ISSUES IN BANKS MISSELLING OF INTEREST HEDGES

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Terence Reynolds
5 years ago
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1 ISSUES IN BANKS MISSELLING OF INTEREST HEDGES DR M. DESMOND FITZGERALD UNIQUE CONSULTANTS LIMITED TEL: FAX: JULY

3 1. On 29/6/12, the FSA stated that it had found failings in the sale of interest rate hedging products to small and medium sized businesses, and suggested a process by which the banks may provide redress to customers following a review of such sales and the scrutiny of an independent reviewer. 1 The FSA is careful to divide bank customers into the categories of unsophisticated and sophisticated. Unsophisticated customers are defined as those likely to lack expertise and understanding of the products. Sophisticated customers are those who meet at least two of three criteria in the financial year in which the entry into a hedging product took place. (a) (b) (c) A balance sheet total of more than 3.2 million. A turnover of more than 6.5 million. Having more than 50 employees. Further a bank can apparently declare a customer to be sophisticated if the customer had the necessary experience and knowledge to understand the service to be provided and the type of product envisaged, including their complexity and the risks involved. 2. Two issues arise immediately. First, it is by no means clear that any of the objective criteria are appropriate in determining whether a customer is sophisticated with regard to even simple interest rate derivatives such as interest rate swaps and interest rate collars, let alone more complex products such as structured collars. For instance, one could imagine a chain of garden centres with a turnover of 10 million and 100 employees, who would not recognise an interest rate derivative if they met one on the street. Additionally many individuals or firms who would regard themselves as sophisticated with respect to cash markets such as equities and/or fixed income, may well be unsophisticated with respect to derivatives or hedging products, whatever the size or scope of their financial activities. Second, it remains to be seen how aggressively the banks will try to classify as sophisticated, those customers who would appear unsophisticated on the objective criteria. Previous experience would suggest that a fairly high degree of such aggression can be expected. 3. The agreement between the banks and the FSA provides that the banks will: (a) (b) (c) provide fair and reasonable redress to non-sophisticated customers who were sold structured collars; review sales of other interest rate hedging products (except caps or structured collars) for non-sophisticated customers; and review the sale of caps if a complaint is made by a non-sophisticated customer during the review. 4. While it is difficult to argue with the FSA s treatment of the sales of structured collars and other complex instruments, and simple interest rate caps, one hopes that the review of the sales of interest rate swaps and collars will be 1 I attach the relevant FSA Notes as Appendix 1. 3

4 searching. As I will discuss in more detail below, apparently simple interest rate products can conceal a range of additional risks that may not be apparent to either unsophisticated or some sophisticated customers. For instance, does an interest rate swap contain embedded options giving the bank the right to close the position prior to maturity? Does the amortisation schedule on the underlying loan, if any, map into a similar amortisation schedule on both sides of the swap? Does the interest rate swap have a significantly longer maturity than the underlying loan? Is the interest rate swap leveraged with respect to the underlying loan, such that impact of an interest rate change on the swap is a multiple of that on the underlying loan? Does the interest rate swap have mandatory or optional break clauses requiring the customer to pay the market value of the swap on specific dates to the bank? In other words, it is dangerous to assume that interest rate swaps or interest rate collars are necessarily simple hedging instruments whose risks will be readily understood. In my view, a significant proportion of the unexpected losses on interest rate hedging transactions by banks customers will involve simple interest rate swaps and collars, as opposed to apparently more complex products. 5. I will now discuss the major issues involved in the determination of redress to customers, whether through the FSA process, or the Financial Ombudsman, or the Courts, on missold interest rate hedging products. 6. Clearly the banks will argue that a requirement for customers to protect against exposure to higher interest rates on floating rate loans made by the banks to small, less creditworthy, businesses was a perfectly reasonable business requirement. It is difficult to argue against that position, in my view. Hence, for a loan of a specific maturity, the cost to the customer on a simple fixed for floating swap in the same size and of the same maturity, would, in my view, represent a suitable benchmark to measure the actual hedging cost against, with a view to estimating the appropriate level of redress. Such a simple swap would represent a zero cost hedging solution at the time of the loan drawdown. 7. The question of whether the customer required a zero cost hedging solution could play a role in a number of cases. I suspect in the majority of cases, the banks will claim that this was indeed a customer requirement. Such a requirement would preclude the use of the simplest possible hedging vehicle for a floating rate loan, namely an interest rate cap. Clearly given what has happened to interest rates in recent years, a comparison with the cost of a cap programme would give rise to the largest claim for damages on the part of the customer In a number of cases with which I am familiar, however, a cap programme simply does not appear to have been suggested by the banks as possible hedge alternative. No doubt the banks will claim that is because the customer had the requirement of a zero cost hedge. However, I think the banks can be criticised overall for not including simple caps in any illustration of hedge 2 This is likely to be one of the reasons the FSA has effectively removed interest cap purchases from the review process. 4

5 alternatives to relatively unsophisticated customers unfamiliar with alternative hedges. 9. If the customer insisted on a zero cost hedge, a zero cost collar would be an alternative to a simple fixed for floating swap. Clearly given the way rates have moved, a comparison of the actual hedges placed with any zero cost collar would result in a larger redress or damages claim for the customer than a comparison with a simple swap. The problem is that a zero cost collar can be constructed with a wide variety (almost infinite) of combinations of interest rate floors and interest rate caps. It will be difficult therefore to persuade an independent assessor of customer costs or the Courts that one zero cost collar structure is more appropriate for comparison or redress purposes than any other. 10. By contrast, customers are on strong ground in claiming that the more complex zero cost hedging solutions, including structured collars of various kinds, were not at all suitable as hedges of simple floating rate loans for relatively unsophisticated, and many sophisticated, customers. The various structured collar hedges that I have seen in many of these cases do not appear sensible hedge solutions, and, in my view, would be completely incomprehensible to many customers, even if explained in detail By far the biggest issue in the majority of hedge misselling cases, however, which has been responsible for most of the customer losses, appears to be the frequent mismatches between the maturity of the underlying loans and the interest rate derivatives used to hedge them. 4 In many cases, the duration or maturity of the derivatives hedge was two or three times that of the underlying loan, which meant any gain on the loan from lower interest rates would be more than offset by losses on the hedge, as so many customers have experienced. The banks may attempt to argue that the maturity of certain of the hedges was designed to map into regular extensions of the loans at maturity. However, I find it difficult to believe that such an argument is sustainable, given the obvious disparities in interest rate sensitivity between, say, a five year loan and a fifteen year swap. This will be the key to most customer claims, however, 12. In specific cases, there will need to be analysis of any rights the bank has to require repayment of the loan and settle the hedge at its mark to market value, or any mandatory break clauses on the hedge at the maturity of the loan, or rights to cancel the hedge at regular intervals, or whatever. Such bells and whistles can in practice have a significant influence on the market value of derivative hedges. 13. In general, the customers aim should, I think, be to compare the actual cost of the loan hedge package with two possible benchmarks. In the case where 3 This is presumably why there is an apparent assumption in the FSA Note that purchases of structured collars by unsophisticated customers will be subject to redress. As I shall discuss below, however, the vital question is to what hedging benchmark should the final cost of a structured collar be compared. 4 The FSA refers to this as over-hedging i.e. where the amounts and/or duration of the hedges did not match the underlying loans. 5

6 there is convincing evidence that the customer insisted on a zero cost hedge, the actual cost can reasonably be compared with that of a fixed rate loan created from the combination of the actual loan and a simple fixed for floating swap of the same maturity. If the customer can establish that he or she would have been willing to pay for a cap hedge, then one can try and argue for the cap cost to represent the benchmark. In most cases, however, I think the banks will argue for the former benchmark, and I suspect any independent reviewer or the Courts may be receptive to this. 14. It is important though for customers not to believe that they can simply ignore the benefits of lower interest rates on the underlying loans, and expect the banks to redress all the losses on the hedges. On the assumption that the standard benchmark would be a simple fixed for floating same maturity swap, one would expect the swap to have involved very substantial payments. The point is that the value of those payments will be substantially less than any combination of a structured collar, and/or longer maturity on the hedge than the loan. 15. As an example, suppose on 1/1/07, a customer entered into a five year 10 million loan with six-month resets at an interest rate of LIBOR plus 100 basis points. The fair mid fixed swap rate for five years starting on 1/1/07 would be around 5.35%, although obviously in practice the bank would indicate a higher fixed rate in order to make a profit on the hedge transaction. As can be seen in Exhibit 1, the cash flows for the customer on the swap would have been significantly negative, but, of course, these would be offset by similar falls in the floating payments on the loan. The net result is that the customer would have paid 6.35% overall for the five years 1/1/07 to 1/1/12. I would not expect the customer to receive any compensation in such circumstances. It was reasonable for the bank to require hedging, and a simple swap was a reasonable hedge. However, if the maturity of the swap had been 15 years instead of 5 years, then as can be seen in Exhibit 2, the remaining ten years of the swap would have a market value of 3 million against the customer on 1/1/12. That is the amount that the customer could reasonably be expected to be compensated for, in my view. 16. In addition, though I am sure the banks will be reluctant to provide such information, it would no doubt help the customers if they insist on the banks providing information about their mark to market profits booked on the interest rate hedging products at the time of the transitions. In any case, the mid-market valuation of all the products on the transaction dates should be established using independent interest rate and volatility curves. Any evidence of predatory pricing by the banks of hedge products to unsophisticated customers, may well be an influence on the level of redress deemed to be appropriate by an independent reviewer or the Courts. 17. I would note here that in discussing what I regard as major issues in establishing an appropriate standard for redress, I have not considered what may be termed collateral damage associated with unsuitable or toxic interest rate hedging products. For instance, the need to cover significant breakage costs on unsuitable hedges may have led to a weakening of the financial 6

7 condition of the underlying business, which could affect its loan covenants, and the margins charged by the banks on loans. Indeed one could imagine cases where the inability to cover excessive costs on hedging products could lead to the borrower going into liquidation, and I am aware of cases where that indeed has happened. In such circumstances, the fair level of redress would be well in excessive of the total cost of the unsuitable hedging products. Obviously the degree of excess would depend upon the specific circumstances of each borrower. 18. So in general my conclusions as to the best course of action for the customers and their advisers in the swaps and derivatives misselling cases would be as follows Assert strongly the view that it is not just structured collars and other complex products that are the issue for unsophisticated investors, but also standard interest rate swaps, zero cost collars and similar products Assert that for unsophisticated customers, all interest rate hedging solutions sold by the banks should be subject to redress based on comparisons at least with the performance of a standard interest rate swap with maturity and amortisation schedule identical with that of the underlying loan at the commencement of the transaction. This avoids the complications which will be created by the FSA approach stating, The appropriate redress for each customer will be determined on the basis of what is fair and reasonable, and could include a mixture of cancelling or replacing existing products with alternative products, and partial or full returns of the costs of those products. In my view, this more diffuse and less straightforward approach will delay settlement of these cases unduly, allow the banks too much scope to reduce the amount of redress, and overly complicate the task of arriving at the actual losses incurred by customers due to hedging product misselling In my view, a comparison of a specific and defined hedging benchmark with the actual costs incurred on the combination of the underlying loan and the actual hedge transaction entered into by the customer is both the cleanest and most defensible approach to the redress issue The only other benchmark which might appear reasonable is the net cost of the loan plus a simple interest rate cap, in cases where the customer can establish that he or she was willing to pay a cash amount for an interest rate hedge that would have satisfied the bank In my view, the level of redress for customers should also be influenced by the profit margins earned by the banks on the interest rate hedge transactions at the transaction dates, and the levels of margin charged by the banks on the underlying loans. 7

8 18.6 There should also be a careful analysis of those cases where the banks have claimed substantial mark to market sums on the interest rate hedges when the loan has been prepaid by the customer, or called in by the banks In cases of what I have termed collateral damage to the underlying business of the borrower, a careful assessment needs to be made of excess payments or damages over and above the assessment of excessive direct payments on the interest rate hedging products Finally, in my view, it should be for the banks to prove that the customer had a sufficient knowledge of interest rate hedging products as actually sold, to make a reasonable assessment of the comparative risk and returns. In my view, there is a significant danger following the FSA approach to classification, that customers who are actually unsophisticated would be classified as sophisticated, and therefore ineligible to receive redress under the FSA agreement with the banks. 8

9 EXHIBIT 1: CASH FLOWS ON 5.35% FIXED FOR FLOATING SWAP 1/1/07 1/1/12 EXHIBIT 1: VALUATION OF 5.35% 15-YEAR SWAP ON 1/1/12 9

10 APPENDIX 1 FSA INFORMATION NOTES ON INTEREST RATE HEDGING PRODUCTS 10

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Information relating to Clydesdale and Yorkshire Banks Review of Interest Rate Hedging Products (12 October 2012)

Information relating to Clydesdale and Yorkshire Banks Review of Interest Rate Hedging Products (12 October 2012) Sections List (click on one of the below links to jump to that section): Introduction A.