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17 March 2015

Detoxication Through Law - The Orbán Government's Solution for the Mortgage Crisis

We live in an age of fierce global competition, owing in no small part to the permanent revolution of electronic communications. Today, news, ideas, images, even billions of dollars can be transferred from one continent to another at the speed of light, by a single click of a button or touch of the screen. The market for financial services is inundated by lucrative, highly sophisticated, and increasingly innovative products. Indeed, some of them are so complex that even the people selling them cannot always foretell how they will affect the markets.
Informationis overwhelming and scarce at the same time; at the very least, it is often hardly transparent. Ostensibly favourable conditions may turn out to be a decoy concealing a toxic product. And, as we know, certain toxins take a long time to get washed out of the system. The problem discussed in this essay first arose in 2006–2007, and we have not been able to address it in meaningful terms until now. The less transparent the market, the greater the responsibility of the state as the supreme body of public power to regulate it. This is certainly the approach embraced by the Fundamental Law of Hungary when it not only permits, but expressly requires the state to exercise this power and intervene in case of need. Furthermore, the Fundamental Law describes decent housing” for everyone as a goal that the state must “strive to ensure”.(1) Under these provisions, we in the government simply could not afford to risk the caving in of the mortgage market, which would undoubtedly have rendered huge numbers of families homeless.
Upon my appointment as Minister of Justice in June 2014, the Head of Government entrusted me with a mandate to help strengthen public trust and confidence in the administration of justice. Indeed, this is an ongoing challenge we face day by day, for trust is not something that can be won once and for all. Circumstances change, and an institutional system incapable of adapting to new scenarios will inevitably lose public trust. Moreover, a government should be expected not simply to adapt, but to proactively initiate change on its own discretion.
Reinforcing public trust in the rule of law is an all-important question of sheer survival. If people feel there are glitches in the operation of the rule of law, they will look elsewhere for solutions to crises afflicting society and the economy. If this came to pass, it would be a development far more severe than any loan crisis.
Perhaps not coincidentally, the bill I submitted to Parliament in my capacity as Minister of Justice became the first component of a bailout package for foreign currency or foreign-exchange (“forex”) loan holders.
The Government was faced with the challenge of coming up with a legislative solution for a problem more than a decade old, initially economic and legal in nature, but which over time swelled into a massive social predicament.
Let us look at how the problem arose in the first place. The first Orbán cabinet (1998–2002) treated new housing construction as a top priority. A President of the United States once described home ownership as part of the American Dream. Well, it certainly is part of the Hungarian Dream as well, part of everyone’s dream in fact. To help turn this dream into reality, a series of loan products subsidised by the state were made available to a wide range of eligible applicants. The stimulation of demand triggered a boom in the real estate market, and prices began to climb. As the home building sector of the construction industry had remained predominantly in Hungarian ownership, the gains were funnelled back into the domestic economy. The left-wing political opposition of the day attacked the scheme as socially callous, arguing that it benefited well-to-do families selectively, and pledged in its election campaign to introduce a needs- based system of housing subsidisation instead.
The Socialist Medgyessy cabinet, which took office in 2002, wasted no time in tightening subsidised loan conditions by lowering the ceiling of subsidised amounts and stipulating the demonstration of financial need as an eligibility condition. By so doing, the government put an end to the stimulation of the market, and spent the savings earned by effectively abolishing interest subsidisation on financing its own policy objectives, such as wage hikes for public servants. From this point on, long-term residential lending virtually came to a halt, and home seekers began to look for alternative solutions. This period saw the emergence of forex loans, i.e. various types of loans denominated in foreign currency. These contracts became ubiquitous between 2006 and 2008. Loans taken out in the latter year alone amounted to nearly HUF 2 000 billion (around 6.5 billion euros at today’s exchange rate), or nearly 7.5 per cent of the gross domestic product (GDP), while the forex indebtedness of households hovered around 14 per cent of the GDP. (The same ratio is a fraction of this figure in the Czech Republic and Slovakia, even Poland has a significantly lower rate than Hungary.(2) The vast majority of consumer forex loans were taken out in Swiss francs (80%), followed by euros (17%) and yen (3%). No less than 62 per cent of all loans signed in the household sector were denominated in a foreign currency.(3)
The loan plan owed its allure to the yawning gap between the interest rates on the Hungarian forint, kept high by the monetary policy of the day, and interests on loans denominated in foreign currencies. This gap, however, turned out to be a dangerous chasm – a risk almost exclusively shouldered by the debtors, without so much as a protective railing. And fall they did, as soon as the forint began to plummet in the wake of the financial crisis of 2008. The disaster was compounded by the simultaneous weakening of the euro, to 1.1 from around 1.65 to the Swiss franc in the mid-2000s. The Swiss franc became a currency in flight. As the cross rate continued to sink, the forint lost two-thirds of its value against the Helvetian currency, causing regular loan payments to rise dramatically, sometimes as high as double the original amount. In addition, the banks applied a bid-ask spread, accounting loan disbursements at the asking rate while accounting incoming payments at the bid rate of the foreign currency. The margin invariably augmented the earnings of the banks.
Who is responsible for the forex loan crisis, and in what way? Whatever the answer, the question of why the prime interest rate had to be kept at such a high level will no doubt remain contested for a long time to come. At the very least, the question seems certainly valid in light of the interest-rate reduction programme launched by the new management of the Hungarian National Bank (Magyar Nemzeti Bank, MNB), which took the helm in 2013. Nobody had foreseen the forint’s 54 per cent meltdown against the Swiss franc. Could anyone have been expected to? I cannot tell; I am a lawyer, not an economist. But anyone even remotely familiar with the history of Hungary and Europe during the last century will know how many generations shouldered the burden of war, financial crisis, hyperinflation, and the caving in of various currencies. Currencies greater than the forint did not hold their value forever. In the early 1960s, the American dollar was worth four German marks; just before the introduction of the euro (as scriptural money) in 1999, less than two. The lessons of history would have called for prudence and risk avoidance, but the MNB remained snugly indolent for too long, except for a single occasion when it spoke out on the hazard of loans denominated in yen. (The warning was issued in a joint Recommendation of the Governor of MNB and the Chairman of the Board of the Hungarian Financial Supervisory Authority on 15 February, 2008.) As it turned out, people with yen-based loans got the better end of the deal, because the forint never caved in against the Japanese currency, and their interest rates remained low.
The paradoxical nature of the situation is well illustrated by two phenomena. The introduction of forex loan transactions to the Hungarian financial services market was spearheaded by two Austrian-owned banks. After the European Central Bank (ECB) began to raise interestrates around 2006, consumer loans denominated in Swiss francs appeared in Austria as well except that the loan contracts there stipulated a ceiling, requiring the outstanding balance to be automatically converted to euro any time the Swiss currency appreciated by 10 to 15 per cent.(4)
Furthermore, the Austrian financial supervision, smelling unreasonable risk even with this proviso in place, effectively halted the sale of these loan plans. Meanwhile, the Hungarian subsidiaries of the Austrian bank groups in question had no reason to fear similar intervention from the Hungarian authorities during the tenure of the Socialist Governments.
It was not until the new Cabinet – the second centre-right Orbán Government – assumed power in 2010 that Hungarian authorities abandoned their passive stance. The government’s first move was placing a ban on forex loans, then it introduced early lump sum payoffs, followed by an exchange-rate ceiling.
The focus of my essay here, however, consists of the series of legislative measures adopted under the third Orbán cabinet and my own tenure as Minister of Justice. To begin, let us take the situation I inherited upon taking over Justice affairs from my predecessor.
Many were of the opinion that such a lopsided distribution of the exchange rate risk rendered forex loans an inherently flawed banking product, and thus created a basis for making the contracts void, at least in part. Indeed, large numbers of debtors decided to file suit, requesting the courts to rule to this effect. However, in its first resolution for legal uniformity in the matter of forex loans, adopted in 2013, the Curia (as Hungary’s Supreme Court is called as of 2012) deemed the exchange rate risk as a material part of the transactions, and did not, therefore, regard its devolution to the debtor as constituting an unfair condition in and of itself.(5) This resolution tied the hands of the government and the legislature by leaving intact – and untouchable – the most controversial ingredient of the loan plans in question.
It is plain to see, however, that the depreciation of the forint alone, no matter how dramatic, would not have caused calamity on this scale. The emerging situation was brought about at least in equal degree by the bank practice of securing the loans by a mortgage or similar title to the property purchased with the lent money, without really examining the debtors’ creditworthiness in any other meaningful way. In approving a loan, the bank officials evaluating the application seldom took into consideration the applicant’s actual ability to repay. The pertinent guidelines of responsible lending were only adopted later, in the form of industry codes of conduct and relevant legislation (in 2009 and 2010, respectively).
Then, as real estate prices in Hungary entered a downward spiral in the wake of the global economic crisis, the value of the collateral often dropped below the value of the loan amount tied to it. The steep rise of the unemployment rate after the crisis broke out had an equally drastic effect. Faced with the quandary of having to meet rising monthly payments from a plummeting income, many families became insolvent and saw their lifelong dream vanish into thin air.
The banks, too, were out of money, while the hardship of debtors was aggravated not only by the exchange rate loss but also, and perhaps even more severely, by the unilaterally imposed hike in interest rates, fees and costs. Initially, the added expenses seemed justifiable by the mounting costs of refinancing incurred by the banks, but this held true only for a few months. In face of the onslaught of recession, the European Central Bank then began to cut interest rates, and the associated indices, including the LIBOR,(6) embarked on a downward path in tow. At that point some of the banks made their big mistake, by deciding to raise their rates, fees and costs – unilaterally, irrespectively of their own refinancing costs, during the repayment term, and obviously to the detriment of debtors who were still making their payments at the time. It is also conceivable that they merely wanted to pass the increase of their operating costs on to the consumers. In short, the hike in many cases served only to boost the banks’ profits. A case in point is the Code of Conduct of the Hungarian Banking Association, which in 2009 still permitted the unilateral hike of rates, fees and costs, even if the goal was to cover an increase in the monthly rental of the bank’s headquarters building! Difficult as it may be to believe today, the executed contracts and laws in effect at the time did leave this loophole wide open.
The first time legislative restrictions were placed on the banks’ right to unilaterally amend contracts came about after the new Government took office in 2010. Then, certain specific conditions were stipulated for the exercise of this right.(7)
By the early 2010s, the volume and structure of consumer loans had reached the point where they threatened the stability of the bank system and indeed the entire economic and social order, as well as putting massive brakes on development. In the first half of 2013, the ratio of forex and forint loans in default stood at 23 per cent and 13 per cent, respectively. With an average case load of 160,000 civil suits launched per year, the domestic judicial system faced similarly extreme consequences. The number of contracts, including those contestable by litigation, is 600,000. In the worst (and admittedly absurd) case scenario, if pursued without exception, these claims alone would have supplied Hungary’s courts with a case load to keep them busy for fifty years.
And the consumers did not acquiesce; far from it. Instead, they launched an attack against the contracts on two fronts. One of them I have already mentioned: they filed suit requesting the courts to rule the unilateral exchange rate risk unfair. As we have seen, the Curia blocked this avenue of redress. The debtors, however, achieved a breakthrough on the other front when the Curia, in a resolution of legal uniformity adopted in June 2014,(8) declared the application of the bid-ask spread to have been unfair and advanced the admittedly rebuttable presumption that, in respect of a wide range of consumer loan contracts, the unilateral raise of rates, fees and costs was also unfair and consequently void. In the same breath, the Curia called on the legislature to find a way to settle the by then systemic problem.
It was not until this resolution of uniformity was passed that the Government had an opportunity to submit a bill to the National Assembly proposing a solution for the predicament of the forex debtors. The bill was drafted two weeks after I assumed office, and passed by the National Assembly at record speed on 4 July 2014.(9)The law enshrined the principles set forth in the Curia’s resolution of uniformity as norms binding for all consumer loans, regardless of their being denominated in foreign currency or in Hungarian forint. The purpose of the act was to preempt costly and time-intensive court proceedings en masse. It proclaimed the unfairness of the bid-ask spread as applied to consumer loan contracts, and required banks to settle accounts with their consumers. By articulating the rebuttable presumption about the unfairness of contract provisions that allowed unilateral amendments, it effectively reversed the burden of proof. It was thus no longer up to the consumer to demonstrate unfair conduct by the lender, but the banks had to prove that they had acted in fairness. This prompted a number of banks to go to court on their own, although only a few of the cases ended to date have been decided in their favour, and then only in part.
It is highly unusual indeed for a Government and a National Assembly to enact a law rectifying bona fide private contracts. Yet one must bear in mind that this was a measure of last resort, adopted with a view to solving a burning economic and social problem, and thus ultimately in the interest of legal certainty. From the point of view of trust in the rule of law, it is of the essence for the legal system to be able to effectively handle similar exigencies judged unfair on a social scale and arising from the dominant position of one of the parties to a specific type of transaction. In my ministerial exposé I cited Article M of the Fundamental Law: “Hungary shall ensure the conditions of fair economic competition” and “shall act against any abuse of a dominant position, and shall protect the rights of consumers”.(10)
It is important that three Metropolitan Judges of Budapest, acting in the first instance, petitioned the Constitutional Court to examine whether the provisions of this law did not violate the ban on legislating with retroactive effect, and whether the procedures followed by the courts were compatible with the criteria of fair trial. In a decision of 11 November 2014, the Constitutional Court ruled the law constitutional on both counts.
It follows from the nullity of the unilateral contract amendments that the consumers have been overcharged, and that the banks must account for the discrepancy. The rules of settling accounts in this regard are set forth in a second instalment of the legal package, adopted in September 2014,(11) which defines the manner, procedure and deadlines of the settlement, the notification of consumers thereof, and the consumers’ options of review and remedy. Furthermore, it orders the suspension of lawsuits in progress and forestalls all measures of foreclosure and mortgage call.
The Settlement Act obliges banks to notify their debtors between 1 March and 30 April of the amount they are to be repaid as of the settlement deadline of 1 February. Preliminary calculations estimate that the average forex debtor’s balance of principal will be reduced by some 25 per cent. This is expected to impose a total burden of about one thousand billion forints on the bank sector, and the same amount will remain with the households.
Putting a cap on unilateral contract amendments to the detriment of consumers, combined with the settlement of accounts and the overall phasing-out of forex loans, is a necessary but insufficient condition for us to close a chapter and open a new one. We must follow the work of weeding by planting new crop.
This work has been under taken by the Fair Bank Act,(12) the fourth instalment of the legal package, passed in November 2014. The gist and mission of this piece of legislation is to raise the level of consumer protection to European standards specifically in respect of the loan contracts, in accordance with the provisions of EU law. Although the previous government and National Assembly had accomplished the task of transposing the relevant Directive(s) in 2009, we perceived a need to further bolster the protection of loan consumers wherever permitted by the Directive. Here, we used Austria and Germany as models of reference. Why should we leave the Hungarian client of a Hungarian bank in a position more vulnerable than that of his Austrian or German counterparts? In drafting the bill, we took into consideration not just the law but the judicial practice of the aforementioned two countries.
Below are a few examples of the reforms introduced. In order to ensure parity between the parties, fees, costs and interest rates may no longer be unilaterally raised to the detriment of the debtor, except as allowed by law and subject to stringent rules and conditions. Interest periods of three years must be incorporated in the contract. Before the end of this period, the bank may not amend the contract to the detriment of the client, and even afterwards it is tied by strict conditions, in that it is not allowed to raise rates save for, and to the extent proportionate with, the purpose of offsetting any trend unfavourable to it in certain objective indices, such as in interest rate and premium changes. If, on the other hand, the climate of operating in the market improves, the principle of parity dictates that the bank will have not only the option but the express obligation to pass on the favourable trend by reducing its rates, fees, etc. In other words, the normative text permits increases and prescribes reductions if certain objective conditions prevail. Finally, even if the interest rate has been raised legitimately, the debtor will have the right to cancel the contract, go to another bank, etc., free of charge.
The German practice was also the one codified in business policies and general contract terms to be published by the Hungarian Banking Association, and to be adopted universally by its members. The goal was obviously to make each bank adhere to the same standardised general contract terms – in other words, to make business policies underpinning individual contracts transparent for the consumer and to enable individual contract offers to be compared with one another. Moreover, under the new rules, banks must provide their prospective clients with more in-depth information in advance. If a potential contract involves a mortgage, a draft must be made available to the consumer for consideration seven days before the scheduled execution date.
The fourth piece of the legislative package provides for the conversion of forex loans into Hungarian forints.(13) The conversion of residential loans denominated or actually maintained in foreign currency serves the interest of the entire society by eliminating the exchange rate risk hitherto shouldered by forex mortgage debtors unilaterally, and by improving the stability of the overall financial mediation system. In drafting the law, legislators followed the principle of least intervention while aiming to uphold contractual parity in a constitutionally acceptable form, and to ensure conversion at the market rate.
Beyond regulating the forint conversion of consumer loans, the law also provides for the initial interest rates applicable directly after conversion, and for other rules intended to protect the interests of the consumers whenever their contract is amended. The primary objective of the Conversion Act is to release future consumers from the unilateral risk inherent in fluctuating exchange rates by making it mandatory for banks to convert into forint the entire balance outstanding under a forex or forex-based loan contract in a manner set forth by law. Individual contracts will therefore be amended by force of law. The banks will be responsible for taking care of all tasks related to the amendment of the contracts and the notification of consumers, at no extra charge to their clients. The conversion obligation accrues to all mortgage loans maintained or denominated in a foreign currency, although it does not apply to car loans, the holders of which were consequently hit very hard by the dramatic appreciation of the Swiss franc in mid-January 2015.
Like other components of the package, the Conversion Act has elicited criticism from many corners. Some of its typical detractors argue that the measure should have been introduced much sooner to enable debtors to convert their outstanding balance at a more favourable exchange rate. We counter this argument by pointing out that we had to consider the load tolerance of the banking system and indeed the interests of national financial stability. Reckoning with a total repayable amount of one thousand billion forints, as already mentioned, the difference of each forint in the euro/forint exchange rate to the benefit of the debtors would have inflicted an extra expense of nine billion forints on the bank sector. The adverse fallout of such an extra burden would have been felt across the whole system, including clients who had never owed a penny to the banks. Also, the National Bank had to be ready and willing to supply the amount of foreign currency required for the conversion without depleting its reserves to an unsafe level.
The government’s intervention reaped an unexpected – and, in this form, hardly desired – reward on 15 January 2015, when the central bank of Switzerland abruptly lifted the exchange rate ceiling that had blocked the appreciation of the franc against the euro. In the span of a single day, the Swiss currency skyrocketed from 265 to 378 forints. Several major opinion-formers, including Bloomberg(14) and the Frankfurter Allgemeine,(15) praised the Hungarian government’s foresight which sheltered the country’s forex loan holders from yet another shock. Given that the mandatory conversion involved loans totalling 3,300 billion forints, or 12 billion dollars, the sudden leap of the Swiss franc would have added 700 billion forints to the total amount owed by Hungary’s households – a sum comprising two per cent of the GDP.(16)
I am proud that the Ministry of Justice had the opportunity to play a key role in solving one of the most severe social problems since the regime change, one which had been dragging on for eight years. Yet we would not have made it without dialogue and cooperation, without the input and support of the other competent ministries and the financial supervision of the National Bank. The courts stood firm; both the Curia and the Constitutional Court provided much- needed guidance. The National Bank contributed to the end result by using its leverage in monetary policy. The Banking Alliance proved to be a loyal partner in the negotiations. Last but not least, I owe a debt of gratitude to the forex loan holders themselves for their patience. By holding fast amidst grave hardship and never tiring from seeking justice from the courts, they ultimately confessed to the core values of the rule of law, even if they sometimes must have felt that the state and the legal system had failed to shield them from the emergence of an unfair situation. Trust is always easy to squander, and difficult to regain. I am confident that we took enough action in time not to have to rebuild that trust again from the ground up.
(Translated by Péter Lengyel)

1 The Fundamental Law of Hungary, Article XII, paragraph (1).
2 Gergő Tardos – Levente Pápai: A devizakitettség pénzügyi következményei” [Financial consequences of foreign exchange dependency]. In: Negyedszázados a magyar bankrendszer [The quarter-century of the Hungarian banking system], p. 68. Budapest: Magyar Bankszövetség, 2012.
3 Zoltán Nyeste – Zoltán Árokszállási: “Devizahitelezés Magyarországon – régiós makrogazdasági, fiskális és monetáris politikai megközelítésben” [Foreign exchange lending in Hungary – from the angle of regional macroeconomy, fiscal and monetary policy]. In: ibid, p. 150.
4 Cf. relevant rulings of the Austrian Supreme Court: No. OGH 2Ob22/12t – 24 January 2013, No. OGH 8Ob49/12g – 30 May 2012.
5 Resolution of Legal Uniformity No. 6/2013.
6 Short for “London Interbank Offered Rate”, LIBOR is an interest rate that an average bank is charged for loans sourced from the interbank credit market, as estimated by London banks.
7 Government Decree No. 275/2010 (15 December) on the Terms of the Unilateral Amendment of
Interest Rates Stipulated in Contracts.
8 Resolution of Legal Uniformity No. 2/2014.
9 Act XXXVIII of 2014 on the Resolution of the Curia Concerning the Uniformity of Law Regarding
Consumer Loan Agreements of Financial Institutions.
10 The Fundamental Law of Hungary, Article M, paragraphs (1)–(2).
11 Act XL of 2014 on the Rules of the Settlement of Accounts Provided for by Act XXXVIII of 2014 on the Resolution of the Curia Concerning the Uniformity of Law Regarding Consumer Loan Agreements of Financial Institutions, and on Certain Other Provisions.
12 Act LXXVIII of 2014 on the Amendment of Act CLXII on Consumer Loans and Certain Other Associated Acts of Parliament.
13 Act LXXVII of 2014 on Settling Certain Issues Related to the Conversion of the Currency of
Certain Consumer Loans and to the Rules Governing Interest Rates.
16The articles in the two publications also offer a regional comparison. Borrowers in Poland and Austria, who respectively owe USD 35 billion and 29 billion in Swiss franc mortgage loans, are now “experiencing headaches”, as Bloomberg’s analysts have put it. The FAZ adds that Hungary has the highest rate of Swiss franc debtors, holding 26 per cent of all private loans in the country. The ratio is 18 per cent in Austria, 14 in Poland, and 5 in Romania.

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