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Friday, 29 June 2012

Misbuying

Now, I would be the first to admit that the difference between a derivatives salesman and a 3 card Monte dealer is that one of them works in an airconditioned office, but I have to take exception to the FSA's charge that interest rate swaps or cap and collar swaps have been mis-sold. A contract is a contract, freely entered into a by willing participants, or so you would like to think. Maybe the contracts were mis-bought.

What happened was that banks salesmen offered customers the ability to protect themselves against a rise in interest rates. This would give them an advantage over their customers who didn't hedge. Instead of asking for an option premium to provide this interest rate insurance, the bank offered them a cap (limiting the most they could pay) and a collar (so that they paid something to the bank if the rate fell below the collar. In some cases the cap and collar were the same, giving an effective fixed rate of interest when the cost of the swap and the loan are taken together. The bank makes its money on the cap and collar because with the cap and collar in place it can do a bit extra of volatility trading (a bit complicated that, but don't worry).

The downside for the customer is that if interest rates fall (which they did), then the customers start paying the banks quite a lot. But their interest rate costs fall so they should end up paying about as much as they were on interest alone, or maybe a little less. The trouble is those pesky competitors who did not hedge who get the full benefit of the interest rate reduction. terminating the swap agreement would even things up, but to do that the bank needs to be paid all its discounted future profits, which is quite a lot. Better to stay in the deal.

Oh, and squeal to the FSA that the nasty man from the bank tricked you into getting out your pen and signing his application form.

4 comments:

webwrights said...

I've only taken a passing interest in this one, but AIUI part of the problem is that some of the banks' more aggressive salesmen made contuining access to loans and/or other more conventional and everyday services - which they really did need - conditional on businesses entering into a swaps contract - which they clearly didn't. So, they weren't so much tricked as blackmailed.

Alex said...

But that is hardly aggressive and certainly not blackmail. If a customer is highly geared but with a stable income then the lender doesn't want the company to be exposed to high rates of interest. he is effectively saying "I will lend to you at a fixed rate but not a floating rate, because high interest rates increase my risk".

That is fair enough. The customer is at liberty to go elsewhere.

webwrights said...

There's a small but growing business in my village, which has gone from start-up to break-even in 12 months. The owners wanted a small increase in their overdraft limit to expand a bit faster.

Their Small Business droid at NatWest said, "We're not lending at the moment", despite NatWest drowning in cheap money itself, and they expect HSBC to say much the same.

Imagine if, a couple of years ago, the banks had said not only that but, "And, sorry but by the way, if you don't take this exciting new product (that you don't really need but of which I have to sell contracts worth £25m by Friday) we're going to have to call in your existing overdraft".

I would count the summary withdrawal of facilities as aggressive and as close to blackmail as makes no difference. I will, however, compromise at "irresponsible". A couple of the small business owners I heard interviewed last week were alleging just that. What the hell need does a halal butcher in Smethwick have for a cap'n'collar facility with a £0.5m early termination penalty?

Alex said...

"We're not lending at the moment" 'Fraid it happens all the time in banks, and it shouldn't, or shouldn't happen very much from a large bank, but it can happen despite virtually free money, because of (a) a lack of regulatory capital, (b) industry limits, (c) country limits, (d) currency limits, or any number of other reasons. I once knew of a bank that cut down its exposure to North Sea Oil and gas because its three credit analysts who worked in the sector went on maternity leave at the same time, so they cut down business until their replacements got up to speed.

Not writing new business is fair enough. Nobody is obliged to enter a new contract. Withdrawal of existing facilities is very bad, both morally and business-wise.