Interest rate swaps

The businesses have all claimed that banks profited at their expense and many were unaware of the significant costs attached to the products that were supposed to protect them from upward movements in interest rates.

Typically sold between 2006 and 2008, businesses found themselves paying far higher rates of interest than they expected as Bank base rates fell to historic low rates.

Err, yes, that\’s what happens with swaps and futures. You remove uncertainty on the upside and replace it with certainty on the downside.

If you\’re too dim to get this you\’re too dim to be in business.

9 comments on “Interest rate swaps

  1. I’m sympathetic to the argument that there are people who were sold a product which they were told would protect them from an increase in interest rates in exchange for an upfront fee, but were actually given a straight interest rate swap, and the fee pocketed. If that happened – and I haven’t seen any evidence it did – then that’s clearly wrong.

    But the quote you lifted above is just absurd. “…products that were supposed to protect them from upward movements in interest rates…” SUPPOSED? There’s nothing “supposed” about it; an IRS does precisely that. And conversely “…businesses found themselves paying far higher rates of interest than they expected…”. If you agree to an IRS, then it’s literally impossible to then face an unexpected interest rate. If you are facing an unexpected interest rate, then it either wasn’t an IRS, or you didn’t realize you were agreeing to one.

    I’m not sure what actually happened, but the journalism has been simply terrible.

  2. “Business minister Nor­man Lamb’s officials wrote [that the] bank should have made clear that interest rates may fall as well as rise…”

    There are people running businesses unaware that rates can go both up AND down? The mind boggles.

  3. The quote at the bottom says a “collar”, which is not a simple interest rate swap – it is actually a combination of a cap and a floor, so effectively limits the range within with interest rates may move on the loan. I’d guess that the floor was set higher than the historically low interest rates that we have experienced in the last three years, and that these businesses are griping that they have therefore had to pay higher rates on their loans than they would have done if they had not been sold that derivative to limit the interest rate movements on a variable rate loan. As we discussed on a previous thread, they may well also have been overcharged for the derivative, but that is a separate issue from the accusation of mis-selling. Personally I would regard an interest rate collar as a reasonable product to sell to a business that wished to limit its interest rate risk but wasn’t eligible for a fixed rate loan.

    Tim adds: I would go further. A collar, which rules out the incredibly low interest rates of the past few years on the downside, would be a cheaper product to purchase than a product which only limited the upside.

  4. The problem is not the swap, it’s the fact that in many cases the offer of funding was made dependent upon the customer hedging the interest rate risk.

    The bank then sent a salesman who sold them a swap, the misselling part is that the they were only offered a product from the funding bank and the product was often unsuitable and did not match the terms of the original loan.

    I know this because I was offered this “service” from the nations favourite government owned bank

  5. “Typically sold between 2006 and 2008, businesses found themselves paying far higher rates of interest than they expected as Bank base rates fell to historic low rates.”
    If that is true, then it was totally unethical mis-selling.
    An interest-rate swap from variable to fixed should have left them paying *exactly* what they expected.
    I suspect that this is a financially illiterate journalist.
    @ Tim, collars aren’t that much cheaper than caps and are more expensive than swaps because the bank is taking an interest-rate risk and has to allocate capital while on swaps it mostly matches fixed interest loans with fixed interest deposits from customers and only has a very small credit risk

  6. John77

    I agree about the illiterate journalist. And although I’m prepared to believe that these small businesses didn’t fully understand exactly what they had been sold, and were perhaps ripped off both on the choice of product (as Alan says) and the charges, I’m not totally convinced that this is necessarily mis-selling as such. Really someone running a business should have had more sense than to enter into financing deals that include products they don’t understand.

    I think what is really happening is that small businesses who are pissed off about their high interest rates are looking at the PPI payouts and thinking “we could have some of that”.

  7. @ Frances
    I think you are quite right – I just can’t prove it.
    I know of one or two medium-sized companies who from choice took out an interest rate swap and consequently ending up paying more than they would have with a variable rate loan but would do it again because they were more interested in the security of knowing the interest rate than the extra cost.

  8. John77

    Use of derivatives to reduce borrowers’ risk for SMEs was the subject of my MBA project. The key is transparency. Borrowers HAVE to know what they are buying. But they are in my view absolutely essential for any business that needs to manage its interest rate and, for exporters, currency risk. I think it is very unfortunate that simple swaps and options have been cast into outer darkness along with CDO squared and other highly leveraged, complex products. They serve a useful purpose.

    Interestingly, on that project I worked with two people from the insurance industry, because we regarded derivatives as insurance products.

  9. @ Frances
    I fully agree except for “absolutely essential”, where I should say “very highly desirable” – if the business has massively more capital than it can use (or a guy who rolls a six every time) then it doesn’t need them. While others also have a choice the swap is the only sensible one to take.
    “we regarded derivatives as insurance products” – well, yes they are when used properly.

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