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Interest rate swap doing your head?


The "Toxic Sausage" Theory of Interest Rate Swaps

In many ways, a financial services product is similar to a sausage. In a sausage,you would expect to have nutrients (good for you), neutral elements (neither good nor bad) and toxins (bad for you). You wouldn't expect to get much toxin.

The equivalent qualities in financial service products are benefits, neutral items,and financial detriment.

Neutral items are parts that are neither good nor bad, but that you are paying for. For example, an allowance for the provider's overheads, for sales and administering the product, are unavoidable costs. You know you need to pay for them, but would rather not (with some products, such as on line motor insurance, these can be cut dramatically). The provider's profit margin is another example.Again, this is a necessity of life. Ideally, the provider prices his products including a consideration of the profit margin as a percentage of customer benefit. Then, there is some alignment between the customer and provider's interests.

What probably caught your eye is the possibility of toxins in a sausage. Food laws probably restrict these to a small fraction of the contents. I suspect it is impossible to get lower, but it is certainly possible to get higher - remember the CJD crisis. So you would expect mainly nutrients (probably in the form of meat), and neutral items in your sausage, with maybe more neutrals and less meat in a cheaper sausage. You can choose whether to buy at Waitrose or Iceland.

Now,let's compare the swap derivative products (and TBLs) that were being sold by banks and building societies between 2006 and 2009. These were sold in conjunction with (or as a variant of) loans, which in themselves were usually(but not always) beneficial to the client. But what about the"add-on"- the separate derivative sale, in the case of derivative sales, or the fixed rate variant, for TBL's? These need looking at more carefully.

The problem is, the balance of financial nutrients and toxins in any of these products can only be determined by using expensive and precise methods, using the conditions prevailing at the day of sale. The banks (and building societies)had the technology and the skilled staff to assess the levels and balance - as this costs thousands of pounds each year, the SME in the street didn't. Nor would he, or any retail or commercial loan broker, know of its existence.

Let's look at a similar market - the UK housing market. You may be invited into a house - and be told that the owner is selling it. To negotiate a mutually acceptable price, you would probably ask the views of local agents. Their assessments would be based partly on the condition of the house itself, but very much on recent deals in local property - similar houses.

It's the same with swaps, other derivatives, and TBLs. These can be priced accurately nowadays using hi-tech equipment and skilled staff. Using cash flows for swaps/TBLs and Black Scholes and similar techniques for caps and floors,accurate pricings can be produced, which the market will, to a large degree,agree on. But the very existence of this market is a closed book to most,and its workings closed to those without a Bloomberg or similar pricing system - and the skill, not insignificant,to use it. I have asked accountants, lawyers, IFAs and mortgage brokers about this. Many within the last category do not even understand the financial link between interest rate falls and the theoretical break cost of a fixed rate loan.

So as far as SME 'getting advice' on their product offerings, in reality there is nowhere they could have gone. I await any argument of substance from any bank to contradict this last statement.

There just remains for me to define 'toxicity' for a part of a financial product.Here the first part is relatively simple - it is client exposure to risk. So floors, whether in structured or vanilla collars, or the floor element of swaps or TBLs, are pure risk exposure. The second part, which many sellers carefully hid, is the VALUE of this, as obtained from the market.

Take a real life example. A long term family bank client, ten years with the same bank, and the same RM. Looking for finance for additional warehouse space, for expanding a successful business. Loan margins were negotiated, then the concept of 'protection' was introduced. The RM's job was to get the client to trust him. And to trust the bank brand. He succeeded. How was this trust repaid?

The bank sold this client a simple swap. Value of the benefit to the client was £2,000. Value of the toxins was £144,000.

Now, this is obviously a horrible product - sheer profiteering. The client effectively underwrote the probability of an interest rate fall - and on rotten terms. But is it illegal?

As such, probably not. Profiteering is not racketeering. BUT..... When the product is described by the bank as "hedging"...or "protection... Or"insurance" .... that's a different matter. Remember also, these products were presented to clients by "professional" salesmen. As opposed to the RM's, these were often 'one hit wonders'- get in, close the sale, on to the next one. In Building Societies, the RM and sales roles seem to have been combined, which is very interesting. We need to look at their sales behaviours differently.

The pricing theory for derivatives is well established, and can be confirmed from several textbooks.

© Windsor Actuarial Consultants Limited

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