent of their borrowing to increase dramatically. For example, a million pounds borrowed in yen in 1980 would have become four-and-a-half million pounds by 1995.
Many of theses borrowers had little or no understanding of the exchange rate risks that they faced. Others fared little better by hiring managers to manage loans that allowed them to swap from one currency to another. Sterling's withdrawal from the exchange rate mechanism (ERM) in 1992 led to the demise of all but a handful of these managers, as their clients' loans increased substantially. Knowing this why would anyone in their right mind seek to take out a currency loan?
Put simply, it is because the three main benefits are so significant. Firstly a reduction in the capital value of the loan. For example, if a £100,000 loan is switched into yen at a rate of 150 yen to the pound the loan becomes a 15m yen loan. If the pound then strengthens against a weakening yen to 180 yen to the pound and the loan is converted back to sterling at this rate it is reduced to £83,333.
Secondly, for UK borrowers there are considerable interest rate savings to be derived form borrowing in foreign currencies, 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 less than it would have been in sterling. In some currencies that cost of borrowing has been 40 - 75pc lower than that applicable to sterling loans.
Thirdly, for UK borrowers the product has been highly tax efficient. For an individual borrowing against their main residence, both the interest rate savings and the capital reduction of their mortgage have not been liable to capital gains tax.
A currency mortgage is not a retail lending product available from the high street. It is a wealth management tool available only form a select group of private banks. Clients are expected to meet rigorous entry criteria, In addition to a minimum income of £75,000, relatively low income multiples (2.5 to three times) and loan-to-values (65pc or less) they are expected to be financially sophisticated and to have an appetite for risk. Currencies can fluctuate wildly and clients must have the temperament to deal with this.
The approac of today's leading players in multi-currency debt management mirrors that of the leading fund management groups. It blends technical and fundamental analysis, underpinned by market intelligence and experience provided by investment committees comprised for some of the industry's most highly acclaimed economists and analysts.
There are a number of measures taken by modern managers and lenders to manage the risks 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 - 20 pc higher than the starting balance of the loan. If the sterling equivalent of the client's loan then rises to that predefined limit, the bank reserves the right to convert the loan back to sterling.
Over the last 14 years, ECU has developed trading systems in conjunction with the lending banks that allow the manager the flexibility to adopt a range of 24-hour risk management tools for entering and exiting currency positions. Despite this, prospective clients are advised that they must be willing and able to withstand an increase of at least 20pc in the sterling equivalent of their loan.
Far from getting something for nothing, currency borrowers must face significant risks. But for those that are prepared to do so the benefits can be considerable. For example, clients who joined ECU's managed currency mortgage programme in the late 1980s are now able to pay off in full all loans taken out then without having paid any more than they would have paid with a conventional sterling interest only loan. Alchemy indeed!
Cormac Naughten is head of Private Client Division at The ECU Group.
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