To the extent that the benefit of a swap was explained to customers it was generally said to protect them against ‘a rise in interest rates’ and it was generally said that the borrower would ‘give up the benefit from any fall in rates’. I’m afraid that is just too simplistic.
What the borrower was protected from was a rise in rates greater than the fixed rate not a simple rise in rates. In some cases it was not made clear that the borrower could also lose, and lose big, if rates stayed the same or did not rise by more than the amount priced into the fixed rate. At inception the customer was locking in higher rates AND an immediate profit for the bank that would immediately form part of the break cost for the swap or other product.
What was priced into the fixed rate of a swap – how the fixed rate is calculated
It is the aggregate of the floating rate predicted by the whole market over the length of the swap plus the bank’s profit margin on the swap. I have seen margins charged to SMEs of 0.90% per annum which is vast when you consider the wholesale margin is often less than 0.01% and on a 20 year loan that would be 18 % of the value of the loan. If the bank argued that the spread is for credit risk then I would say that banks had already charged a significant margin for credit on the underlying loan. All of the prodcut sold to borrowers could be bought back or hedged by the banks in the market. The market price for interest rates over time is called the yield curve (which often forecasts several rate rises but can include rate falls as it did, for example, in 2005). In October 2005 the market was not expecting/predicting a rise in rates nor was it predicting the significant fall that subsequently took place. That meant that fixed and floating rates should have been very close to each other.
Many SMEs were required or persuaded to enter into swaps to hedge their exposure to a rise in interest rates. The banks represented to their customers that the deals protected borrowers from an increase in rates. What they didn’t always make clear was that before the customer saw any net benefit from their hedge they would need rates to rise by more than the rate predicted by the market plus the profit margin of the bank.
1. Rates needed to rise a very long way to make the hedges break even in some cases.
2. The customer appears to be paying a profit/credit margin on both transactions (the loan and the swap) – why couldn’t the bank just lend fixed rate in the first place if that is what they wanted the customer to do?
3. Was any consideration given to customers’ business performance if the recession, and therefore the period of low rates, was longer or deeper than expected? Had the customer been left to float then the benefit to the customer of lower rates could have offset lower revenues the customer is likely to experience in a recession.
4. If the bank merely wished to protect the borrower from large and unexpected rate rises it could have and should have sold them a cap at 3% above the current floating rate and added the cost of the cap to the loan.
5. In 2005-2008 the yield curve was flat and before taking a profit the banks could have and should have offered borrowers zero cost collars where the maximum rate (or cap) was the same distance from the current rate as the minimum rate (or floor). So for instance if the floating rate was 4.5% the cap could be 7% and the floor 2% allowing the borrower to benefit from falling rates whilst having a limit on its cost of borrowing.
It should be clear from the above that pushing the banks hard to explain their pricing and profits is fundamental to understanding any mis-selling claim. No doubt many will have been properly priced and properly sold but it is difficult for a lay person to know the difference.
If you want to estimate how much profit was made on your transaction, what zero cost collar you could have been offered and what profit the bank made on entering your trade and what profit it proposed to make on their quotes to break the transaction please contact Jonathan Waters using the links below.
Jonathan Waters is the founder of Helix Law. Before qualifying as a Solicitor he worked in industry and in investment banking for over a decade. He was also the Partner in charge of Commercial Litigation, Employment Law and Property Litigation at Stephen Rimmer LLP. Jonathan has wide experience of helping and advising businesses to avoid or to deal with commercial disputes and in particular construction disputes.
This article is written to raise awareness of the issues it discusses and it may not be updated after it is first written, even if the law changes. It is not intended to be legal advice and cannot be relied on as such. Helix Law is not responsible or liable for any action taken or not taken as a result of this article. If you think the matters set out affect you and you wish to apply them to your particular circumstances then we are happy to give you free initial telephone advice.