SHOULD LOSSES ON PAYER SWAPS BE RECOVERABLE?
Feature
Key Points Banks rarely, if ever, reveal the extra charge concealed in the structure of a swap. The 2001 Rights of Action Regulations (which implemented s 150 Financial Services and Markets Act 2000) must be taken to have been repealed by MiFID. A better solution for disappointed investors than the Conduct of Business Sourcebook (COBS) (and other MiFID implementations) is a straightforward action for breach of contract.
Author Julian Roberts
Should losses on payer swaps be recoverable? Some years ago, when the UK base rate was at 5% or higher, many SMEs took out hedging swaps to “fix” interest rates on their commercial loans. In late 2008 Lehman Bros went bankrupt and interest rates plummeted. Base rate is now 0.5%. For many SMEs facing an exceptionally difficult economic climate, the rates they fixed earlier are proving ruinous. What are the prospects for SMEs who have been sold hedging swaps to recover damages in the courts? A series of recent cases involving derivatives suggests that this may be difficult. Here, in summary, are the reasons why that conclusion would be premature.
otherwise affect the result. In Preston Street, for example, the bank’s expert put the compensation figure on an indemnity basis at £173,463. Using the same assumptions (notional £1,853,901, strike 5.06%, effective 1 September 2011, maturity 28 months, mid-market price), the bank’s claim on a swap would have been around 15% higher, at £199,356 (Bloomberg).
Swaps sold as “hedging“
A third reason for preferring swaps is that they allow bank sales staff to be economical with the information they give out about prices. The superficial simplicity of a payer swap – effectively a “fix” on the rate which the borrower has to pay for a loan – masks a considerable degree of complexity. A payer swap can best be regarded as two options. One is an option sold to the borrower by the bank: if interest rates rise above the rate fixed in the agreement, the bank will make up the difference (this sort of option is commonly known as a “cap”). The other is an option sold by the borrower to the bank: if interest rates fall, the borrower will make up the difference (a floor). This structure, like most options written on market indexes, can be valued. The value depends on the relative value of the swap’s two halves (ie, the value of the “cap” compared to the value of the “floor”). If these are equal and balance each other out, the value of the swap is nil (the swap is said to be “fair”, or sold “at par”). If, on the other hand, either party has to provide less than its counterparty, then the swap’s value is no longer nil, but has a positive value to the benefit of the party with the less onerous obligations. Therefore much depends on being able to value the obligations on each side. Doing this, however, requires access to data and to statistical techniques only available to financial market professionals. Moreover, the
Flexibility over pricing Loan agreements put out by banks have commonly included clauses requiring the borrower to acquire “an interest rate hedging instrument acceptable to the Bank and at a level, for a period and for a notional amount acceptable to the Bank...” (NatWest standard term agreement, May 2007). Typically, banks have themselves offered corresponding agreements to the borrowers. These have regularly taken the form of payer swaps: the bank pays the client whatever variable rate the underlying loan agreement has specified, while the client pays the bank some agreed fixed rate. Although, on the face of it, payer swaps merely reproduce the effects of traditional fixed-interest loans, there are significant differences. First, they are expensive, though this is not usually made known to the client. Secondly, for the purposes of borrowers they cannot legitimately be described as “rate hedging” instruments. On the other hand, banks like swaps. In order to understand the problem, we need to look at this more closely.
bank can claim in respect of future interest payments (prepayment loss) in the event of a customer terminating a fixed-interest loan prematurely. In principle, the bank should be compensated if it can only re-lend its capital at a lower rate of interest. However, as the recent case of K/S Preston Street v Santander [2012] EWHC 1633 (Ch) illustrates, quantifying this loss may not always be straightforward. Even if careful drafting avoids the specific pitfall faced by the bank in that case, the decision points up one of a number of difficulties which may arise in recovering indemnity losses. In contrast, a swap, which is a freestanding agreement separate from the loan, provides unambiguous consequences for early termination. Creating certainty is, indeed, the whole point of a swap, which is a vehicle for ascertaining the market value of an exposure at any given point in time. Premature termination is equivalent to transfer: all the parties need do is establish the value of that transfer and pay accordingly. The sum is actionable as a debt.
Why banks like swaps
Higher indemnity
For the bank, selling a variable-rate loan coupled with a swap is generally more satisfactory than selling a fixed-interest loan.
The second advantage is that a swap is commonly more valuable than whatever compensation may be obtained for prepayment loss. Calculating the latter is a relatively unsophisticated procedure and leaves out of account factors which would
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Certainty First, it is by no means certain how much a
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December 2012
Butterworths Journal of International Banking and Financial Law