Swap shop

We regularly hear about various types of mis-selling. But the widespread mis-selling of hedging against increases in interest rates has yet to receive the publicity it deserves.

In the early 2000s, in a flurry of highly rewarded salesmanship, the treasury departments of Britain's largest banks sold swaps and other interest rate and currency hedging products to more than 40,000 medium and small British enterprises, which required bank financing to develop their business. Until then, these highly complicated structured products had only been sold to banks' most sophisticated and largest customers.

Small and middle entrepreneurial bank clients were sold these products on the basis that they needed to address the possibility that interest rates would climb significantly, which would leave them heavily exposed. This warning resonated with entrepreneurs who had experienced the striking increase in interest rates in the late 1980s.

Instead, today's unprecedentedly low interest rates mean that these products have been disastrous purchases, now costing far more than the loans they were supposed to be hedging. As the term of these underlying loans expire, many businesses find themselves unable to refinance because the security they have granted over their assets is more than doubled by the anticipated break costs of the hedge.

Of course, many entrepreneurs needed to address their potential exposure if high interest rates were to return, but in other instances the small debt levels or the short-term nature of the debts did not justify hedging. Even where hedging was appropriate, many bank customers were not appropriately told about the possibility of buying, for example, a much more straightforward interest rate cap. Instead, they were sold interest rate swaps, structured collars, and other sophisticated instruments with intriguing names, without the true costs of these instruments being disclosed to the client.

Because interest rates have declined to record lows, the banks are making virtually no payment to the customer under these complex structures, and the clients are making very significant payments to the bank.

Insolvency risk

The agreements often contain break provisions at the insistence of the bank, and the break costs associated with the swap agreements are of staggering value. In many cases that we have seen, the break costs for the swaps are in the range of £15m to £30m, although the average is thought to be £500,000 per swap agreement, out of all proportion to the original loan. In the worst cases, the clients can be offside their loan-to-value covenants with the bank, unable to refinance their loans and in serious risk of insolvency.

The full scope of this problem has only relatively recently been realised even by the banks, some of which have recently increased their provision for their exposure to claims. For example, not long ago, RBS increased its provision for its exposure for mis-selling these swaps agreements from £50m to over £1bn. Even this may be a conservative estimate.

One difficulty in negotiating a settlement claim for a mis-sold product is that the banks themselves are generally no longer the appropriate counterparty. The banks rarely held onto their obligations under the swaps agreements, but packaged them into bundles and resold them to, among others, hedge funds.

That may sound familiar. Accordingly, if the bank can be induced to admit liability for mis-selling and that the customer should not have to make payments under the swap, the bank has to step into the customer's shoes and make those payments to whoever bought the swaps. They may not be able to afford it.

Advisers should urge those who believe that they have been mis-sold these products to take action immediately - the majority of sales took place between 2005 and 2008. This is particularly pressing as a six-year limitation period will generally apply to these claims.
 

Nicholas Holland is head of contentious trusts and estates at Bircham Dyson Bell

The firm writes a regular blog for Private Client Adviser