Interest Rates Swaps being mis-sold to SMEs: a layman's guide to a textbook banking rip-off

To understand a rip-off of this scale, designed to be incomprehensible to customers, regulators and lawmakers, you need an insider's insight. Provided by our guest author Honestly Banking, the undercover banker.

At Honestly Banking we wanted to have a look inside the workings of Swaps, Hedging, Caps and Collars and throw some light into this obscure and complicated world. There has been a remarkable amount of media interest around the Swap mis-selling scandal. Inevitably it is hard to capture the real complexities of this involved area without over simplifying matters or getting highly technical.

A brief background: Banks have been selling Interest Rate Derivatives under the guise of ‘risk management’ for many years, firstly to big corporates, then to smaller companies and then when the greed got the better of them to anyone they could. You may think this sounds a lot like the sub-prime mortgages. Back then banks sold mortgages to unsuitable clients. Now they are selling swaps to unsuitable clients. Different product, same motivation – a quick profit.

With lower Interest Rates many people are discovering that they have been sold something that actually increases their risk. Additionally the banks have not been sticking to the rules and have been profiteering at the expense of small businesses and individuals. This is a completely different order of magnitude to PPI mis-selling. Homes, businesses, farms and livelihoods are being lost. Families are being ripped apart. Barclays have tried to gag their clients from even talking to the regulator, the FSA, about it.

Banks have developed this area into a highly profitable multi-million pound industry. It’s so profitable they have set up many regional sales centres to peddle their wares. They are staffed typically by smooth talking ‘risk advisors’ who bamboozle the unsuspecting client into something that will possibly be the worst decision of their lives.

Interest Rate Hedges (we will call them Hedges for brevity) fall into two main sorts. Those made of barriers and Swaps. They are all constructed out of Derivatives called Interest Rate Options. We will concentrate on the barrier type in this article as Swaps are really a series of barriers.

The simplest and most effective ‘Hedge’ is the Interest Rate Cap.  Here the client never pays more than the Cap level that they can choose to match their needs best. They get the full benefit from any falls in Interest Rates and there’s no break (penalty for ending the contract) cost as the premium is paid straight away up front. It’s a bit like  having a cap on your mortgage interest rate. Remember, no SME buys a hedge to make a profit – they just want to get protection from surprise interest rate hikes. It’s also the one banks sell the least of and are mostly likely not to mention to you. The simple reason is they make the smallest profit on them.

A development of the Cap is the Collar where the bank makes the client agree to a floor (below which the interest rate won’t fall whatever happens to the base rate), ostensibly to reduce the premium. In reality the value of the Floor far outweighs the cost of the Cap and the bank slyly pockets the difference. This also introduces new risks to the business of falling Interest Rates and means that the client is now speculating on Interest Rates - they are becoming Derivative Traders. If the interest rate falls beneath the floor then the client doesn’t benefit from the lower rate.

In reality they are often far more complex than this. A real life example: Mr Paul Adcock, of Adcock’s Electrical, who has been widely covered in the media, was sold a ‘Structured Collar’ by Barclays. In a Collar your Interest Rates float between two barriers. They have their risks, but the ‘structured’ bit is a nasty twist of the Investment Banker’s knife. In Mr Adcock’s case, this can mean as Interest Rates drop, the rate he pays actually goes up! More of a ‘Structured Noose’ really – the trouble starts when the floor drops!

In the example below, which is similar to Mr Adcocks’ toxic hedge, the floor is 4.7%. However much the Interest Rate falls beneath Floor Barrier, the client pays the bank the difference between the Interest Rate and the Floor, plus an equal amount above the Floor. This means as Interest Rates go down, the rate the Client pays actually increases. This isn’t risk management – it’s gambling. That’s what banks do, not SMEs.

As we can see in the example below, when Interest Rates drop to 2% the client is paying 2.7% below the floor and 2.7% above the floor giving the client an Interest Rate of 7.4%!

The effect on Mr Adcock is that he has had to lose 2 members of staff and this toxic structure has cost him over £175,000, in addition to the original £970,000 loan. Of course Barclays have made a fat profit out of Mr Adcock’s misfortune.

As can be seen in this example, a Structured Collar is a very poor Hedge against Interest Rate movements as there is only a narrow benefit within the collar; thereafter it increases the risk to the client. There are many other toxic Hedges being sold, often including the bank (only) having the option to cancel or extend the structure. These are Hedges, they are roulette.

The banks are not explaining all the risks and clients are pressurised into agreeing to these Hedges without fully understanding them. The banks know that they are required by legislation not to trade these products if the client doesn’t understand them – this is breached on a daily basis.

There is another hidden feature of Interest Rate Hedges that the banks have liked to keep quiet, and that is the cost of getting out of them. These are known as the exit or break costs. Banks like to use jargon to confuse their customers so they call this ‘mark to market’. Banks typically tell clients that there may be a cost or indeed a benefit when you exit your Hedge, but normally don’t give you any idea of how big this can be.

The break costs depends on market conditions and is a real cost to the bank as it goes and incurs this cost in the Interest Rate market. On a typical fixed rate loan this is a pre-agreed amount, often a percentage of the loan from 1-5%. On a Hedge it will fluctuate, but currently exit costs are varying from 25%-50% of the loan. This is because the Hedges are made up of Derivatives that derive their value from an underlying market. A small movement in this market can be magnified many times over, creating a huge liability. The way many of these trades are structured means that low interest rates have caused these high exit costs which the clients are stuck with if they want to exit. This is in addition to the loan repayment, the interest, and the fees. If you are confused by this, then you are in good company: not only the ripped-off SME businesses, but also many bankers. This is precisely why complex products like this are not permitted to be sold to unsophisticated customers. What this means is a business that borrows £1,000,000 may have to find another £500,000 to get out of the Hedge. As many clients are now saying, ‘if they told me that up-front I never would have agreed to it’.

Inside the bank’s Swap Sweat Shops there are legions of sales people, all getting bonuses, and they all have targets. It’s in their interests to sell the clients the most complex and costly Hedge possible. One rule is clear from the world of Hedging, that we would advise clients to keep in mind next time the sales man comes to call. The more complex the name of the Hedge, the more profitable it is for the bank and the worse it is for the client.

Despite the esoteric nature of the Hedging world, there’s been a notable up swell of activity by those affected. Probably the best known is Bully-Banks, which orchestrated a meeting of MPs on the issue. The FSA are slowly looking at the area and there have been some court cases settled already. The other concerning development is the plethora of claims management firms advertising in this area. This is a far more complex area than PPI and most of these claims companies do not have the relevant experience or required regulatory licences to advise on these Hedges. We may be selling another scandal developing in the claims management world.

Warren Buffet famously described Derivatives as being ‘weapons of financial mass destruction’ in 2003, some 5 years before the current financial crisis started. He also warned that Derivatives can push companies into a "spiral that can lead to a corporate meltdown". This is now happening across the nation of shopkeepers that is Britain. Why did the banks push people into unsuitable and dangerous contracts that will destroy their lives? It wasn’t banks providing prudent risk management, it was avarice.

[Authors Note: Interest Rate Hedges, Swaps, Caps, Collars and Derivatives are a very complex area. This article inevitability over-simplifies some of the issues. For more in-depth discussion, please visit www.HonestlyBanking.co.uk]

[Note from Jake: in June 2012 the FSA completed its investigation and instructed the banks to compensate their "unsophisticated" customers, stating the "sophisticated" customers are not covered. The FSA, in the judgement, defined "sophisticated" as being a customer who met "at least two of the following: (i) a turnover of more than £6.5 million; or (ii) a balance sheet total of more than £3.26 million; or (iii) more than 50 employees." This is the EU definition of a 'small business', letting the banks off compensating any medium sized businesses. So the battle is still on.]