Allegations of interest rate swap mis-selling by banks to borrowers have gained much press attention recently. The issue has been likened to that of payment protection insurance mis-selling, suggesting it will be the next big financial scandal, leading to lawsuits and mass compensation.
But there are few similarities between these products. The commercial effects of a swap are little different from a borrower choosing between a fixed-rate and variable tracker mortgage; one guarantees a single interest rate payable, the other offers the chance to benefit if rates fall, with the counter risk of higher costs if rates rise.
Interest rate hedging became a condition of commercial real estate loans in the early 1990s, for very good reasons. Prior to this, high interest rates had damaged the sector when loans could not be serviced from income; the requirement to hedge against this was to prevent this from recurring.
Particular criticism has been levelled at long- dated swaps. It may be hard to see, in hindsight, why a borrower would enter a swap far longer than the loan term. But why this should confuse property professionals who have made a career writing long-dated, upward-only leases is a mystery!
It is important to remember that in the period leading up to summer 2007 Libor was rising, and forecast to rise further, presenting borrowers with a real refinance risk. At this time property was refinanced, on average, every three years.
To mitigate against refinancing risk, investors entered longer-term swaps, moving them from bank to bank as they refinanced, taking advantage of lower margins but maintaining the same pre-margin fixed-cost of funds. Lower rates for longer-term swaps than shorter ones added to the attraction, so borrowers could generate greater surplus cash from property and, in cases, increase the initial leverage secured against the cashflow.
A subsequent crash in interest rates, unfathomable at the time, has led to the huge liabilities (break costs), particularly for longer dated swaps. As the graph above shows, while in January 2007, the interest rate markets forecast a 95% probability Libor would remain above 3.57% for the next two years and above 2.92% for the next three, the actual rates were 2.705% and 0.609%.
But just because interest rates have fallen and many interest rate swaps have accrued big negative values, banks cannot be expected to forgive these contracts without good reason. Banks laid off their own interest rate risk in the market, so to forgive these contracts would represent a very real cost.
Of course, over the years we have seen many examples of inappropriate hedging and, in some cases, banks may be found wanting in respect of their regulatory obligations.
Most borrowers will aim to negotiate a resolution with their bank, often in relation to new or extended debt facilities, which seems to be the most pragmatic approach. Apart from anything else, most property companies will want to maintain relationships with their funding banks rather than taking legal action against them.
It will take a court case to fix the true definition of mis-selling, most likely in the SME sector first, where there seems to be greater evidence of mis-selling. Property companies seem less likely to benefit. While there are many examples of inappropriate hedging, the number of borrowers who can attest that products were not explained and they were not cognisant of the risks is far fewer.