At its most basic, banks offered clients what is called an interest rate swap. The bank would offer the right to fix the base rate on a loan at a certain level to ensure a rise in interest rates would not lead to a company's borrowing costs rising to a level they would be unable to pay.
This would be explained to the customer by comparing it to a form of insurance or fixed rate mortgage. What appears to have been less clear was that while the swap would compensate them if rates rose, it would cost them if rates fell.
Banks have also been accused of failing to mention the "break costs" of exiting the swap should a customer wish to terminate the agreement. It is here that the complexities of the swap market become apparent. While the customer was told the protection was "zero cost" this was not so.
Take the example of a five-year loan for £1m taken out in 2007. In this example the customer wants to fix their rate for the duration of the loan. The bank, with its sophisticated pricing systems, would look at the swap market and get the price of buying the equivalent swap. The rate at the time might be 5.2pc, however the bank, wanting to make a profit and knowing the customer has no access to swap market prices, would quote the customer a cost of anything from 5.5pc to 6pc.
If the customer agreed to the swap, the bank would instantly lay off the risk by selling the swap in the market and locking in a profit for itself of between 30 basis points and 80 basis points. In the case of a £1m, five-year swap, the bank would effectively get a customer to buy a swap worth £200,000 for a cost of £225,000 to £250,000. The bank would immediately claim this profit by selling on the swap into the market, netting itself a gain of between £25,000 to £50,000.
However, many banks did not stop here. In some cases the bank would offer the customer a "cheaper" rate by suggesting they take out a hedge for a longer duration than their loan. The customer would be told that if they did this – in some cases businesses took out 10-year, 20-year and even 30-years swaps – they could achieve a lower interest rate. For example, while a five-year rate might be offered at 6.25pc, a 10-year would be offered at 5.9pc, 20-years at 4.95pc, and 30-years at 3pc.
Again, the customer, with no access to swap pricing data, had no idea of the additional profits the bank would make by offering a longer-dated swap. While a profit of about £25,000 might be the norm on a £1m 5-year swap, if the customer were to take out a 30-year swap, the banks were often making a profit of up to £100,000 on the deal from the moment it was agreed.
Some banks would offer swaps for a greater amount than the actual loan being taken out, as well as offering more complex products, such as "multi-callable swaps", known in the industry as Bermudans.
Here a bank could generate profits of about £250,000 from swaps sold against £1m five-year loans, simply by taking advantage of the customer's ignorance of swap market prices. In some cases, salesmen even charged upfront "arrangement fees" of £35,000 even though the bank might be making a huge upfront profit from mis-pricing the swap it was selling.
For the customer problems did not become clear until they tried to cancel. One case uncovered by The Sunday Telegraph, and currently the subject of a complaint, involves a businessman who took out a five-year loan for £5m and was left with a break cost of terminating the 30-year swap of £4.1m.
Source: How the derivatives sold by the banks work - Telegraph
Just another good reason to ban derivatives.
This would be explained to the customer by comparing it to a form of insurance or fixed rate mortgage. What appears to have been less clear was that while the swap would compensate them if rates rose, it would cost them if rates fell.
Banks have also been accused of failing to mention the "break costs" of exiting the swap should a customer wish to terminate the agreement. It is here that the complexities of the swap market become apparent. While the customer was told the protection was "zero cost" this was not so.
Take the example of a five-year loan for £1m taken out in 2007. In this example the customer wants to fix their rate for the duration of the loan. The bank, with its sophisticated pricing systems, would look at the swap market and get the price of buying the equivalent swap. The rate at the time might be 5.2pc, however the bank, wanting to make a profit and knowing the customer has no access to swap market prices, would quote the customer a cost of anything from 5.5pc to 6pc.
If the customer agreed to the swap, the bank would instantly lay off the risk by selling the swap in the market and locking in a profit for itself of between 30 basis points and 80 basis points. In the case of a £1m, five-year swap, the bank would effectively get a customer to buy a swap worth £200,000 for a cost of £225,000 to £250,000. The bank would immediately claim this profit by selling on the swap into the market, netting itself a gain of between £25,000 to £50,000.
However, many banks did not stop here. In some cases the bank would offer the customer a "cheaper" rate by suggesting they take out a hedge for a longer duration than their loan. The customer would be told that if they did this – in some cases businesses took out 10-year, 20-year and even 30-years swaps – they could achieve a lower interest rate. For example, while a five-year rate might be offered at 6.25pc, a 10-year would be offered at 5.9pc, 20-years at 4.95pc, and 30-years at 3pc.
Again, the customer, with no access to swap pricing data, had no idea of the additional profits the bank would make by offering a longer-dated swap. While a profit of about £25,000 might be the norm on a £1m 5-year swap, if the customer were to take out a 30-year swap, the banks were often making a profit of up to £100,000 on the deal from the moment it was agreed.
Some banks would offer swaps for a greater amount than the actual loan being taken out, as well as offering more complex products, such as "multi-callable swaps", known in the industry as Bermudans.
Here a bank could generate profits of about £250,000 from swaps sold against £1m five-year loans, simply by taking advantage of the customer's ignorance of swap market prices. In some cases, salesmen even charged upfront "arrangement fees" of £35,000 even though the bank might be making a huge upfront profit from mis-pricing the swap it was selling.
For the customer problems did not become clear until they tried to cancel. One case uncovered by The Sunday Telegraph, and currently the subject of a complaint, involves a businessman who took out a five-year loan for £5m and was left with a break cost of terminating the 30-year swap of £4.1m.
Source: How the derivatives sold by the banks work - Telegraph
Just another good reason to ban derivatives.
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