More borrowers are seeking refuge in these uncertain times with certainty on their interest costs. Indeed, the banks are also increasingly making some form of hedging a mandatory condition of the underlying loan terms. More and more banks are offering ‘Fixed Rate Loans’ (“FRLs”) as a hedging alternative and although these would appear to be straightforward in structure with an assumption that they would operate as per the domestic fixed rate mortgage market, these two types of fixed rate must not be confused.
Critically the FRL offering will have an ‘embedded’ swap or derivative that enables the bank to offer a fixed rate loan by entering into an internal ‘swap’ through its treasury function. As with a stand alone swap, the rate payable on an FRL typically consists of a combination of the underlying market swap rate for the term being considered, plus a credit spread. This spread reflects the bank’s cost for providing the fixed rate as well as a ‘profit’ element for the bank. Since banks know that borrowers don’t have access to this information, there is a natural tendency to hide extra margin within the fixed rate being provided to borrowers. Therefore, there is potentially real value to be had in benchmarking the pricing of an FRL, to ensure that both the underlying market rate and any credit charges are comparable to those prevailing in the market. If entering into an FRL, we can assist with this benchmarking, given our extensive market knowledge and access to the required live information which is not available online.
The fact that there is an underlying swap in an FRL has serious implications for any ‘early redemption’ as the bank would have to re-enter the money market to unwind the associated swap at prevailing rates. Once again access to live market rates is essential to ensure that the associated termination costs are transparent and market related. This is unlike the domestic fixed rate mortgage market where actual early redemption charges and costs are known and explained at inception. Typical fixed-rate mortgages may have a 1% exit cost or perhaps three months interest for example.
The rationale for this apparent confusion in ‘terminology’ may be explained by the requirement of stringent compliance procedures for any derivative products that are not required for what banks call ‘straightforward’ fixed rate loans. The anomaly being that as explained above, the commercial FRL does in fact include a swap, however, the Bank is not providing the same regulatory safeguards as if it were selling a stand alone swap, which is a regulated financial product.
Worryingly, we have seen one major UK Bank actively try to persuade a customer to take out a fixed rate loan compared to a swap or a cap, by offering a reduction in the loan margin of 0.20%. Live benchmarking of the FRL pricing with the bank revealed that they were simply adding the 0.20% back into the FRL rate, when compared to the rate they were offering for a stand alone swap. This throws up another important issue to bear in mind, which is a loan margin is only payable for the period that the loan is utilised, while any spread incorporated into a fixed rate hedging product (be it FRL or swap) is payable for the life of the product, either while utilised or included in the termination cost.
Any incentivisation should throw up a red flag to a borrower, because when the bank is really keen on you choosing a certain option, it begs the question why! Many of us know this such as when we are pressured to buy insurance from say a mobile phone retailer (Dixons Carphone were fined £29m this week for misselling these). However, given the hedging misselling these banks have had to pay billions for in the past, it is concerning that they are still not being fully transparent with borrowers about the costs and risks associated with particular methods of hedging.
As we have explained thousands of times to borrowers, clients, the FCA and also the Government, there is nothing wrong with a fixed rate loan or a swap if they are explained carefully. There are other options like a cap (which I will explain more in a future article) which provide more flexibility to borrowers with no threat of nasty breakage costs.
We are the UK’s largest FCA authorised firm that is regulated to be able to advise all types of business on derivatives. Please don’t hesitate to call us.