Selling, mis-selling, and something in between

I’m not going to lie to you. This post is about interest rate swaps. Wait, though. Don’t go away. Not yet. I’ll try to make it painless. In fact, I’ll pretend it’s all about shoes. That better?

Those shoes you bought last month. Remember them? Looked beautiful on display, and not bad on your feet under the perfectly-judged shop lighting. They might work out; they might not. A risk worth taking. They got their first outing that weekend and to your disappointment, no one noticed them. You’d been hoping for a bit of appreciation, ideally a jealous comment or two, but nothing. You looked down. Hmmm. OK. But nothing special. Not really worth the money. Too late to take them back, now, too, because they’re all scuffed from where you fell over outside the bar.
Imagine your surprise, then, when you were suddenly informed that the shop that had sold you the shoes wasn’t properly licensed. Oh, sure, they were allowed to sell shoes, but not these shoes. Flemish suede, not Italian leather. One phone call later and the money’s back in your account – and the best part of it is you get to keep the shoes. Maybe they’re not the shoes you really wanted, but hey, free shoes! You can hardly complain.

OK, it’s not a perfect analogy. I don’t doubt some businesses were genuinely mis-sold interest rate swaps. Some people were lied to, kept in the dark about the duration of the trades and the penalties they might have to pay if they wanted out.

But for the most part, what follows is a generic description of what happened. Stop me when you think it’s become unreasonable.

A business approached the bank for a loan.
The bank looked through the business’s trading figures and decided that yes, they were a pretty solid bet and should be able to repay whatever they were asking to borrow.
But banks have to be cautious. That’s still reasonable, isn’t it? We’ve been shouting at them for the last five years for not being cautious enough. The bank looked at the interest rate (a floating rate of interest, standard for business loans much as it is for your domestic residential mortgage) and looked at the business cashflows and worked out that if interest rates went up a couple of per cent, the numbers that had looked so solid might start to get a little shaky. The business might not have enough money to pay back the loan and this new, higher interest rate after all. And rates were low (not as low as they are now, true, but these are exceptional times). Looking back through history it seemed sensible to assume that at some point during the life of a (say) seven year business loan, the interest rate would spike.

Still reasonable, right?

A little aside, now. If you’re a mortgage borrower and you’re worried about interest rates going up, you get yourself a fixed rate (if you can). The bank might lend you money at a fixed rate, but if you choose to end the deal during the period of the fix, you’ll have to pay a penalty. There’s a reason for this (beyond greed, of course): the bank gets most of its own money, the money it’s lending to you, at a floating rate. And like I said, banks have to be cautious. They want to be sure they can balance their own books, so a mismatch between what they’re receiving from you, the fixed-rate mortgage borrower, and what they’re paying out to the market, a floating rate, makes them want to stick their fingers in their ears and shout “Lalalalala”.
But they don’t do that. Instead, they make a deal with someone else to turn your fixed rate interest into floating rate interest, so you can pay them and they can swap what you give them into what they need to pay the people they need to pay. If the bank wants to end that deal early, they have to pay a penalty. So if you end your fixed rate deal early, which forces them to end their deal early (because, being a cautious bank, they still want to balance the books), they push the penalty onto you.

Still reasonable?

Back to our hypothetical business borrower. They want to borrow, but to be safe, they need to borrow at a fixed rate. So they enter into an interest rate swap, usually (but not always) with the same bank that’s doing the lending. The business pays the bank a fixed rate, the bank pays the business back a floating rate, and the business uses that to repay the interest on its floating rate loan. Once again, the bank has to enter into a deal, another swap, with someone else, to make sure they balance their own books. Once again, breaking that swap early incurs a penalty, so if the business wants to bring the whole house of cards down, they have to pay their share of that penalty.

It might seem complicated, but really, it’s no different from your fixed rate mortgage.

A year goes by. Interest rates don’t go up. In fact, they go down. You (the fixed rate mortgage borrower) are not happy about this. You have to sit there listening to all your friends gloat about how little they have to pay on their mortgages (you have some seriously boring and rather unpleasant friends), while you carry on paying the same old fixed rate. You keep your mouth shut and keep on paying and part of you hopes interest rates hit the roof so your smug so-called friends have something to cry about.

Much the same thing has happened to the business borrower. Sure, he has a floating rate loan, so the interest he has to pay on that has shot right down, but the fixed rate he pays on his interest rate swap hasn’t changed a bit. So overall, he’s paying just what he always paid. No more, no less. That’s it. He wants out, because he doesn’t need this swap any more. Of course he doesn’t. Like you don’t need your betting slip once your horse has fallen at the first fence.

But the businessman doesn’t keep his mouth shut and his fingers crossed. He hires a lawyer. And the lawyer goes through all the paperwork and calls him up one night in a state of high excitement because he’s found it, he’s found the holy grail, the golden fleece, the get-out clause.
What he’s found is that on one of those bits of paper the bank sent over back at the beginning, the ones where they set out all the things that could go wrong, or the Key Facts Illustration where they throw together some sample calculations, or just the boilerplate bog standard terms and conditions, in amongst all this lot, they missed something out.

It isn’t something important. It has no relevance at all to this particular situation, but that doesn’t matter. Because the banks are regulated, you see, and when the rules say they have to do something, they have to do it, or by golly they’ll pay the price. And in this case, the price is the end of the swap, and all your money back.

Oh, and by the way, the bank is probably owned by the Great British Taxpayer.

Spotted anything unreasonable yet?

Like I said at the beginning, this isn’t the whole story. Some swaps were genuinely mis-sold, with a duration far longer than the loan they were supposed to protect, say, or an amount far greater, and no proper explanation of what might happen. But I think for the most part, what you’ve got with interest rate swaps is some people who’ve eaten their cake and didn’t like it very much and would like their money back, please. The banks broke the rules, and they’re going to have to pay for it, and what with Libor and PPI and the rest we tend to assume that when a bank breaks the rules it must have stamped all over them, and celebrated with a feast of roast baby. Not this time.

So would you take your losing lottery ticket to the shop and ask for your money back, just because the salesman didn’t say “have a nice day” when he sold it to you? Would you demand the return of your last twenty years of life insurance premiums, because look, you’re still alive after all? Would you really expect to get your money back for those scuffed Italian leather shoes?

Maybe you would. Maybe we all would, maybe that’s the world we live in. But this time, for once, we should think twice about abusing the shoe salesman while he writes out the cheque.

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If you liked this, please comment and share, and don’t forget to take a look at some extracts from my soon-to-be-published novel Without Due Care here.

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