A brief look at how the desire of bankers to increase their bonuses has contributed to the Interest Rate Swap problem
This article was going to be entitled “Why did the banks do it?” but the answer seemed so obvious, the question barely needs to be asked.
The banks have been bonus-driven for years, but it is only now that the true extent of what has happened is coming to the fore. For the last few years, the banks have been ridden with claims for PPI mis-selling and the LIBOR-fixing debacle but, in the last year, the Interest Rate Swap (IRS) scam has hit the headlines.
It starts off fairly simply: borrower seeks loan, bank offers loan. But invariably, the bank encourages or, more often than not, requires the borrower to enter into an interest rate swap, or Interest Rate Hedging Product (IRHP) as the FSA is calling it. The Bank explains it to the borrower as a fixed rate loan rather than the usual variable rate loan, giving the borrower certainty against a future with potential rising interest rates and a better ability to budget.
What actually happens is that the bank buys a hedging product on the inter-bank market at, say, 5% then, adding a profit margin of, say, 1%, then sells the IRHP to the customer for an apparent fixed rate of 6% per annum. Regardless of whether the interest rate increases or decreases, this is the fixed sum that the borrower pays and throughout all this, the bank makes a 1% profit on the arrangement. But the big benefit for the banks is that they take all the profit up front – which means the bonuses to the bankers get paid in the first year.
So, what can the bankers do to maximise their bonus?
For starters, bankers can sell more expensive IRHP’s, increasing the margin to say 1.5% or higher. Better yet, buy a hedging product on the inter-bank market for a longer period of time than is actually needed (so the purchase rate is lower) or even for a greater amount than the amount of the loan actually needed. Customers can easily be persuaded to ‘over-hedge’ their Swaps if it appears the interest rate they pay will be lower and in this way it increases the banks profit and the banker’s bonus yet further.
These behind-the-scenes calculations aren’t seen by the customer. All they know is that they have a potential guarantee against a potentially rising market: That is, until the base rates drop to an all time low of ½%, lending rates fall below the IRHP fixed rate and the customer tries to get out of the arrangement. It is at that stage the borrower realises they are required to pay ‘breakage costs’ which reflects the loss of the bank’s profit over the remainder of the term of the loan – made even greater if the loan has been over-hedged. The FSA has recorded some instances where the breakage costs have been as much as 40% of the original loan.
For those reading the news, they will be aware that the FSA has released two reports so far on their investigations into the IRS Scandal, confirming that in over 90% of 173 cases they investigated, customers were found to have been mis-sold their loans. The FSA has ordered that there be a review of any Swaps that have been sold. Those customers who have been sold a structured collar will be contacted by their bank (if they bought it with one of the ten banks affected), who will then undertake an automatic review. As to the other types of Swaps, it will depend on what type of IRHP you were sold and whether you are considered to be a sophisticated or unsophisticated customer.
If you would like a free consultation with a specialist interest rate swap solicitor, then please do not hesitate to call us on 0808 139 1595.