Mayad Rassam, a derivative expert at Vedanta Hedging was interviewed by Property Week about the mis-selling scandal of derivatives
13 July 2012
Swaps have received much attention in the national press, mostly negative and focusing on high street banks misselling hedging products to small and medium-sized businesses, so-called non-sophisticated customers.
This prompted the Financial Services Authority to launch an investigation into the sale of interest rate hedging products.
The regulator published a statement criticising banks for selling unsuitable products, having poor disclosure of exit costs and failing to ascertain customers’ understanding of risk.
However, we might be missing something by providing this level of protection solely to non-sophisticated customers. The property industry is full of property investors with multimillion-pound property portfolios, who are not sophisticated capital markets traders or derivatives pricing experts. Should they be protected against poor disclosure of exit costs or a bank’s failure to ascertain their understanding of risk?
To find out what went wrong and whether anyone is to blame, we need to look back to 2003-07 — a time of high-leverage deals, ever-increasing loan-to-value ratios (LTVs) and squeezed cashflows. The Bank of England base rate was increasing, and many investors wanted to hedge their already stretched cashflow against potential further increases.
However, when interest rates fell to deal with the credit crunch, some investors were faced with huge swap breakage costs that were unexpected and sometimes not understood.
They had increasingly complex hedging solutions put in front of them, often by the capital markets teams of their lenders. In a period of rising interest rates, these products promised to hedge their cashflow, and more cheaply than the industry benchmark: a plain five-year swap, which is basically your standard fixed-rate that only hedged the duration of the loan.
But there is no free lunch, and these so-called cheaper alternatives were in fact more expensive, because they achieved the “cheaper” headline rate by incorporating options into the structure. Options pricing is complex and non-transparent, because it relies on individual banks’ proprietary pricing models. Moreover, options often command a large bid-ask spread, which means it is more expensive to enter, more expensive to exit and more profitable for the bank to sell.
The high-leverage culture of the pre-credit crunch years led borrowers to chase hedging products with ever-decreasing headline rates, thereby artificially improving their cashflows and enabling them to borrow at higher LTVs.
That allowed banks to push increasingly complex products. I was recently introduced to a client who had such a complex hedging structure, it took two days to model it fully. It consisted of a series of caps and floors that is like passing through an interest rate labyrinth.
The client’s interest rate payable was so far removed from the underlying base rate he was trying to hedge, it required a spreadsheet to model the relationship between the two.
If he wants to repay his loan before maturity, he has to be able to understand the complex pricing of this structure. Most borrowers may
try to negotiate low early repayment penalties on their loan, but would not be aware of possible hedging break costs or the wide-ranging economic factors that contribute to the costs.
My client is now faced with a high break cost and pressure from the lender to repay the loan at maturity, but that is impossible: although a sale of the property can repay the loan in full, it would not be enough to cover the break cost in full.
This story is typical of what we are seeing in the market today. Was this customer treated fairly? He was offered a lower interest rate product and took it. Most people would — and why not, if it is offered by the bank manager, whom you have known for years, and who has helped you grow your business?
However, swaps are not all bad news. In a research paper published earlier this year entitled “Swaps: expensive insurance?” I looked at more than 20 years of historic swap rates, and found that 90% of the time it is cheaper to stay on a variable rate. I attributed this to our optimism
bias — it is human nature.
I recommended that banks show flexibility in hedging and use it to their advantage. Allowing borrowers to stay on a variable rate — where the cashflow allows it — will result in less interest being paid, which leaves more cash to amortise the loan faster. This in turn lowers LTVs and derisks the borrower and bank faster.
What do we do to existing breakage costs? The banks that worked with clients early, broke the hedging and added the cost of that to the loans, are now seeing the good results of their actions. Four years of low interest rates have meant those banks have been able to amortise these loans fast, and are now well below 2008 loan levels.
Others banks that kept hedging in place have had to make do with 100% interest cover or even negative cashflow because of pre-2008 rates and leverage. It is time for those banks to act.