Viewpoint: Uninformed exchanges mar debate over swaps


John Rathbone (new)3John Rathbone

After a quiet period, the subject of the mis-selling of swaps has suddenly reappeared, probably due to a recent Panorama programme on the subject and a DTZ research article suggesting that claims against banks might rise to as high as £10bn.

The Panorama programme did not seem very well informed. The fact that a swap is a commonly used word meaning the exchange of one item for another appeared to completely escape the BBC. A failure to understand that borrowers who entered into a swap were compensated against its increasing cost by an equal and opposite saving on the loan robbed the programme of its relevance.

DTZ’s research, on the other hand, is a sensible attempt to quantify the potential costs to banks of mis-selling by partially extrapolating to larger sized amounts the results of banks’ redress programme for unsophisticated borrowers. We suspect this analysis may be based on faulty assumptions. DTZ notes the amount of swaps that were for a longer period than the underlying loan, but does not look at how these arose.

They came about in three circumstances. First, some loans looked to arbitrage the difference between income on long-leased properties to undoubted covenants and prevailing long-term interest rates. Second, there were bank loans provided against securitisations, where rating agencies required the loan’s refinancing risk to be covered by hedging for an extended period.

The relationship between swap and loan was so crucial it is inconceivable that the borrower was not fully aware of their implication. In both situations, the relationship between swap and loan was so crucial it is inconceivable that the borrower was not fully aware of their implications. Also, for much of the 2000’s, the UK had a reverse yield curve and many borrowers virtually pleaded with banks to allow them to take out swaps longer than the loan, to obtain the lower rate. Banks will find it easy to produce documentation to that effect.

DTZ also raises the issue of bank cancellable swaps: toxic instruments sold in droves, which reduced borrowers’ underlying swap rate. Banks were seldom emphatic enough on the dangers of these instruments being called in, thus leaving the borrower unhedged at a time of high interest rates.

Even if these instruments were deemed to have been mis-sold, it is hard to see how that will cause banks problems in terms of redress, as long as the swap period matched that of the loan. If the loan was required to be 100% hedged, presumably any redress would be calculated with reference to the higher, prevailing vanilla swap rate at inception.

Where banks do face a potential redress problem is where the callable feature was applied to swaps longer than the loan, thus leaving the borrower with a legacy issue. Banks may also face problems where they have agreed a credit break (usually on a mutual basis). These were often applied to swaps longer than the loan, but where the bank did not want to take on the residual risk on the swap value if the borrower refinanced away with a third party on the maturity of the loan.

Nobody thought credit breaks would be a problem, because if the borrower moved lenders, the swap would be novated to the new bank funder. Nobody imagined that a major fall in rates would produce a valuation loss so large that it impeded the ability to refinance, as potential replacement funders would be unwilling to accept a swap that produced such a large mark-to-market loss. If the failure to warn borrowers of this potential, but unforeseeable, outcome is deemed mis-selling, one might have some sympathy for the banks.

There is no doubt that banks will have to pay considerable redress to borrowers outside the small and medium sized enterprises defined as unsophisticated borrowers. But to assume that this will stretch to vanilla swaps with maturity mismatches or even some mis-sold toxic instruments where the borrower suffered no loss in comparison with a vanilla swap is questionable.

If so, the potential for the banks to suffer losses up to £10bn should prove alarmist, specially if the FCA holds the line on its arbitrary judgement that any swap in excess of £10m takes the borrower outside the unsophisticated ranking.

John Rathbone is founder of JC Rathbone Associates, which offers debt financing and hedging advice