A primer on interest rate swaps and the mis-selling scandal in the UK and the US

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A swap is a derivative contract entered into by two parties who agree to exchange two streams of payments (legs of the swap). In interest rate swaps (IRSs) the two counterparties agree to exchange interest rate cash flows, from a fixed rate to a floating rate or vice versa, where the floating rate is normally linked to a reference rate like LIBOR for instance.  In a simplified example, a firm A agrees to pay a stream of periodic fixed interest payments to firm B, in exchange for periodic variable interest rate payments linked to LIBOR.

The immediate advantage of employing IRSs is to limit or manage exposures to fluctuating interest rates or also to obtain a lower interest rate than would be available without the swap. IRSs are often entered into by firms that desire a type of interest rate structure that can be provided less expensively by another firm. Thus, by swapping the variable interest rate mechanism with another fixed mechanism, a borrower could reduce its exposure from fluctuations and better serve its needs. In this guise IRSs accomplish a hedging function. Parties seeking to exchange interest rate cash flows do not normally swap directly with each other but enter into a separate standardised swap agreement with an intermediary, normally a bank acting as seller of the financial product.

IRSs present a number of characterising features. They normally include an “interest rate cap”, a facility that protects borrowers against rises of interest rates above a certain threshold. This means in practice that if the variable rate is higher than the fixed rate, the borrower will be credited, while if the variable rate is lower than the fixed rate, the borrower will be debited. Another peculiarity is that IRSs can be entered into with a degree of flexibility as regards the amount and duration of the underlying loan that they cover. IRSs remain a separate contract from the loan and must be terminated independently by the borrower, which means that the repayment of the underlying loan does not automatically terminate the swap. For an early termination of the swap, a party will incur the “break cost”, which is the difference between the interest rate on the contract and the prediction of the interest rate for the remaining life of the transaction.

In the UK and the US IRSs have come to represent a large portion of the derivative products traded by financial institutions. While in the UK financial market IRSs have involved to a great extent small and medium enterprises (SMEs) that were sold swaps by banks, in the US government entities have been the main purchasers of hedging products, either seeking protection from the increasing volatility of interest rates or obviating long-term inconvenient fixed rates, in both cases unable to predict the correct price of borrowing over a certain period.

Very similar concerns emerged recently across the Atlantic for the way in which hedging products have been sold by the largest banks from US (Wells Fargo, JP Morgan, Morgan Stanley, CityGroup, Goldman Sachs and Bank of New York) and UK (Barclays, HSBC, Lloyds, Royal Bank of Scotland), giving way to what has been dubbed a mis-selling scandal. Some of the main pitfalls of the selling processes include the conflicts of interest that affect banks selling IRSs. Banks in fact have been motivated by huge commissions to sell complex hedging products in large quantity, often to clients who were not fully aware of the products they were purchasing. Clients in particular were not adequately informed about the costs related to exiting the swap and had overall a poor understanding of the different components of the deal. The mis-selling scandal exploded both in the UK and in the US chiefly for the charges that accrued under IRSs,as termination costs would amount to up to 50% in addition to the value of the loan. When in the post-crisis years both the Bank of England and the Federal Reserve lowered interest rates to record level, the situation for borrowers under IRSs became unsustainable as they had to either make higher payments under the swap or pay huge “break costs”.This led in the US, among other things, to the spectacular debacle of the city of Detroit (together with other municipalities), while in the UK it was followed by an FSA (Financial Services Authority) investigation and a redress scheme. 

Two prominent cases, notably Green & Rowley v. RBS and SEC v. JP Morgan provide an illustration of the legal issues that emerged in connection with the IRS mis-selling scandal in the UK and the US.

(Altalex, 13 march 2014. Article by Vincenzo Bavoso)

 

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