by Peter Crowley FIA BSc MEWI
Managing Director, Windsor Actuarial Consultants Interest rate swap misselling, a topic which has taken up many hours of Court and House of Commons time, is, in essence, simple. A bank misleads its borrowing client into buying what the bank maintains ishedging, but what the bank knows is the opposite. Then, when the extra risks crystallise, the bank pretends it is the borrowers fault – the dodgy swap impairs his ability to refinance elsewhere - and he gets plundered or destroyed by the bank. Regulators were either too ignorant or too conflicted to do anything about it.
The process is as follows. Imagine you are a property developer, and want to develop a new site. You need £5 million for the project. You might borrow this on an overdraft basis, but you would be imprudent to do so. The documentation would be likely to say that the bank could call the funds back at 28 days’ notice, say. However nice the bank manager was to you, there could come a day when you might offend him, his boss might not like you, or Head Office (or the Bank of England) had decided too much had been lent in that sector – and it needed to be clawed back. If you were eighteen months into your project, without any current liquidity – tough. You might be bankrupted over a very short space of time – especially if refinancing deals had dried up.
One solution to this is to bank with more than one bank – this might solve the “I don’t like your tie – pay us back” syndrome. However, in a financial crisis, banks might well all behave the same. As crises do happen – despite the much-vaunted “end to boom or bust” – the solution is to secure the funds for a defined term – say five or ten years. That way, the bank can’t just ask for the money back, for whatever reason.
Of course, there are snags. As the bank is locking into you, you may have to pay a higher interest rate. Fair enough, if it avoids the “give it back now” risk. The main issue is that the bank imposes covenant, or rules, which the borrower must obey.
These are of three kinds:
1) Pay interest (and capital instalments, if specified), on time
2) Ensure the net income from the business is enough to cover the loan repayments to an adequate extent
3) Ensure the net capital within the business, perhaps restricted, is enough to cover the outstanding loan capital to an adequate extent
These requirements are formalised and extend throughout the term of the loan. They may require formal inspection of audited annual accounts, and/ or more frequent assessment. They are often described via mathematical formulae, within the documentation.
One further point – item 1) above is viewed much more seriously than 2) or 3). Clearly, if the most basic of lenders’ requirements is not met, the bank has the right to take things into its own hands. It can then demand immediate repayment, and – remembering the bank knows how feasible that is – if that is not possible, impose onerous sanctions – often under the guise of “support”.
What happens then, I quote from Roger Lane-Smith’s excellent autobiography, “A Fork in the Road”:
“If the loan runs into choppy waters it normally moves into “intensive care” or whatever other soothing and helpful description (“business support”) masks the true summary that the bankers in this section are hard as nails, charging their struggling clients substantial fees for advice, big fees for renewed facilities (even if only short term) and if they have to move to administration then the bank’s lawyers move in and sell off the assets and/or ‘restructure’ the banking facilities.”
The bank would argue that the loan has become an unacceptable risk – that the fees/extra interest are compensation for the higher risk – and, covertly, that the client is likely to be lost, if he manages to ‘escape’ to another bank – so milk him while you can.
All this is part and parcel of borrowing. Certain banks attain reputations of being “harder “than others – these banks may need to offer keener terms to get the business, but word will get round in the market that those who have the broadest smiles often have the sharpest teeth.
However, what if the “choppy waters” are created by a derivative sale that the client didn’t really want? That puts things into a wholly different context. First, let’s see how the trick is done.
When applying for the loan, the bank’s relationship manager mentions “interest rate risk”, and the possible introduction of a “hedging” salesman. As the client perceives this as part of the loan underwriting process, he is keen to look prudent, and so agrees a “concern” for “interest rate risk”. The plan is to get him to express a concern about “rates rising”, and ultimately, to express “his” target figure. The relationship manager writes down “client concerned about interest rate rises” on his assessment form.
Sometimes the requirement for “hedging” is specified in the loan documentation – this wording is adequately vague to imply that the “hedging” is a bona fide de-risking instrument. In fact, it is almost invariably the opposite.
The most clear sales processes are carried out with the aid of a set of slides. These start off with a personalised introduction slide, naming the salesman (under such a title as “Treasury Advisory”), and citing awards. The main slides are the product descriptions, but, before then, some “scare” slides are introduced, emphasising the volatility of interest rates, and asking questions such as “good time to fix”? The whole aim is to present as much of the product as “something the customer wanted/specified”, rather than something dobbed onto him by the salesman. The products are then described – typically, a swap, a collar, and a structured collar. The swap receives regular fixed payments, and pays out floating rate ones, which correspond to the ongoing interest cost of the loan – so in cash flow terms, the net result is that of converting a floating (variable) rate loan to a fixed rate one. The collar offers a cap on the rate paid (ie, it pays out if the net loan interest rate rises above the cap level), and requires payment if the rate falls below a floor (set, obviously, lower than the cap). The net result is that payments remain within the ‘band’ set. For the structured collar, a lower (ie, more beneficial) cap is offered, but the floor is exacerbated in some way – doubling the penalty, or triggering a higher fixed interest level then payable.
The slide pack then ends with the “small print” – detailed clauses absolving the bank from any liability or damage which these products might do.
The description of each of the products above is usually segmented with a single sentence. “Break costs may apply if the product is terminated prematurely”. The borrower may think – “fair enough – if things go wrong, I’ll just end up making higher payments than I otherwise would have. I can live with that”.
Big mistake. The products have a capital significance far in excess of the break cost risk described. The main issue is that the market assesses the derivative continuously, and that it can get negative – and substantially so – very quickly. In other words, it gives you an extra debt – probably invisible to you – and that debt can technically break your loan covenants.
This is like entering a boxing match when you think the rules are like a tennis match. A tennis match continues until the end of the predetermined “time”, ie, until one player is a certain number of sets ahead. However, although a boxing match has a fixed maximum time limit, it can get stopped at any time if one contestant’s disadvantage is great enough.
What makes things worse is that your conventional guidance as to the health of your company – your annual accounts and your regular cash flow statements – are now seriously inadequate when it comes to prudently running your business. You, unknowingly, have turned into a part time amateur derivatives speculator – and all you can do is to hope your derivative does not get too negative.
Up until 2015, accountants did not need to put the current market values of derivatives into the balance sheets of the holders. This meant your company could be technically insolvent without you knowing it – and you would be breaking the law. You might see those accounts as “True and Fair – but Useless”.
However, there’s worse to come.
Every derivatives issuer who incurs risk insists on cash (or similar) deposits to be made to him if the value of the contract is likely to deteriorate. He assesses that likelihood using a formula (usually kept secret), which involves the current levels and volatility of interest rates, and the term of the contract.
In swap misselling, the collateralisation requirement was replaced by the bank covertly marking down your surplus assets with the intention of utilising these within “Business Support”, if “things went wrong” (and, of course, there was quite a lot more to go wrong now).
That means, dear heart, that if you try to take your borrowing to another bank, they will see you as a far less creditworthy company than you believe you are. To summarise, there are three extra types of risk the borrower is now exposed:
1 Capital Risk
While business loans are not actively traded in any market (apart from loans considered “distressed”, operations such as Isobel or Cerberus involved in bulk purchases), derivatives are – and the capital values can be determined quickly by a practitioner – cap elements, floor elements, and any combinations which form swaps. From 2015, these capital values have to be recognised in formal accounts under the accounting provisions of FRS102.
2 Collateralisation Risk
By marking down a portion of the borrower’s assets (“hidden line of credit”) behind the borrower’s back, the bank effectively operates the loan on a different basis to the borrower. If interest rates fall (NB – base rate does not have to fall – the middle of the yield curve alone could drop), the borrower loses money – and the bank will immediately see a worse position than the borrower, unless he is pricing his derivative on a frequent basis.
3 Creditworthiness Risk
Due to the above risks, and immediately on the sale, the borrower becomes less creditworthy than he would otherwise. Every bank judges derivatives not only on the current market value, but also on their collateralisation assessment. Although this may vary between banks, the principle is the same. To quote Mr Rainford in the recent Thornbridge hearing:
“Mr Rainford in his evidence said that "CEE" stood for "credit equivalent exposure". He said that it was determined by putting it into a model which he described as "a black box that determines an output based on historical market rates, future market rates, the transaction, the type of transaction, the length of the transaction, future volatility."
1 Capital risk applies to the borrower, personally or in respect of just his company.
2 Collateralisation risk applies to the relationship between him and the lending bank.
3 Creditworthiness risk applies to the lending community as a group.
Of course, all this may come to naught, as the bank has a trump card. It says – “All of this you could have found out by consulting an expert. You signed an agreement to say that you were taking responsibility for assessing the product. If you didn’t understand the risks, you should have taken advice”.
The reply, as I see it, is that this statement would apply to 1 and 3 – but could not apply to 2. If you went to the best and most knowledgeable expert in the world, they could not say how your relationship with your bank might transpire. This would be like going to a marriage guidance counsellor before getting married, and asking if your marriage was going to “work” – you would be sent away with a flea in your ear. All future problems are unknown, are idiosyncratic to that relationship itself, and depend on each of the parties’ attitudes to permanent and temporary problems.
You are also marrying a partner who has decided to deceive you from day one…
As I opened describing both the House of Commons and the Courts, I finish with an example from each. Mr Steve Baker, MP, Treasury Select Committee. Main Chamber Debate, 25 November 2016 – (main areas shown in italics)”
I am very glad to be called to speak in this debate. I support the motion, and congratulate the hon. Member for East Lothian (George Kerevan), which whom I serve on the Treasury Committee, not just on securing this debate, but on the excellent work he has done in having the initiative to bring forward the all-party group on fair business banking. I am glad to be a vice-chair of it, and am grateful to him for the invitation to take that role. I shall make three points: the first is about incentives; the second is about the cost and accessibility of courts; and the third is about complexity.
I have spoken previously in the House about the incentives for bad behaviour, particularly in relation to accounting under the international financial reporting standards, and liability. It is appropriate that the House is so well packed with Scottish National party Members, because I know at least one of them will be glad to hear that I recently attended an event at the Adam Smith Institute, where I helped launch the book “Legislating Instability: Adam Smith, free banking and the financial crisis of 1772”, by Tyler Beck Goodspeed, a brilliant American economist working in the UK. That event may seem irrelevant, but it goes to the heart of what is wrong today. The book shows that the Scottish banking system, characterised as it was by unlimited strict liability among partners, had very good, strong incentives for the owners and staff of banks to behave well. I am grateful to the hon. Members who are nodding in agreement.
Of course, we have come a long way since then, and we are not about to go back to free banking, much as I would wish us to. I shall quote an actuary, whom I do not wish to name, who talked about his work:
“I have examined around 100 individual cases, all of which had the same negative qualities. It is a case of bank salesmen deliberately withholding key information about the risks embedded in the ‘hedging’ products they sell. The term ‘hedging’ is therefore itself misleading.
Overall, the process is disgusting. Banks sold derivative products on top of loans to their clients which those banks knew would render them less creditworthy at the point of sale, and therefore render the business more likely to fail. How this can be described as ‘hedging’ by any financial organisation with a scrap of integrity is beyond me.”
I agree. The actuary went on to say:
“This misleading use of language, unfortunately, is maintained by some of the ‘experts’, some of whom charge large fees for reports to take into the courts. If these reports miss out on key risks, the cases become far weaker, possibly to the point that the case fails. At the best, the bargaining power of victims is much reduced.”
I want to pick up on that experience, because my second point is about the cost and accessibility of the courts system. This points to why our debate is so important. I am sure that the hon. Member for East Lothian has, like me, heard evidence in constituency casework and from the authorities showing that the system that was set up was not adequate to the task in hand. Indeed, I am sure many Members will have constituents whose businesses have been in grave difficulty, and whose lives have been affected, who found that the system failed them.
However well intentioned the authorities were in setting up the system, it has not worked well. We need to find some middle ground between the courts, which are too expensive, complex and require expert evidence—often either unavailable or too expensive to purchase at quality—and the failed semi-formal system. The court system, its inadequacies and the necessity of avoiding it is an old problem—Matthew 5:25 refers to it—and the Government have quite some task ahead of them if they are to deal with this matter.
As for complexity, even Treasury Committee members, who have been elected by the House to deal with such issues, have found derivatives fabulously complex and difficult to follow. If that is true of those of us who are charged with developing the expertise, it will no doubt be true of the small business people who buy the products. To ensure that similar problems do not reoccur, the Government may want to consider whether small businesses — limits on size is something else to consider—ought to be treated as consumers for regulatory purposes.
I am glad that we are interested in a tribunal system funded by the banks, and that we are open-minded. Although my hon. Friend the Member for Henley (John Howell) is not in his place, I am grateful that he will be working with the APPG to take things forward. Finally, I again congratulate the hon. Member for East Lothian. I look forward to making progress, and to hearing what my hon. Friend the Economic Secretary to the Treasury has to say.
Secondly, from the recent (21 Dec. 2016) judgment from The Hon Mrs Justice Asplin DBE:
(Regarding the expert witnesses – key points in italics)
Mr Virji (the borrower’s expert) gave his evidence clearly and confidently. In summary, first, in his opinion, an "interest rate hedge" is "a product which if transacted mitigates the adverse consequences of changes in interest rates" and "will reduce the risk of loss should interest rates change." Where the product eliminates some interest rate risk but assumes others, he also considers that "products in which the assumed additional risk cannot be understood, monitored, controlled, valued or where they outweigh its risk mitigation element should not be considered as hedges." He gives as examples of such instruments those in which there may be a mis-match in the amount being hedged; a mis-match in the maturity of the hedge when compared to the tenor of the risk that is being hedged (loan repayment date, for example); or where the risk of increasing interest rates is mitigated but other risks are assumed such as the risk of interest rates falling or the risk that the counterparty may at its discretion only increase the amount being hedged or extend or cancel the tenor of the hedge at no cost to itself. He is also of the opinion that an instrument must be judged at the outset and that it must be viewed as a whole rather than dissected into parts.
As to the First Swap, Mr Virji considered the advantages to be minimal and to be far outweighed by the disadvantages. In any event, he considered the mismatch of maturity of the First Swap and the facility and the cancellation options in RBS's favour to be determinative. In his opinion, therefore, the First Swap was not a hedge. For the same reasons, he considers it to be a speculation rather than a hedge and therefore, not suitable for ‘PAG’. As to the Second Swap, he also concluded that the disadvantages outweighed the advantages and accordingly was not a hedge nor was it suitable. He accepted however, that he had not set out any quantification of those elements. The same was true in relation to the Third and the Fourth Swaps. Instead, of the Swaps, Mr Virji considers that derivative contracts in the form of caps would have been the appropriate product for ‘PAG’ although he accepts that those products required payment of a premium of somewhere in the region of £200,000.
… and for the second expert:
Ms Robbins accepted that her expertise was in regulatory compliance in relation to the sales of equity derivatives and rather surprisingly, also accepted that she had never structured, designed or priced a derivative or been involved with interest rate derivatives. She was unable to answer questions about the structuring of interest rate derivatives and quite candidly stated that such questions "would be more appropriate for a derivative trading expert." Her evidence was given haltingly and at times, she was unable to answer the questions put to her. In cross-examination, she also stated that she had been instructed not to compare different derivative products but to consider the Swaps from the perspective of the relevant FSA rules at the time.
In her report, Ms Robbins approaches the Swaps from a regulatory perspective. However, she stated that in her opinion a hedge was "a transaction or strategy that in some way contains or mitigates a party's exposure to risk" and that all the Swaps operated in that way. She also stated that she did not consider that whether an instrument was a hedge or not turned on whether there was an exact match between the Swap's effective and maturity dates and the effective and maturity dates of the loan facilities in question and considered that such mismatching could be part of a hedging strategy and whether it was a hedge would depend upon ‘PAG's’ commercial and investment objectives. She also did not consider that the cancellation and extension features contained in the Swaps had the effect of preventing them from being hedges. She considered that they were plainly hedges during the guaranteed period and that the counterparty had accepted the risk that they would be cancelled; that during the periods between rights of cancellation, which operated on an annual basis, (as in the case of the Second Swap) or after the right of extension passed, the Second and Third Swaps continued to be hedges; that where the cancellation right arose on a quarterly basis after the guaranteed period, the effectiveness of the Swaps as hedges was limited; and that the extension and cancellation rights are the corollary of a reduction in the headline interest rate achieved and part of the overall pricing package of the hedge.
She also stated in cross-examination that it would be rare that a bank would assume an advisory relationship and therefore, would be unlikely to discuss break costs or MTM in relation to a derivative with a client and otherwise that there was no obligation to do so.
In fact, she stated that it was not industry practice to do so at the time. She was also of the opinion that the question of whether the advantages outweighed the disadvantages of a swap was irrelevant to the question of whether they were hedges. As to suitability, Ms Robbins set out a detailed consideration of the relevant FSA rules and considered whether personal recommendations or advice was being given. She concluded that the Swaps were appropriate and suitable investment products for ‘PAG.’
In my view, each contract contains elements of both hedging and “uprisking”, and it is dangerous to try and insist on one overall classification or the other. Rather, it is better to look at both elements separately, and see whether the benefit under the first outweighs the detriment under the second.
For further information please read “The WholeTruth” by Peter Crowley
How Banks Weaponised Lending, Accountants Monetised Ignorance and We Ended Up With a 1/4% Economy
Interest rate swap misselling, and the group ignorance which surrounds the issue, has caused enormous damage to businesses, their financial soundness, their employees, their prospects, and their very existence, in many cases. The government and its agencies miscalculated badly when they thought the issue could be resolved by a quick “flip” of RBS back into the private sector, and a slow bank recapitalisation driven by a secret and sustained programme of what many would see as extortion and destruction. The penalty has been the withdrawal of demand for borrowing, which continues to decimate the UK’s economic prospects. Without the entrepreneur class willing to borrow from such banks, economic expansion remains at a flat lining level, holding back recovery and restricting tax funds to government.