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Wealth Management Research

18 August 2011

Global risk watch

Could Hungary shake the Eurozone?
Swiss franc mortgages and consumer loans are a looming risk in
Eastern Europe, particularly in Hungary. Swiss franc appreciation has strongly increased the debt burden for borrowers and pressure on the banking sector has been rising recently.
Kilian Reber, analyst, UBS AG kilian.reber@ubs.com Claudia Sigl, analyst, UBS AG claudia.sigl@ubs.com

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Austrian and some German banks are heavily present in Hungary and are at risk from non-performing Swiss franc loans. Although not our base case scenario, continued Swiss franc strength could shake several Austrian banks and send ripples through the Eurozone, intensifying the Eurozone sovereign debt crisis. In such a scenario, a flight to safer assets, including to an even
stronger Swiss franc, would likely exacerbate the problem of CHFdenominated mortages in Hungary. Gold and US Treasuries would likely gain while Eurozone financials would stand to lose. Hungarian and Austrian assets would likely suffer the most. Swiss franc mortgages now a looming risk factor With Swiss mortgage rates much lower than local rates in Eastern Europe, many borrowers in the region took out long-term mortgages and consumer loans in Swiss francs. This occurred particularly in Hungary, where between 2004 and 2008, close to HUF 4tn of Swiss franc loans were taken out (Fig. 1), bringing the current stock to close to CHF 30bn. Today, they make up 60% of all mortgages and consumer loans in Hungary, as well as 16% of GDP. In Poland and Croatia they make up 10% of GDP. In Hungary, though, the situation is much more serious due to the recent foreign exchange (FX) movements: the forint depreciated by 60% most recently compared to the levels when most borrowers took out their CHF loans (also Fig. 1). The corresponding non-performing loan (NPL) ratio there stands above 10%, while being around 1.5% for Poland and 6% for Croatia. Risk remains with the banks Hungary, in order to ease households debt burden temporarily, recently introduced an FX fixing scheme to help troubled borrowers ease their debt burden. Under this scheme, the interest payments are made at a fixed CHFHUF exchange rate of 180. For the resulting gap between this fixed rate and the spot exchange rate, a bridging loan is issued by the bank, to be repaid after 2014.
Erratum: Fig. 1 'Hungary piling up CHF mortgages' in this report, published 18 August, and the referring text originally showed an incorrect value. We apologize for this error and have corrected it in this version.

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Fig. 1: Hungary piling up CHF mortgages Accumulation of new CHF mortgages and consumer loans (in HUF trn) and CHFHUF exchange rate rate
4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 05 06 07 08 09 10 11 CHF mortgages (HUF trn) (lhs)
Source: MNB, UBS WMR, as of 18 August 2011

260 240 220 200 180 160 140 120 CHFHUF (rhs)

Fig. 2: Austria and Germany going East Banking claims towards Eastern Europe (EUR bn)
350 300 250 200 150 100 50 0 Jun.05








Source: BIS, UBS WMR, as of 18 August 2011

This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 6. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

Global risk watch

This measure, however, merely shifts the debt burden from borrowers to the banking sector, as the latter continues to bear the risk of a potential further rise in non-performing-loans. Hungarys loan-to-deposit ratio already stands at a stretched 130% and the overall banking sector remains vulnerable (Fig. 3). Most recently, local Hungarian governments asked for a delay of the repayment of Swiss franc denominated principal sums, thus adding further pressure on the banking sector. Austrian and German banks in the thick of it Over the past decade, but particularly over the past five years, Eurozone banks expanded heavily into Eastern Europe as part of their growth strategy (Fig. 2 on previous page). Especially Austrian banks expanded aggressively into Hungary and to a lesser degree German banks. Today, according to data from the Bank for International Settlements, about 80% of Hungarys banking sector is owned by foreign banks, with Austria and Germany making up 27% and 21%, respectively. The majority of Hungary's Swiss franc mortgages and consumer loans was handed out by foreign banks from Austria; German banks accounted for a lesser amount. Assuming that a large portion of this currency exposure was not hedged, foreign, and particularly Austrian, banks are now at risk of a further rise in non-performing loans - a development that has already taken place (Fig. 4 for current state). Among the banks under coverage, Austrian banks have sizable exposure to Central and Eastern Europe (CEE) and particularly to Hungary. We see the largest links with Raiffeisen Bank International, the total exposure of which to Hungary amounts to EUR 8bn, together with Erste Bank, which has total CEE exposure of EUR 31bn and a large part thereof to Hungary. Unicredit's subsidiary Bank Austria is also strongly exposed to the CEE region, but only 4% is related to Hungary. Regarding German banks, the Bayerische Landesbank would likely be the most strongly affected through its 89.6%-owned subsidiary MKB (Magyar Kuelkereskedelmi Bank) which is also active in Hungary, and faces a weakening of asset quality. We see less pronounced linkages through Bawag PSK (Bank fuer Arbeit und Wirtschaft und Oesterreichische Postsparkasse); this bank's loan exposure in Hungary makes up a modest 15% of its total CEE loan portfolio, or EUR 234mn. High uncertainty for CHFHUF Market implied volatility in CHFHUF options suggests that the market sees a 66% percent chance that the exchange rate will be somewhere between 200 and 300 in six months (see Fig. 5). Markets lend only a very small probability that EURCHF would reach a value of 180 or lower. Within our base case (see below) of a mild appreciation of the forint versus the Swiss franc, we assume that the Swiss National Bank will eventually try to stabilize the franc versus the euro at a weaker level than at present, and also that the HUF will stay stable versus the euro. However, nothing is certain here and clever political strategies in Europe, Switzerland and Hungary are needed to ensure this form of stabilization. It thus seems justified to consider situations in which the coordination fails and the HUF depreciates further, since such a move could trigger a process of further political mistakes which would even accelerate the CHF versus the HUF. Thomas Flury, fx strategist

Fig. 3: NPLs in Hungary at elevated levels NPLs in CHF mortgages (HUF bn), various overdue dates
350 300 250 200 150 100 50 0 Mar.09


Sep.09 Dec.09 Mar.10 61-90 days


Sep.10 Dec.10 Mar.11 > 1 year

31-61 days

91-180 days

181-365 days

Source: MNB, UBS WMR, as of 18 August 2011

Fig. 4: Asset quality and capitalization levels of Austrian banks in EUR bn

50 45 40 35 30 25 20 15 10 5 0 Bawag RBI 2010 Q1 2011 Loans CEE NPL ratio (rs) Erste Bank Unicredit BA H1 2011 Q1 2011 o/w loans Hungary T1 ratio (rs) 12% 11% 10% 9% 8% 7% 6% 5% 4% 3%

Sources: EBA, Moody's, company data, UBS WMR

Fig. 5: Weaker CHF should contain damage Our CHFHUF base case expectation
320 310 300 290 280 270 260 250 240 230 220 210 200 190 180 08.10 Volatility Range


Forecast Volatility Range 02.11 08.11 02.12 08.12

Source: Reuters, UBS WMR, as of 18 August 2011

Wealth Management Research 18 August 2011

Global risk watch

Base case: weakening CHF should contain damage It is our base case assumption that a weakening Swiss franc should be able to contain the risk of a further sharp rise in non-performing loans in Hungary, and thus prevent additional stress on Eurozone banks (Fig. 4). At current strongly overvalued levels, we see the Swiss franc as likely to depreciate in the near future. A EURCHF exchange rate close to parity is not sustainable for the Swiss economy and leading indicators are indicating a slowdown of the economy while the Swiss National Bank has started to intervene in the currency market both verbally and factually. To be sure, the issue of non-performing loans is unlikely to disappear in Hungary anytime soon. We believe that the underlying problems within the banking sector are here to stay for the medium to long term. Nonetheless, a weaker Swiss franc should, in our view, make it possible to contain the damage for the Hungarian banking system and thus, also for foreign Eurozone banks, particularly those from Austria and Germany. Risk case: Hungary shaking the Eurozone Given the ongoing Eurozone debt crisis, coupled with an unstable US recovery, there is a fair chance that coming weeks or months will see a renewed flight to safe havens. This would include a renewed strengthening of the Swiss franc, thus putting the Hungarian banking system under further pressure as the government does not have sufficient funds to bail out its banking sector. Renewed Swiss franc strength over a number of months could impact local banks capitalization and liquidity substantially, since Tier-1 capital ratios could fall below the 8% stipulated by the Basel II accord. This would affect not only Hungarian banks but as shown above, likely also Austrian and to some extent German banks. While it is difficult to anticipate market reactions, we see a reasonable chance that markets would take such a contagion as further evidence of the deepening Eurozone crisis, with Eastern Europe now also a source of instability. Should Austria come under pressure, this would likely send shock waves through the Eurozone as a whole, since Austria is no mere domino, but has so far been perceived as a safer member of the Eurozone core. Such an event could induce a reassessment of Eurozone safety as a whole. This risk case scenario could materialize near-term (Figs. 6 and 7), depending on the CHFHUF exchange rate.

Fig. 6: Risk metrics: Hungary shaking Eurozone Limited longer-term impact, but high probability
Likelihood 4 3 2 1 Time horizon 0 Potential impact

International dimension

Explanation: The likelihood dimension represents the probability of occurrence. For a scenario to be considered, a minimum probability of 5% will typically be required, while any probability above 40% would bring the events out of the risk scenario and into baseline territory. Potential impact refers to the degree of diverse implications for financial markets. While a score of 1 would be associated with a stock market correction in the order of 10%, 4 would correspond to an extreme bear market such as the 2008 meltdown. The international dimension rates the degree of spillover across major world regions. Finally, the time horizon describes how imminent the risk scenario is over the two-year horizon we have chosen for these analyses.

Fig. 7: Risk assessment score

1 Likelihood Potential impact <10% Low 2 10 to 20% Medium 3 20 to 30% High 4 >30% Catastrophic Global <6 months

International SubTransRegional dimension regional regional Time horizon < 24 months <18 months < 12 months

Source: UBS WMR, as of 18 August 2011

Implications for markets under our risk scenario

Fixed income Most affected countries: First and foremost, Hungarian and Austrian banks would be hit most severely in our risk case scenario. We emphasize our cautious view on these bank bonds as we expected further rise in impaired loans. The manifestation of our risk case scenario would even strenghten our conviction. Assuming that Hungarian, but also Austrian and German banks most likely did not anticipate such extreme exchange rate developments of the forint versus the Swiss franc and, accordingly, are not hedged for a large part of the loan portfolio, the risks of non-performing loans rising strongly will likely not be manageable at the bank level, and would likely require a sovereign bail-out. This would also worsen the respective sovereign's public finances. While Hungary is already struggling to meet its deficit and debt targets and a bail-out would likely have to be supported by the IMF and the EU, in Aus-

Wealth Management Research 18 August 2011

Global risk watch

tria government-led banking support is likely, if required, but would also worsen the sovereign's balance sheets. However, we think Austria would not necessarily lose its AAA rating following such an event. Other Eurozone countries: In contrast to other Eurozone hotspots, a crisis of Austrian banks should raise investors awareness for widespread contagion risk from the periphery to core countries. We think even financial institutions with only limited direct links to our risk case could face deteriorating credit profiles, resulting from second-order effects of a potential sovereign default. Our risk case would most likely result in higher reluctance of bank to lend to each other in the interbank money market. As a consequence, Libor rates would increase. Consequently, banks would suffer from raising refinancing costs due to renewed disruptions in the European interbank market and a general rise in risk premiums, especially for weaker borrowers. In general, we maintain a cautious view on bank bonds and recommend preferring non-financial-corporates. In the short term fixed income assets would be affected by so called riskoff trades, meaning a shift from risky to safe haven assets. As a result, high yields corporate bonds and particularly government bonds of peripheral markets would be hit most. Overall, our risk scenario would intensify investors focus on the European sovereign debt crisis. Hence, pressure on government bonds of other AAArated countries such as France would increase, leading to higher interest rates in those countries. The only liquid safe haven market left within the Eurozone would be German Bunds, which would at least in the shortterm benefit. Other major government bonds outside the Eurozone (e.g. US treasuries, UK Gilts, Swiss confederations bonds) would benefit as well despite in the case of the US and the UK - facing similar debt related challenges as the Eurozone. Dirk Effenberger, strategist Equities An escalation of the situation in Hungary would send yet another negative signal to equity investors already troubled by a variety of risk factors. In an initial market reaction to this risk scenario, overall European equity markets would likely take a hit, since the scenario would be further evidence that the European economy and financial system are on unfirm ground and face severe risks. In particular, European financial stocks would suffer substantially in this scenario. At the same time, emerging European equities overall and emerging European financials would likely suffer the most. The broad, longer-term impact on equity markets of a sharp increase in non-performing loans and mortgages in Hungary will, however, likely be limited to emerging Europe as well as the European banks engaged in the region, which represents a relatively small portion of the total European equity market. Philipp Schoettler, strategist Commodities and currencies In an environment of renewed flight to safe havens triggered by a worsening of the situation in Hungary, gold is likely to spike temporarily. Accordingly, the euro would likely suffer in such an environment and weaken versus the US dollar as investors shied away from the euro again. However, as long as the Hungarian crisis did not trigger a global slowdown, we think the impact on other commodities would be rather limited. Giovanni Staunovo, analyst
Wealth Management Research 18 August 2011 4

Global risk watch

Potential impact on asset classes

Risk Factor Update Description, Latest developments triggers and outlook Eastern Europe The currently receding Swiss shaking the franc gives banks in Eastern Eurozone Europe, primarily those in Hungary, some breathing room. Probabilities: 0 - 10% Likelihood Current Previous Equities EMU EMU non-banks banks Impact Asset class impact if risk scenario materializes Fixed Income EMU EMU. US gov. USD core Periph.




Commodities Gold Others


10 - 20% 20 - 30%




30 - 40%

Impact direction: - expected drawdown (EDD); + expeced "draw-up" (EDU) n neutral; n.a. not available impact scale: '-' represents EDD < -10% for Equities, FX and commodities and ED < -5% for bonds - any additional '-' works as a multiplier. For '+' we use the same scale to the upside
Source: UBS WMR

Wealth Management Research 18 August 2011

Global risk watch

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Global risk watch

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Wealth Management Research 18 August 2011

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Wealth Management Research 18 August 2011