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Interest rate swap mis-selling scandal: Difference between revisions
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{{a|disaster|}}{{quote| | {{a|disaster|{{image|Interest Rates|png|Bank of England Interest Rates in our lifetimes. Annotated.}}}}{{quote| | ||
Nine banks including Lloyds, RBS and HSBC agreed in 2013 to compensate companies that were sold inappropriate products that were supposed to protect them from changing interest rates on their debts. However, these hedges could expose the firm to the risk of rate movements even after their initial loan had been repaid. | Nine banks including Lloyds, RBS and HSBC agreed in 2013 to compensate companies that were sold inappropriate products that were supposed to protect them from changing interest rates on their debts. However, these hedges could expose the firm to the risk of rate movements even after their initial loan had been repaid. | ||
:— {{plainlink|https://www.telegraph.co.uk/finance/rate-swap-scandal/11402982/Companies-let-down-by-interest-rate-mis-selling-redress-say-MPs.html|''Daily Telegraph''}}, 10 February 2015}} | :— {{plainlink|https://www.telegraph.co.uk/finance/rate-swap-scandal/11402982/Companies-let-down-by-interest-rate-mis-selling-redress-say-MPs.html|''Daily Telegraph''}}, 10 February 2015}} | ||
{{quote| | |||
In 2008, interest rates plummeted and thousands of customers found the [[mark-to-market]] value of their [[IRHP]]s materially changed, leaving them with significant losses if those IRHPs terminated early. Alternatively, customers were tied in under the IRHP contracts to pay far higher interest rates than the prevailing market rate for years to come; in some cases the IRHP contract terms extended well beyond the period of the underlying loan. | |||
:— Swift Review into the supervisory intervention on interest rate hedging products | |||
}} | |||
====The interest rate environment in the early 2000s==== | |||
Weird things were happening in the interest rate markets which had been pretty stable since — well, the Glorious Revolution: | |||
{{drop|S|kulduggery in the}} LIBOR submission process was not the only saucy carry-on in the interest rate market. For something that is meant to be dullsville, after school chess club was quite the hotbed. | {{quote|''For two hundred years the Rate hovered between 2 and 10 per cent, and in the gloom of Threadneedles’ cave, it waited. Darkness crept back into the forests of the world. Rumour grew of a shadow in the East. Whispers of a nameless fear. And the Rate of Power perceived its time had come.''}} | ||
Since the early seventies, interest rates had bounced around between about 8 and 15 per cent. But after a brief spike when the UK unceremoniously exited the Exchange Rate Mechanism in 1992 they fell towards thirty-year lows. As the Cool Britannia vibe suffused the nation and Gordon Brown banished boom and bust [''subs: can we check this?''] rates stayed abnormally low, around six per cent. | |||
In the meantime some [[First Men|bright sparks at Salomon Brothers]] had invented the {{strike|One ring to bring them all and in the darkness bind them|swap}} and the era of {{strike|Sauron|tradable interest rate derivatives}} was upon us. | |||
JC has written elsewhere about the [[LIBOR rigging part 2|revolutionary confluence of technologies that led to the interest rate derivatives market]] What didn’t change — what hasn’t changed since the invention of credit, and which will not change until the apocalypse, is a business’s basic need borrow funds for working capital at a predictable cost. | |||
This is a cost of business as inevitable as employees, plant and machinery. Businesses are figured out ways of managing employee costs: discretionary bonuses. These are ''ostensibly'' tied to business performance — the better we do the more you get paid — but really are tied to ''market'' performance: the higher your bid, the more you get paid. | |||
It would be fun to develop [[employment derivatives]]. They would be like interest rate swaps. | |||
But we can surmise that businesses seeking to borrow money in 2002 might have been thinking rates were abnormally ''low'', and it might be a good time to lock in an interest rate. | |||
Had swaps not been invented, they might have done this by borrowing at a fixed rate for a fixed term. | |||
==== Interest rate exposure. Borrowing money? ''Inevitable''. ==== | |||
Fixed rates, of course, also give you exposure to the interest rate market. If you are borrowing money, ''you have exposure to the interest rate market''. Your only question is what kind. | |||
The basic problem of business borrowing is to meet debt servicing costs — interest and principal — out of business revenues. Your incoming revenues are not tightly coupled to interest rates — it isn’t like they move instep or anything — but they are probably related. If interest rated go up, people generally save more, spend less and so business might drop off a bit. But as a general proposition, fixing an interest rate you can afford to service given the general ebb and flow of your revenue, is your best bet. | |||
However, if you fix at ten percent, and then variable rates drop off a cliff, you might be kicking yourself. Sure, you can refinance elsewhere — but there will be some penalty for paying your loan off early. This is precisely because you locked in that fixed rate, and the bank hedged for it, so if you break it, the bank has to break its hedge. Also, a deal’s a deal. | |||
You can manage this a bit by shortening the period for which you borrow. But there’s a tension — the shorter your term the more susceptible you are to higher rates when you come to “roll” your loan. | |||
But the basic crux is this: your interest rate risk is not a function of venal bankers, or bad hedging or anything like that: it is a function of borrowing money. If you don’t want interest rate risk don’t borrow anything. | |||
Note here a fundamental axiom of finance, which JC believes in the derivatives age has been wildly overlooked: an interest rate is not some abstract thing, that exists out there in the wild, by itself, independent of any other activity. It is constitutionally, spiritually bound to the business of borrowing and lending money. | |||
Yes, we have developed clever tools that enable us to see interest rates as discrete, lighter than air things, but this is a misleading picture. All rates, somehow, can be routed back to borrowed money. Interest rate is no more independent of loaned money than a shadow is independent of the boy who casts it, or the light source he stands infront of. | |||
There is an argument that had interest rate swaps ''not'' been invented corporate borrowers fixing term loans in 2008 might have been just as badly burned, but would not have had anything to complain about. | |||
====The banks==== | |||
{{drop|S|kulduggery in the}} [[LIBOR rigging|LIBOR submission process]] was not the only saucy carry-on in the interest rate market. For something that is meant to be dullsville, after school chess club was quite the hotbed. | |||
Take the business of lending to small and medium enterprises. | Take the business of lending to small and medium enterprises. | ||
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Bear in mind what the businesses of middle England want from their banks: finance, for a predictable term, at a predictable cost. | Bear in mind what the businesses of middle England want from their banks: finance, for a predictable term, at a predictable cost. | ||
We take it as generally axiomatic that if you want to give, or take, back your money at any time, interest will accrue at a variable rate, and if you want to lock in the borrowing or lending for a term, interest will accrue at a ''fixed'' rate. | |||
And remember, in the good old days — specifically before [[Swap history|1981]] — if you wanted “exposure” to an interest rate, you had to actually borrow, or lend, money. But England’s businesses didn’t want “exposure to interest rates”. They wanted ''money''. Capital. Indeed, before 1981 the idea of “isolated exposure to interest rates” would have seemed more or less incoherent, the same way a shadow seems incoherent, without the boy who cast it. | And remember, in the good old days — specifically before [[Swap history|1981]] — if you wanted “exposure” to an interest rate, you had to actually borrow, or lend, money. But England’s businesses didn’t want “exposure to interest rates”. They wanted ''money''. Capital. Indeed, before 1981 the idea of “isolated exposure to interest rates” would have seemed more or less incoherent, the same way a shadow seems incoherent, without the boy who cast it. | ||