Negligence solicitor, Emma Slade attempts to demystify the Hedge.
I am often asked, what exactly is a hedge?
If you are thinking in terms of that leafy thing at the end of your garden, then you probably need to be on a gardening website. However, if you have been a victim of the Interest Rate Swap (‘IRS’) scandal, then read on.
Interest rate swap products involve a financial concept known as a hedge. IRS schemes were originally conceived and created by professionals for professionals; it was not the sort of product that should have been sold to members of the general public. To make matters worse, institutions selling Interest Rate swap hedges, frequently failed to explain the concept properly to the consumer, leaving them with a false impression of how the product works.
I will explain how a hedge operates by giving an example.
Mr Li owns a couple of rice fields in the Hubei Province of Central China. Each November when he harvests the rice, he could easily take it into the local market and sell it on his stall, 1 kilo at a time. However, he cannot guarantee he will sell it all so instead, sells it to a rice trader, Mr Wang, at a price which is lower than he would get if he sold it on his market stall but at least he knows he has a guaranteed income. This goes on for a number of years.
The following January and before the rice planting season begins, Mr Li’s mother-in-law threatens to move in with him and he needs money to build an annex. Mr Li goes to Mr Wang and offers to sell Mr Wang his rice harvest for that year (which will be harvested in November) in advance. There is no guarantee that Mr Li will produce the same amount of rice that he has done in the years past. At the same time, Mr Wang – when he offers a price – does not know whether he is paying too much as there may be a glut in the market in November or whether he has got a bargain as there may be a huge pest problem affecting production. It is a gamble. Again, Mr Li does not receive as much as he would have done if he had actually waited until November but he does have the certainty of the money in his pocket.
This is a very basic “future”. In the money markets, they can get a lot more complicated and operate over longer periods of time. Let us say, for example, that Mr Wang decides that his arrangement with Mr Li is a good one and decides that maybe he wants to buy Mr Li’s rice harvest for the next twenty years. However, this will tie up Mr Wang’s money for the next twenty years and it may be that he will need it. So rather than purchasing the actual rice harvest for the next twenty years, he purchases the option to buy it: Mr Li has to promise that for the next twenty years, he will sell his rice to Mr Wang. This is a hedge.
Mr Wang now has a tradeable product – the option to purchase. It is purely speculative and the only reason it exists is because Mr Wang has been buying rice from Mr Li for a long period of time and believes Mr Li will continue to produce. Mr Wang can now enter the money markets and sell that option to purchase. As time progresses and there are changes and fluctuations in the rice market, the value of this derivative will also change and fluctuate. It will also increase in value as the derivative gets closer to the end of the 20 year option period.
Interest Rate Swap
So how does it work with an Interest Rate Swap?
Let me give you another example.
Baker Enterprises Ltd needs to raise funds to expand its factory. It comes under the category of an SME. Usually, they would simply be seeking a mortgage with their bank but the bank persuades them to enter into an Interest Rate swap.
Rather than offering the factory to the bank as security, the bank suggests that Baker Enterprises Ltd buys into a hedge and it is that hedge which will act as the security for the loan. The bank provides a loan to Baker Enterprises to purchase the hedge which is then placed on the open market and traded, thus providing sufficient funds for the original loan that Baker Enterprises needed.
At the same time though, the bank explains that both the loan and the hedge need to be paid for. Baker Enterprises will need to be making the loan repayments and will also have to pay interest. However, the bank persuades Baker Enterprises Ltd that they will enter into a “collar” interest rate swap: they will cap the interest rate on the funding of the hedge and they will link that interest rate to the LIBOR rate (London Inter Bank Offered Rate). They say to Baker Enterprises that if the LIBOR rate goes over, say, 5%, Baker Enterprises will only have to pay 5% interest plus of course the repayments on the loan and the lending margin on the loan. If the LIBOR rate is less than 5%, then the interest rate payable by Baker Enterprises Ltd will fall at the same time.
However, whilst there is a cap on how high the interest rate will go, because it is a Collar IRS, the bank also set a floor of, say, 4%. If the LIBOR rate falls below 4%, Baker Enterprises Ltd still needs to pay 4% interest.
The directors of Baker Enterprises Ltd are not sophisticated money-men. All they really understand is that the company will get the money it needs secured on an investment but importantly, the loan is repaid with a capped interest rate.
Unbelievably, after being in this arrangement for a couple of years, the LIBOR rate drops to an all time low of, say, 1%. Baker Enterprises are still paying 4% on their IRS scheme and it is obvious that the scheme is no longer financially viable. They decide to redeem the loan (or break it) but this is when the second shock arrives: the breakage costs.
Because the hedge has been bought for 20 years, if the bank sells it now, it is going to make a huge loss. It cannot afford to keep the hedge on its books and will need to sell it but rather than the bank making the loss, it passes the loss back to the consumer in the guise of “breakage costs”. Baker Enterprises had only taken out a loan of £700,000 but would have to pay breakage costs of £300,000.
And that is where the “scandal” has arisen. In this instance, Baker Enterprises is an unsophisticated SME, as are many of the people who have fallen victim to it. Virtually ever consumer says that they simply did not understand the product that had been sold to them or what would happen if the base rates fell to the all time low that they are currently at. Even more importantly, it would appear that the break costs were not properly explained. Break costs were mentioned, but the bank failed to give examples to the consumers of the level of the potential break costs.
There is also a possibility of a second scandal here. I have specifically given the above example based on the LIBOR rate – it could just as easily be the Bank of England base rate – but as readers of the news will know, Barclays Bank has been the subject of substantial fines for fixing the LIBOR rate which is supposed to fluctuate according to market conditions. Indeed, the Guardian Care Homes Ltd case is covering both of these issues – mis-selling interest rate swap products and the fixing of the LIBOR rate which they claim caused additional losses. The trial on this matter is scheduled to take place in October 2013 and it could have serious financial repercussions.
