Treasury Based Loans Using Stand Alone & Embedded Interest Rate Swaps – Impact on SMEs & Large Companies.
By Terry Mulvenna Workout & Corporate Finance Specialist.
The impact of the almost imperceptible change from Banker/ Customer Relationships moving from being one of Agency (no conflict of interest, pre-default) to one of confrontation (based on caveat emptor and contractual exclusions) has come to a head since 2009 because of the impact of Treasury Based Loans (TBLs).
More recently, 2012+, this confrontation has become more heated, as increasing losses have crystalised from the mis-sale of these TBLs, and redress has been denied to customers, especially those that have been made insolvent or bankrupt.
TBLs are essentially Fixed Rate Loans (FRLs) where the “Fix” is derived by an Interest Rate Swap (IRS), its derivative or synthetic/ surrogate. These TBLs were perfected in the late nineties and widely sold to SMEs late 2006+ to protect the banks from falls in interest rates.
In addition, to improve Bank profitability, TBLs also enable Banks to “arbitrage” customers’ lack of knowledge and the Banks interest rate data monopoly.
Please note, that the stated reason banks sold these products was to protect their customers from “rises in future interest rates.” This “protection” was often sold on a “predicated” basis, the predication being introduced late in the application/ renewal cycle.
Essentially, IRSs give rise to undisclosed running (margin calls) and termination losses (Breakage Costs) because of movements in current and forward interest rates. The implications of both the margin calls and Breakage Costs (BC) were not disclosed to the customers and are based on the dynamics of movements in the forward market in interest rates. These movements in rates, impact on the TBL by the process of Discounted Cashflow Analysis, on which the valuation of IRSs are based.
TBLs are essentially totally rigid vis a vis SMEs as they are locked within the terms of the IRS’s Amortisation Schedule and the TBL’s Terms & Conditions.
The concepts of forward rate curves, Swaps and their valuation being driven by the dynamics, and mathematics, of Discounted Cashflow are all alien to SMEs and most businesses who are totally risk averse regarding Capital risk. Most SMEs are also mathematically and Derivative illiterate.
The Banks also “hedged” their positions regarding the IRSs by making them cancellable, often totally at their volition.
1. Essential Pre-Understanding
Before describing the process and effects a Stand Alone or Embedded Swap have on a business entity, it is necessary to appreciate the role of Commercial Banks in the economy in general and their role in lending to SMEs in particular. The role of Security in Lending is critical to that lending process and to the Default/ Collections process which essentially backstops this lending process.
This analysis would normally be classed as “potty training” and relegated to an Appendix. However, the philosophy and impact of the Treasury Based Loans (TBLs), sold by UK Commercial Banks (1997+) is so far from normal historic UK (and most other countries) banking practices that it is included in the main body of this report.
Treasury Based Lending, related to SMEs, can be classed as predatory and deviant in that its rigidity undermines the SME by its very design and implanting process. The espoused characteristics of the simple, simple fixed rate loan, that it is “simple” and “flexible,” are the opposite in practice: total rigidity with absolute adherence to the Amortisation Schedule, save that the margin (on a Fixed Rate Loan! – FRL) can be increased, without default occurring.
2. Simple Economics
2a. The Basis of Banking
From an economic perspective, Commercial Banking is seen as a key Primary Economic function. It is the link between Macro and Micro economic activity. One key function of Banking is the process of Financial Intermediation: the linking of savers & borrowers. Idle funds are collected from savers in return for a reward, interest, on their deposits. These funds are then on-lent by the Bank to businesses needing funds in return for fees and interest. The bank makes a profit on its “turn” and the business puts these funds to work, hence creating products and services. This process produces employment etc. Banks (and Casinos) are the only businesses whose main stock in trade is cash – a commodity all other businesses crave. Via fractional Reserve Banking, Banks can generate their own stock in trade.
The Commercial Banks role in financing SMEs is particularly important as these firms have nowhere else to go. The SMEs role in employment creation is also critical, being the largest source of employment and job creation in a capitalist economy.
Lending to SMEs is, however, intrinsically risky. The viability of the business is the best security for any lender, BUT in the real world, this viability has to be backstopped by perfected Banking Security. Security is the key to successful lending – it is last, but not least. Tangible security is the preferred means of offsetting the intrinsic riskiness of SME lending.
As successful businesses (and their owners) build up profitability, they also build wealth, both within and outside the business. This wealth can be used as security to backstop any residual risks to the bank.
Perfected, Banking Security is easily foreclosable upon, if/ when a business defaults. This aspect of foreclosability is known to borrowers, although the extent of the Banks favourable legal status has been publicly toned down in the last 30 years.
The main pillar of any successful economy is a fully operational Commercial Banking system. The role of the bank is to add value to its borrowers’ business via relaxing the SMEs financing constraint (cash availability) hence allowing the entity to grow faster.
When successful, this is a ‘win, win, win’ situation: the business grows faster; the bank grows its income; and the economy grows quicker, employment is created and taxes are paid/ collected (and paid) by all parties.
Commercial Banks are the key stone of capitalism: by financing SMEs, Banks facilitate a massively Positive Sum Game that drives production, employment and economic growth: 1 + 1 = 3, hopefully 3++ !
Banker/ Customer relationships are symbiotic relationships: the bank being the parasite which provides the essential ingredient of cash liquidity to cash starved businesses. In return for this rare ingredient, the Bank is rewarded with an income stream from lending and fees for services provided. When successfully applied by an SME, this wonder ingredient (cash), allows the SME to grow much more rapidly than relying on its own ability to generate funds. This process not only assists the entity owner, and banks, to enrich themselves but benefits the whole community by wealth and tax creation/ collection.
2b. Banking Principles.
2b.i. Business Basics.
An entity’s Trading Requirements are market driven (product, final and raw material markets, plus production processes). Assets are therefore derived by basic market needs: financial speculation apart, the reason for a business holding assets is that these assets are required to service customer needs. Servicing/ satisfying customer needs produces the sales which drive the cashflow and profitability of any business.
Assets are the tools of the business and are not required per se: asset structures therefore drive liability structures, not the other way round.
2b.ii. Term & Tenor.
Subject to entity viability, success in lending/ borrowing is based on matching Term and Tenor: the longer the term of the asset, preferably the longer the Tenor of the Loan. Ideally, Term and Tenor should match. Banks cannot match the funding requirements of long term assets due to funding, liquidity, interest mismatch and regulatory constraints.
Long Term assets usually have low cash generating capacities and therefore (usually) very long paybacks.
The inabilities of banks to match the funding requirements of their customers (for instance, by providing a10 year repayment loan for an asset with a 20 year payback), means that the Loans are draining their customer entities of cash per se: the bigger the mismatch between Term and Tenor, the bigger the drain on borrower’s cash resources. The pressure on cashflow caused by the premature paying down of loans means that companies etc. must refinance almost continually.
Flexibility in the structuring of long term facilities is therefore essential.
2b.iii. Sources of Business Risk.
The main risk in any business (in a competitive market) comes from the market and technology. These risks are normally outwith the entity’s control. The entity must have
the flexibility to manage its assets to reflect these dynamic risks and cope with changes in technology. Add-in the vagaries and consequences of the Economic Cycle and these market risks can be lethal.
Flexibility of asset (and therefore liability) management does not guarantee survival during recession. However, rigidity within the financing structure; particularly rigidity within long term loans, can accelerate, or even precipitate collapse. To ossify a Liability is therefore a very dangerous matter for a trading entity. This risk is compounded for a Capital Intensive entity which has taken on Long Term Liabilities where any rigidities, and any Contingent Liabilities, are disguised/ hidden and not declared at outset.
2b.iv. Banking Principles & Banking Security: Implications for Swaps/ TBLs.
Due to the reality of “on demand” deposits and the illiquid nature of bank assets (Loans), the legal system has always supported banks. Due to the inherent mis-match between the liquidity of deposits and illiquidity of banks advances, “on demand” loans effectively have no legal protection, when in default.
Banking security has evolved so that upon Perfection of the Banking Security, the customer holds his property “in Trust” for the Bank.
Overdrafts and “on call” loans are repayable “on demand.”
Once a Facility is “in default” it is repayable on demand. Once demand is made and the money not paid, the customer’s security can be liquidated with very little interference from the Courts.
When one Facility is in default, all connected facilities are “in default” due to “cross default” clauses: if one facility is callable, ALL facilities are callable, “on demand” across the connection.
This legal support has evolved due to the implications of bank runs on economic activity: a financial crisis brought on by a run on the bank, quickly spreads to the real economy.
Once an “on demand” facility is called, the Bank can liquidate the customer’s security, in most cases, without recourse to the Courts. However, the responsibilities (and liabilities) of holders (in possession) of land/ property are onerous. Banks therefore prefer to avoid direct possession and work via agents/ surrogates appointed under the mortgage or debenture: these agents are often token “Officers of the Court” including Administrators, Receivers, Liquidators and Trustees. In England and Wales, via the 1925 Law of Property Act (LPA), Banks can appoint LPA Receivers. The power of these LPA Receivers has been extended to include appointments under the Terms of the Mortgage, when they are known as Fixed Assets Receivers – but the common name remains LPA Receivers (LPAR).
The benefits of appointing an LPAR is that, although appointed by the Bank, they are the Borrowers Agent. This is a quick and easy way to foreclose on a “defaulting” borrower without reference to a Court or transparent disclosure of costs. This lack of transparency concerning LPA costs can prove lethal to the residual value (and wealth) of customers in difficulties: whether these difficulties occur per se, or are engineered by the structure of the bank facilities is irrelevant; the end result is the same, the annihilation of the borrowers wealth.
2b.v. Monitoring: Current Account & Covenants.
The benefits of a sole banking relationship, via provision of the payment mechanism
(current account) by the lender for the customer are awe inspiring:
If necessary, the bank has full knowledge of the customer’s activities – the current account being the customer’s wallet.
Complete knowledge of monthly and seasonal patterns of trading and payments.
Lumpiness and signs of distress in payments and receipts.
Detection of hard core developing.
Monitoring (and control of) of excesses, carry forwards etc.
Signs of over trading.
Signs of losses occurring.
Detection of diversions etc., etc.
Detection of inter company/ cross company/ group cross firing.
In addition to real time monitoring of the business via the current account, the business can be monitored periodically by the bank including Covenants within the Facility. Covenants, if designed properly, are essentially a built in monitoring device, a means of detecting and forestalling problems. If these covenants are breached, they can be waived, rectified, or a plan for managing (rectifying/ working out) the causes and consequences of the breach can be made and implemented. Breaches are Defaults but if a workout plan is formulated, this plan should override the Default until the plan has been demonstrated to fail.
Covenanting, when combined with the benefits of running the account, put the bank in a position to monitor the riskiness of the business and therefore the safety of their lending virtually in real time.
In extremis, during workouts of critical importance, the bank is essentially, de facto, in control of the business, by the power of vetoing payments not within the Workout. However, this close control during workout, is often better, and cheaper, for both the bank and customer than invoking legal recovery routes.
The above presumes a viable business, a willing customer and that the covenants and current account are not being window dressed.
IF these prerequisites are not met, the legal recovery/ security realisation options should be considered, urgently.
2b.vi. Rigidity Within Facilities.
Rigidity means lack of flexibility in a bank’s ability to restructure/ reschedule/ rollup servicing of medium /long term loans by the loans very design. The greater the rigidity
of the Loan, the greater is the likelihood of the entity breaching Loan Covenants.
Badly designed/ inappropriately structured facilities within an entity’s financing structure can “engineer” Defaults by their poor or intended design. If these breaches cannot be rectified by the entity; or by resetting the loan, or the breach being waived, the entity is in default. Default can lead to foreclosure.
3. Interest Rate Swaps (IRS).
An Interest Rate Swap, or its derivative or synthetic derivative/ surrogate, is a Contract for Difference (CfD) based on current and forward interest rate curves. By definition, a CfD is a zero sum game: meaning one party’s loss is the other party’s gain. Leaving aside, dealing costs, the two party’s profits and losses equate to zero.
However, including, the Banks “arbitrage” opportunities and the Bank’s information monopoly, the mis-quoting of IRSs (at prices above Fair Execution) can make the CfD an absolute winner for the Bank, before making bulk profits are added!
3a. Treasury Conventions & Amortisation Scdedules.
In a Fixed Rate Amortising Loan, with a Stand Alone IRS or Embedded IRS, of whatever tenor, the cashflows (loan repayments) are contractually fixed by the Amortisation Schedule. In turn, the payment periods are fixed by convention: Day Count Fraction Actual and Following Business Day Conventions. The use of these Conventions are unusual for business loans for SMEs per se: the interest calculations have to be executed within these conventions rather than the use of standard Loan Amortisation packages such as Excel, or, manual equivalents. Access to the Convention’s underlying framework is not made available to customers in open Excel formats, so the calculations cannot be checked. Alternative financing scenarios cashflow implications cannot be tested or costed.
The use of these Conventions, when accompanied by non provision of open Excel sheets, is a major “Barrier to Entry/ Lack of Transparency” as the figures cannot be verified by non treasury specialists. These loans therefore totally lack transparency, the customer effectively being told “take it or leave it,” or, Aunty knows best.” Few accountants know how to check interest calculations within an amortising loan using Excel, or a manual equivalent. I have yet to meet one who can check an amortising loan within the Treasury Conventions!
The absolute none-availability of the interest rate data compounds these Analytical Framework issues exponentially. Data concerning the actual market rates is not available to the public at an absolute level: without subscription to Reuters or Blomberg, the data is simply not available.
This means it is not possible to check the accuracy of any quotes without significant cost. This constraint should be sufficient for the authorities to act: either prohibiting the use of these products completely or the establishment of a “default” rate database. Alternatively, the authorities can use competition/ market abuse Laws to smash this cartel.
Please note the impact of our inability to remodel Treasury Based Loan Terms: it is not possible to model Interest Overpayment Calculations, without access to the basic Interest Rate Data and Day Count Calendars. Without these basic parameters it is impossible to model/ reprogramme Working Sheets within Excel. Therefore, it becomes impossible not only to quantify Primary Losses under a “Reset” but to quantify the interest charges and repayments under different loan resets: amounts, tenor and interest rates.
Amortising Schedules/ Interest Refund Calculations must be provided in open Excel Sheets, to facilitate checking and remodelling. Interest Rate must be verifiable from a Public Data Base. Without commonality of data, we would be having “parallel conversations” with the Bank concerning Redress, both per se and concerning specific “Resets.” Difference in process could divert from the key issue: differences in outcomes/ losses/ consequences created by the TBL.
The non-provision of Amortisation Schedules in an open Excel format, and a verified Interest Rate Data Base, by all UK banks is a major example of Obfuscation regarding the TBLs.
3b. Swaps: Running Losses (Margin Calls) & Breakage Costs.
The running loss/ profit on the Swap is derived by the use of Discounted Cash Flow (DCF) Analysis to determine the Net Present Value of the Cashflows. Under DCF, as interest rates fall, the Present Value (PV) of a given Cashflow stream rises: the longer the cashflow stream, the greater the impact of the fall in rates; the shorter the cashflow stream the smaller the impact. Likewise, the greater the fall in interest rates, the greater the rise in the PV of a given cashflow.
The difference between the PV of the Cash Inflows and the PV of the shorter cash outflows, gives the Net Present Value (NPV) of the Swap – its market price. As the price of the Swap varies from the Original contract price, the difference is paid/ received by the buyer – known as margin calls. This is why Swaps are CfDs – it is the difference between the agreed price (at Date of Execution – DOE) and current price at swap reset (monthly, three monthly etc.), which is payable under the contract by one counterparty to the other.
The terms “Day Count Fraction Actual,” “Following Business Day Convention,” “Date of Execution” and “Counterparty” are Treasury Terms, totally alien to SMEs and, more critically, their borrowing needs.
In embedded Swaps, the margin call is not paid but rolled up in the “bucket account”/ Breakage Cost, which is secured against the entity’s Banking Security.
3c. DCF Process, Margin Calls & PVO1.
With FRL TBLs, the interest rate “protection” (the fix) is derived by an Interest Rate Swap: short term (one/ three/ six month), variable rate loans are swapped for long term fixed loans (one to fifty years), via a banking entity, which are then on lent to customers.
Given a normal yield curve, long term money is more expensive than short term money. Forward curves determine the predicted forward rates for a particular rate.
IF long term rates fall and short term rates stay the same, the PV of the Cash inflows, determined by the Repayment/ Amortisation Schedule, rises significantly compared to the PV of the outflows which stay the same. Thus the NPV (the value) of the Swap rises. In the case of the TBL, with an embedded swap (for the borrower), these margin calls are represented by the Breakage Costs (BC) and bucket accounts.
The DCF process itself is dynamic: small changes in current short term interest rate or long term interest rates can produce major changes in the swaps NPV, its value. These changes in NPV are the “margin calls” for either party at reset dates. The Breakage Cost (BC) represents the NPV of all “future” resets using the forward rate for the given reset tenor of the variable rate leg of Swap. The longer the Tenor of the whole loan, the greater the variation in NPV/ margin call and BC.
This “dynamic” is recognised by Bankers as the “PVO1” (Price Value of one One Basis Point). This figure represents how many £s are lost/ made for a one hundredth of one per cent move in interest rates (one basis point). Thus a position with a PVO1 of £4500 would lose/ gain by £4500 for every move of one basis point in interest rates.
Putting this in comprehensible English: the borrower will lose £450,000 per 1% fall in interest rates if he has a FRL fixed by a Swap/ embedded Swap with a PVO1 of £4500.
The higher the PVO1, the higher the risk but the PVO1 of £4500 is not made up, it is the actual figure for a loan to an SME, with a Networth of £1.5m!
With TBLs using embedded swaps, the margin calls are rolled up for the customer but (theoretically) made by the bank to the seller of the Swap, the Bank’s exposure to the customer hence increases. As the exposure increases the Bank’s Security Cushion is eroded. Covenants are also breached but not declared to customers.
This DCF concept is unknown to most owners of SMEs. The DCF “dynamic” – the PVO1 – is totally alien in both concept and application to owners of SMEs and even large companies. Most SMEs are totally risk averse: unquantifiable and unpredictable (dynamic!) cash losses and BCs are to be avoided like the plague.
3d. The Legal Management of Swap Contracts.
This is done via the International Swap Dealers Association (ISDA) Master Agreement (MA). An ISDA MA is attached as Ex. I. This is well worth reading.
For embedded swaps (derivatives and synthetics), the rules of the loan (the Amortisation Schedule), the Terms & Conditions (T&Cs) and Covenants are sufficient to legally enforce the embedded Swap. The Amortisation Schedule, in conjunction with the T&Cs is sufficient to act as a surrogate for the ISDA agreement. The implications of the rolling up of any margin calls under the embedded swap will be examined later. The T&Cs of these TBLs are well worth reading. It is these T&Cs upon which the Bank is reliant in terms of legal enforcement.
An intimate knowledge of the ISDA MA and Loan (& mortgage) T&Cs, plus the origins and compilation of the Amortisation Schedules is a pre-requisite for understanding TBL FRLs.
How many SMEs possess this knowledge?
3e. The Legal Position of Swaps.
The ISDA MA forms part of the Loan Agreement for stand alone Swaps and its variants (Collars, Caps, Participating Collars etc., etc.). Similarly, the Amortisation Schedule and T&Cs forms part of the Banking Security for an embedded swap.
These agreements are all embedded within the Banks security. Thus, essentially a Securities Transaction (a Swap or embedded Swap) which is undeclared to the customer, avails the Bank of the protection of its perfected security over the customer’s tangible assets. Embedding the Swap in the Banking Security, ensures the Bank can access the Court’s rubber stamp procedures or the LPAR route, in terms of the liquidation of the customer’s security.
Did the customer know what a Securities Trader was?
Was the customer aware he was becoming a Securities Trader?
Was he warned he was becoming a Securities Trader?
Did the customer (now a Securities Trader) know that the trade (with the mandated ISDA MA, and T&Cs) he was making would be embedded in his banking security, thereby exposing his banking security (and possibly the whole of his wealth) to finance “cash losses” under this security contract?
4. Credit Implications of the Swap/ Bet on Interest Rates.
Both Stand Alone Swaps and embedded Swaps have the same implication on the credit status of the customer: if the customer has bet the wrong way, it loses money and the banks exposure to the customer increases, if “only” by the increase in BC.
Bet the wrong way?
If the customer bets that rates were going to stay the same/ rise and they fall, the customer loses.
If the bet is made by the customer fixing a variable rate loan by a swap at near the initial rate, it pays these losses by margin calls.
If the customer fixes his rate via a TBL, with an embedded swap/ derivative/ synthetic, the losses are rolled up and undeclared to the customer.
BCs under both types of loan, increases the banks exposure proportionately to that customer. The rolling up of margin calls with an embedded swap, further increases the banks exposure to the betting customer. These exposures are an entirely predictable consequence of the loan process: therefore, at least on a contingent basis, the increased bank risk will have to be sanctioned in advance. Interest rates fell further and faster than expected (or did they?): the increased exposure will have led to “undeclared” Covenant Breaches; and these ever increasing breaches will have put lenders under pressure to seek to have the breaches remedied.
Did the customer know he was making a bet?
Did the customer know he was responsible for the losses made under a bet he knew nothing about?
Did the customer know about BCs at all, and that he was responsible for them.
Did the customer know about the Contingent Liability (CL) associated with the BC at all?
Did he realise the implications of this CL on his accounts and Fiduciary Responsibilities?
Did the customer know about the increased credit exposure to him by the bank and the fact that this will have been approved in advance of the sale?
Did the customer know that he was exposed to Covenant Breaches,” engineered” by the DNA of the loans?
Did the customer know the absolute contractual rigidity of the ISDA MA (or its synthetic derivative) would stand the logic of the Workout Ethos of the traditional Bank Loan on its head? The covenant breaches engineered by the losses on the Swap and the Contingent Liabilities under the Swap, would enable the Bank to “protect” its position by taking over the working of the company and its assets to minimise its losses, without regard to the “engineered” and “misrepresented” causes of these losses and covenant breaches.
The answer to ALL these questions is obvious for the overwhelming volume of borrowers affected by these loans – whether large or small!!
Treasury Based Loans are totally unsuitable for the overwhelming majority of SMEs.
5. Why Use Swaps to Underpin FRLs at all ?
5a. Benefits of the Swap Based FRL for Banks.
By the use of the Swap, the bank providing the Fixed Rate Loan (FRL) has passed the risk of changing rates to the customer. This increases the availability, and tenor of FRLs available.
The Swaps “created” by the FRL can be sold onto investors, increasing the range and scope of the market.
The use of these products increases the availability of instruments for investors who have constant inflows but want to put their money to use in the long term (paying Pensions etc.).
It enables Banks to speculate and hedge their view of future interest rates.
It creates new profit opportunities by creating new customers and “breaking/ making bulk” opportunities.
These new Swap opportunities increase the volume of the market and enable arbitrage opportunities to be eliminated, increasing market efficiency. Capital allocation is thus improved.
The bank can book the Mark to Market profit/ loss on the undeclared Embedded Swap in its Treasury, whilst not declaring the CL to the customer. The IRS product is thus the link between MTM accounting and GAP accounting, enabling banks to arbitrage the accounting system.
The bank can use the basis of banking security (the Court’s “rubber stamp” repossession or the threat of this) to exert absolute control over the borrowers cashflow and assets in a predatory, undisclosed way, posed to the borrower as being in the “normal course of banking business.”
5b. Benefits To Small Customers.
I see no benefits for even quoted companies in this type of product unless they understand the risks and are willing to “elect” to be Professional Investors or Eligible
Counterparties. The prerequisites for understanding these risks are five fold:
‘A’ Level in Pure Maths – at absolute minimum.
Degree in Mathematical Economics/ Quantitative subject.
Masters Degree in Business/ Economics with Special Subjects in applications of DCF, Derivatives and Treasury.
Access to Screens for Market Data.
Proof of Experience in Market Trading.
There may be other businessmen with attitudes to risk which suit these products but again they must elect and also have Spread Betting experience.
Finally, there may be businesses with very long term contracts and cashflows projectable with high degrees of confidence for whom the Swap and TBL FRLs may be suitable. These Trust types of businesses can simply elect to become Professional Investors or Eligible Counter-parties. Many companies involved in Private Finance Initiatives may be suitable for these products but again must elect etc.
5c. Benefits to Large Bank Customers.
For multi national companies, I see no problems with these products as long as the users are classified, or are willing to “elect” to be classified, as Professional Investors or Eligible Counterparties.
ii. Likewise for quoted and very large private companies, as long as they again
elect to be classified as Professional Investors or Eligible Counterparties.
However, the pre-requisites listed in 5b. sic apply. I would go further regarding public authorities, government owned social enterprises, nationalised companies etc. ALL IRSs should be Ultra Vires, for these Government controlled entities, save with specific written authority from the Government as the ultimate Counterparty is the Sovereign Entity. This reflects the UK Local Authority experience in the 1980s.
Likewise, for large charities (and their operational entities) the Ultra Vires doctrine should apply, unless both the controlling charity and operational entity, specifically elect to be Professional Investors or Eligible Counterparties.
6. Problems with Swaps for Retail Customers.
(i.e. ALL Customers who have NOT elected to be “Eligible Counterparties” or “Professional Investors”).
These loans have the effect of “strapping the business of cash.” They are designed to make businesses “fall off their perch.” Whether this was a deliberate “designed in”
attribute or not, is irrelevant, this is the effect! To reiterate, a few of the negative attributes of these loans are:
6a. Misrepresentation/ Obfuscation Regarding FRLs based on Swaps/ Embedded Swaps:
6a.I ALL RETAIL CUSTOMERS.
DCF analysis is unknown to most owners of SMEs.
The DCF “dynamic” is totally alien in both concept and application to owners of SMEs and even large companies.
This “DCF dynamic” is known as the PVO1 of the Swap. PVO1’s are unknown to SMEs.
Did the Bank explain the PVO1 per se?
Did the bank explain the role of the PVO1 in the TBL?
The ISDA MA and T&Cs, plus the origins and compilation of the Amortisation Schedules is a pre-requisite for understanding FRLs derived by Swaps and TBLs.
Was the customer informed of these documents role? Did he understand these documents?
Was the customer aware he was becoming a Securities Trader?
Was he warned he was becoming a Securities Trader and hence could quickly make/ lose money?
Did the customer know he was making a bet?
Did the customer know that the (bet) trade (and the associated ISDA MA, and T&Cs implications) he was making would be embedded in his banking security.
Did the customer know he was responsible for the losses made under a geared bet he knew nothing about?
Was the customer made aware that he was exposing his banking security (and possibly the whole of his wealth) to finance “cash losses” under this security/ betting contract?
Losses on the IRS product will have been budgeted for by the Bank, therefore the bank has sanctioned an increased exposure via hidden credit facilities and “bucket” accounts to accommodate these losses.
Did the customer know about BCs at all, and that he was responsible for them.
The “locking in” effect of the BC was not explained or demonstrated at all.
Did the customer know about the Contingent Liability (CL) associated with the BC at all?
Did he realise the implications of this CL on his accounts and Fiduciary Responsibilities?
The CL at the entity’s year end was not quantified or declared.
The implication of the CL, and the quantum of the CL, was not explained, or notified, to the customer: when exposed retrospectively, it means the basis of the accounts may be destroyed and solvency issues raised – RETROSPECTIVELY. The entity may have been illegally trading for many years.
“Bucket accounts” and undeclared credit lines affect Covenants even when undeclared. They “engineer” defaults and can lead to the bank altering its stance regarding the customer.
In extremis this can lead to the engineered demise of the business, a la GRG, or SBS.
If the CL raises solvency issues most businesses would have reacted to these issues and manage their activities very differently, especially regarding, CapEx, employment and the payment of taxes. The deliberate hiding of the CL means many businesses ceased to exist needlessly.
Did the customer know about the increased credit exposure to him by the bank and the fact that this will have been approved in advance?
Did the customer know that he was exposed to Covenant Breaches,” engineered by the DNA of the loans?
Did the customer know the absolute contractual rigidity of the ISDA MA (or its synthetic derivative) would stand the logic of the Workout Ethos of the traditional Bank Loan on its head?
Covenant breaches are “engineered” by the losses on the Swap and the CL under the Swap
As the undeclared CL grows uncontrollably, the bank can start to use the “workout” power embedded in the security, not to protect the customer but to protect/ maximise its position.
The bank can become a Shadow Director (Controller) of the business, ignore its Section 251 and 187 responsibilities and prefer itself to the customer’s cash, via fees, rises in margins, cash sweeps, piks, special investigations and supervisory tasks etc.
This interference can accelerate the entity’s demise if these services are charged for in cash – i.e. these charges, per se, force the entity over its limit and into default. If this doesn’t occur by paying the banks charges (these will be debited when cash is available), it will mean others are denied payment or their payments are “bounced.” This is the opposite to the intent of the workout regime borne out of the benefits of controlling “Banking Security.”
6a.II. Misrepresentation/ Obfuscation: Stand Alone Swaps.
A Swap is a Cap and Floor set at the same rate. The Costs of the Cap and the revenue benefits of the sale (to the customer) of the floor are obfuscated by conflating them into a “Swap.”
Whilst it all depends on the shape of the forward curve at the Date of Execution (DOE), the dissection of the Swap into its component parts (Cap & Floor) is essential. There is evidence that on many DOE, the cost of Caps were very cheap (sometimes, very, very cheap).
The sale of the Floor should have been very profitable to the seller. The seller of the floor (to the bank) in this instance is the borrowing customer. Was the customer rewarded for selling the Floor to the Bank or was the customer’s reward gobbled up by the Bank in its extraordinary Value added?
The Swap is often callable by the bank: usually at the point at which the customer is “in the money.” This destroys the basis of anyone speculating in Swaps, never mind using them to protect against changes in rates. The use of “Calls” can turn the Swap into a Heads the Bank wins, tails you lose contract.
Where the purchase of the Swap became mandatory late in negotiations or upon renewal, especially post February/ March 2007 – until 2012, this amounted to a “Savilling” of the business in Broadmoor – i.e. the business was “locked in” and then abused by its cashflow being stolen and then the misapplication of “workout methods” by the Bank to maximise its own position.
6a. III. Misrepresentation/ Obfuscation: Embedded Swaps (their Derivatives or Synthetics).
As above but even worse as the Swap was not declared at all.
Breakage Costs (related to CfDs/ quasi CfDs, surrogate CfDs) are not rigidity, they are concrete ossification via the ISDA influenced T&Cs and Amortisation Schedule. The TBL turns otherwise successful businesses into the walking/ lying dead. The TBL is the opposite to what was advertised – a flexible loan.
TBLs ossify the cost structures, turning what should be a short/ medium term semi-variable cost into a totally nonnegotiable fixed cost. The raising of Fixed Costs is a per se bad outcome for both the entity and its lenders: it raises the Break Even point and means Losses will increase significantly as turnover declines, especially in a recession.
The fixed repayment on a TBL should be likened to a tax on both turnover and profitability.
BC is not only a tax on profitability it is a tax on Capital. In many cases it is a Death Tax which is imposed as a consequence of the premature demise of the entity – a demise which has been accelerated (and sometimes initiated) by the TBL’s effect (the rigidity tax) on cashflow and profitability.
The Death Tax is collected (and divvied up) by the Bank’s surrogates: LPAR, Administrators, Receivers, Liquidators, Trustees etc.
6b. Comparing a Normal FRL and a Treasury Based FRL.
One of the key economic roles of banking is financial intermediation, the linking of savers and borrowers. Regarding SMEs, the Commercial Bank is the only source of outside funding for most entities. As such Commercial Banks are pivotal to the health and survival of the SME sector, the key driver of economic growth: many would say that lending to SMEs is the reason banks are allowed to exist.
6b.i. Problems With Normal FRLs Sold to SMEs.
Lending to SMEs is classified as being intrinsically risky. This characteristic goes with the sector. Candidates for lending therefore must be assessed thoroughly in terms of viability (Products, Markets, Technology, Production, Cost Structure etc., etc.) and management capacity. After meeting these perquisites the entity must also be bankable in terms of security and that security’s structure.
To reflect the inherent riskiness of the sector, flexibility in the provision of facilities is a prerequisite: cashflow crisis are a fact of life for most SMEs. To facilitate this flexibility, competent SME management by lenders needs a cushion of security.
Bankers to SMEs need: adequate security to be in place; have confidence in the SMEs management to sort out its problems; and, have sufficient knowledge of the business to appreciate its risk and the impact of “point of inflection” risks.
Under most circumstances this risk management can be “hands off” and can be achieved by monitoring the borrower’s bank account: a pre-requisite of the lending being that the entity runs its banking/ current account through the lender.
Covenants, current account monitoring and visits can act as the main means of monitoring. These are expensive services to provide, therefore margins and charges need to recover these costs. A margin of 1 – 1.5% (the margin charged on many TBLs) is totally inadequate, so there must be a hidden margin IF these rates are being charged. This lack of “margin” transparency is itself obfuscation, which is only possible because Interest Rates quoted are not verifiable from a Public Data Base.
When problems arise in a borrower, the manager must have access to the data which he can turn into information to isolate the problems’ impact on the risk in the business. Following from this, any increase in this risk’s impact on the bank’s exposure/ risk to the company can be assessed and reacted to.
Most changes in risk, assuming the loan was properly assessed/ structured in the first place, can be catered for by defensive lending: i.e. the provision of more cash to “bridge” the problem. This money should be expensive and the “bridges” cost effectively capitalised within the facility – for the duration of the problem. IF the bridge works it should then be hived off into the other facilities which should be reset to match the entity’s cashflow via adjustments in the repayment profile.
IF the manager is not impressed with the performance of the entity’s controller during the crisis, the reset should include notice of exiting the relationship by incremental margin increases and more frequent reviews.
The borrower can then reassess his performance and possibly find a new banker before the incremental margin increases bite and the reviews and raised charges hit. Any exit fees (3-6 months interest on FRLs) can be negotiated as part of the exit strategy. In extremis, partial debt forgiveness can be included but this is the ultimate sign of a bad lend in the first place: i.e. the money should never have been lent.
Looking to security realisation as a means of repayment is last on the list but realisation proceeds and costs would be reviewed during crisis periods.
The raison d’etre of lending to SMEs is that it is a positive sum game: the provision of cash by the bank enables the SME to grow quicker, often much quicker. The banker then rides this growth by providing more facilities to a safer entity of which he has intimate knowledge and full confidence.
Flexibility is the key to managing crisis and to managing the lenders risk/ exposure.
6b. ii. FRLs & Treasury Based Loans (the Fix being derived by a swap/ synthetic/ surrogate).
TBLs are FRLs based on Stand Alone and Embedded Swaps/ derivatives/ synthetics/ surrogates.
With TBLs, underlying entity risk is assumed away and the zero sum game is pursued: the customer’s loss is the banks gain. The alternative applies but the TBL is cancellable by the Bank. How many “winning” customers have been paid out by Banks?
The customer cannot exit the loan, or renegotiate the loan under any circumstances: its Amortisation Schedule forms the basis of the contract along with other conditions enshrined in the ISDA/ T&Cs, which are not variable.
TBLs were mainly sold when the alternative, a Variable Rate Loan with a Cap were available and cheap. Why were these not offered?
Why was the Cap cheap? The Long Term Interest Curve was flat/ falling: the shape of the Forward Curve on DOE demonstrates obfuscation. Hidden (and undisclosed) margins were also built into the loan as were inflated quotes relative to Best Execution on the DOE.
TBLs were sold with the intent of inflicting losses on the borrower by the sale of the wrong product under conditions where the borrower would lose and when he could not exit the loan and relationship, without paying these losses.
The TBL is totally rigid and the conditions enforced relentlessly. In spite of being “strapped for cash” by the TBL, many customers never missed a payment.
The bank then attempted to “engineer” default by margin increases, when the supposed “defaults” were actually a function of its own loan. The “presumption” of default then facilitate the Bank into forcing the “defaulted customer” into managing his business in a far from optimal and market related manner.
The fact that many customers did not default is nothing short of miraculous, a sign of the financial conservatism of the SME owner and his integrity. The abuse of the “Workout Ethos” to pressurise the SME owner business is counterproductive: the Bank process assumes SMEs need help, when the cause of the problem was the TBL per se.
Helping many SMEs was, and is, simple: remove the “fix;” relax the tenor (life) of the loan; and get rid of the BC to facilitate SME safety, cashflow, profitability,
and ultimately, rebanking!
None of these “Workout Strategies” were even contemplated with most SMEs!
They were outwith the terms of the (mis-sold) TBL within which the SME was entombed! The bank wanted its winnings under the contract and the only way to do this was via engineering default and liquidating the SME’s assets, then bankrupting him, to ensure the non-compliant doesn’t seek redress!
6b.iii. Summarising the Differences between a Treasury & Normal Loan.
I. Normal Loans To SMEs:
Historically, pre-default, the Bank has always been the customer’s agent. This means the Bank and the entity must work together, with no Conflict of Interest.
This is the reason that Bank managers in the UK are/ were held in such high esteem.
Lending to SMEs is about managing risk,
BUT this lending should be a positive sum game, especially within a well balanced portfolio of loans.
Managing risk requires complete flexibility in the DNA of the loan.
Rescheduling, Resetting and Rolling up Loans are essential if the banks capital is to be protected in lending to SMEs.
II. Treasury Loans for SMEs:
Treasury loans are zero sum games where the counterparty risk is assumed away in the DNA of the loan.
The basis of the “in it together” ethos is built on the “Agency” Agreement between Bank & Customer. Agency consensus is destroyed and replaced by near continuous conflict over small deviations from forecast in the entity’s cashflow.
Counterparty risk in this case is offset by the entity’s security and its owner’s wealth: entity viability being of secondary consideration.
The only critical assessment therefore, for the bank, is whether the security is adequate as this is what will underwrite the banks winnings.
The game is rigged by the obtaining of security followed by migration of the customer to the Treasury Loan, whose conditions are already embedded in the Banking Security.
The rigged game then “straps for cash” the borrowing entity.
For its own good, the entity enters “Workout” but this is not “Workout” as it is intended: this is the assessment and preparation of the entity for slaughter but after the last once of flesh (cash) has been stripped out.
When the entity does not comply with instructions or does not default, again for its own good, the entity is placed under “protection and supervision.”
The acid test of who benefits from this “protection and supervision” is the charging for this help. If the costs are reasonable and capitalised, I would say, probably OK! IF the costs are high/ debited to the account I would class them as predatory, intended to engineer the very default they are supposed to avoid!
Likewise the role of valuations. IF the entity is in default and this default has not been caused (engineered) by the loan per se, I would say this is reasonable. IF the loan is not in default what is the role of revaluation?
Post Big Bang, the role of Agency has been eroded, with bankers increasingly (ab)using their trusted status as a means of accessing the customer’s security and wealth to sell unsuitable products by mis-representation, lack of transparency and non-disclosure of risks. The banker then quotes caveat emptor contractual “exclusions,” “boilerplating T&Cs” and contractual estoppel to protect its winnings.
This is a major consequence of lack of regulation and the mis-application of Professional Investor cases to SMEs.
Please look at the sample ISDA MA at Ex. 1. This document is the ISDA MA of a Retail Customer sold an IR Swap. By definition, a Retail Customer is not an “Eligible Counterparty or a Professional Investor.” By definition also, an IRS is a CfD, a heavily regulated product.
Please go to p. 25 & 26 of Ex. 1: clauses 2, 4, 6 and 7 are specifically designed to co-opt the Retail Customer into being a Professional Investor and prevent him pursuing breaches in those rights by signing away the rights of action.
The ISDA MA is not only a legal “try on” but, much more importantly, flies completely in the face of the rationale of lending to SMEs: lending to SMEs being a positive game; the role of the bank as agent to facilitate pre-default risk management of the relationship; and, SMEs lending being one of the main raison d’etres of Commercial Banking.
Treasury based loans are simply unsuitable for more than 99% of SMEs.
Minsky/ Pryamid Loans: An Economic Rationale of TBLs.
The author has searched long and hard for an overall rationale of why a supplier (the Bank) should sell a customer such a toxic product (the TBL) and under such terms that the product, by design, would eviscerate large numbers of its customers.
Rather unwillingly, I have come to the conclusion that this was because of a combination of greed and opportunity facilitated by Regulatory “benign” neglect.
Greed, because: the positive sum “Agency” game of historic Commercial Banking has been supplanted by the zero sum, non-advice game of “no customer recourse” based on contractual estoppel.
The customers had the cashflow and the wealth and their Bankers wanted it. Also, and, absolutely critically, the game could be rigged by the supplier. The upfront profit opportunities gained via mis-quotes were themselves potentially extraordinary and untraceable.
These inflated positions could then be bulked up and on-sold in the market with the mis-sale and mis-quote profits immediately pocketable. The Swaps were cancellable, at the volition of the Bank, for both Stand Alone and embedded Swaps. The Banks bets became: heads the Bank wins, tails the customer loses.
Opportunity, the Regulators were asleep: Regulators believed that the application of financial engineering techniques were improving Capital Allocation and the efficiency of markets with risk being diluted and spread further amongst investors and customers.
For the Regulators, these assumed consequences were per se, good outcomes for the banks, their customers and the economy. Unfortunately, the opposite was true, the Regulators had missed that, in reality, most financial engineering was simply a mechanism for increasing gearing/ leverage, often by the manufacturing of Contingent Assets and Contingent Liabilities which were themselves rollable. MTM accounting enabled profits to be booked, whilst losses were rolled.
The author is a Modigliani & Miller fan: the greater the gearing the greater the risk. Even more critically: that as gearing increases, risk increases proportionately! The main consequence of Sleeping Regulators, combined with a light touch regime, was that gearing rocketed whilst asset quality declined exponentially: a devastatingly toxic mix for Bank viability per se.
With SMEs, a combination of Sleeping Regulators and the historic esteem (and awe) in which UK bank managers are held by their SME borrowers, meant that the scene was set for rogue bankers to stuff their customers with toxic but extremely profitable products for the Banks.
But why would the Banks do this? What is the driving force, the economic rationale?
This is the Minsky moment: Western economies had become “candy floss” economies by the late nineties, with the frothiness spun by bank money.
This can best be illustrated by the Leveraged Buy Out, Hedge Fund and Private Equity movements: extraordinary gains were available to investors who “had the cash” or could access cash (mainly Bank cash). The profits earned by these “Shadow Banks” were pure economic rents, hedged by tax based leverage arbitrage.
At the SME level, these gains in wealth, especially where gained via property assets, were embedded in the SMEs wealth. In the Bankers eyes these gains (economic rents) were financed by the Bank facilities, and, the Banks wanted these gains.
Thus TBLs became a way of accessing the accumulated and current wealth of SME and large customers. At the level of last resort, the embedding of the TBL in the Banking Security accessed this wealth via the Courts “rubber stamping” of foreclosure.
Also, due to loose money, these gains would “roll on” in perpetuity. Ergo the losses caused to the individual SME customer by these losses would be transitory to the economy as a whole, as the resources would be redeployed to the “fittest” to use them.
Thus a “survival of the fittest,” evolutionary argument was used to rationalise a simple hunt for wealthy targets to ensnare and legally deprive them of their assets.
TBLs were simply a method of turning the SME into a surrogate, a Serf of the Bank, by which the bank could access the gains from the Asset Bubbles – the Candy Floss – the Banks (and the Regulators) were themselves creating.
The Minsky/ Pyramid Loan had arrived, with the Bank sitting at the top of the Pyramid and in de facto, soon to become de jure, control of all he surveyed.
Minsky stated that “periods of stability, created instability” per se, because Bankers wished to pursue/ maximise their short term profit. TBLs were precisely that profit reaping mechanism: a doomsday product which, from 2005 onwards, having been perfected as a useful annexe to the Bankers armoury 1997+, could create havoc amongst the finances of SMEs and large borrowers!
7a. Why Would Banks Sell Toxic Products To SMEs.
The profit opportunities (running losses for Stand Alone Swaps and BCs for all TBLs) were immense, especially IF interest rates fell; the customer was locked into the loan; and, the embedding of the swap in the Banking security allowed the bank full control of the customer’s cashflow and assets via perversion of “Workout” and reconstruction techniques.
Within an easy money regime, monetary policy would always be eased to rescue “investors” from the aftermath of bubbles – “the Greespan Put.” Regarding IRSs, “investors” are defined as the Banks. “Reconstruction Regimes & Techniques” had been legally perfected to allow the assets of failed business to be recycled efficiently, under the control of the Banks and their other surrogates, the Insolvency Practitioner (IP), investigating accountant, Administrator, Receiver, LPAR, Trustee etc.
IRSs allowed the Bank to obtain unlimited advantage from the “Greenspan Put.”
If, Swaps could be made “predicated” parts of the Loan, the bank could not only gouge the customers with mis-quotes and by “making bulk,” it could access the customers wealth by mis-pricing the “Floor” component of the Swap.
To repeat (6a. II p. 15 and p. 18 sic):
An IRS is a combination of a Floor and a Cap set at the same rate. Within an IRS, the SME buys the Cap, but sells the floor to the bank. If, interest rates are perceived to going to fall, Caps will be cheap to the buyer. However, Floors, at that rate should be extremely expensive to the buyer. Was the seller of the Floor, the SME customer, even aware he was selling an insurance policy to his Bank?
The answer to that question is a resounding, NO! Most customers are unaware that the components of an IRS are a Cap and Floor, set at the same rate, never mind that effectively they are selling the bank a Floor.
What was the SME customer selling to the Bank?
An unlimited indemnification of the Bank against falls in interest rates! What was underwriting the risk of these falls in rates? In most cases, the extent of the Bank’s security, but with cash shortfalls, most of the customer’s wealth was totally exposed via PGs, Cross Defaults and bankruptcy.
The value of the Floor element of the Swap to the customer was totally withheld (obfuscated) by the Bank, as was the low cost of the Cap to the customer. These (Value Added!) profits could be immediately booked along with the mis-quote and making bulk profits.
IRSs were sold to protect the Customer against rises in interest rates. This could have been achieved by selling a Cap.
Why wasn’t this done?
Firstly there was no profit in the Cap, but more importantly, it was the Floor the Bank was after: the Bank needed the protection from falling interest rates under the “Greenspan Put Regime.”
Is there any evidence that the market view was that rates would fall?
See below for the SONIA (Sterling Overnight Index Average) Forward Interest rate Curve on 3rd September 2007. This Curve looks forward 30 years and the summation of the market bets on interest rate moves on 3rd September 2007.
The yield curve is not just negative it is markedly negative: i.e. the market has put its money on interest rates falling.
Against this market view, who in their right minds would bet significantly against the market and in favour of interest rates rising? Yet that is precisely the stated objective of a “predicated” (mandatory) Swap: it is meant to protect the customer from rising rate!
Why were the banks forcing their customers to take out “protection” against rising rates when their market said the opposite. Why weren’t customers simply sold a Cap?
The answers are obvious: the bank needed to stuff their customers with the “Floor”
which the bank needed to protect itself against the very falling rates they were predicting. Plus, there was no profit in Caps.
7b. How Could Banks Sell Such Toxic Products to SME Customers?
The Customer/ Bank “Agency” Relationship had been terminated by the Regulators, who unfortunately had omitted to tell the SME customers of this change.
As importantly, the Regulators had not thought through (or were possibly unaware of) the implications of the end of the Agency Relationship: that there is no legal protection from foreclosure, resulting from possible abuses, enabled by the ending of the “Agency Relationship.”
The most attractive “on demand” facility for SMEs is the overdraft which was widely used by Banks to finance permanent assets in UK SMEs. Thus a large number of SME were reliant on “on demand facilities” in any case. In addition, and by definition, all facilities “in default and in breach” are “on demand.”
The Agency role was terminated, upon signing of facilities by “No advice” exclusions. Thus, toxic/ unsuitable facilities were sold abusing the “Agency” relationship of “trust and no conflict of interest” between customer/ banker. Having breached the “Agency” relationship to lever the mis-sale, rights of redress were then signed away (contractual estopped) by the exclusion clauses.
The legal process, resorting to caveat emptor, was then used to “strike out” attempts at redress by using “Professional Investor” Cases (Peekay & Springwell) to ignore attempts to negotiate and force legal redress.
At the Regulatory Level, Section 200 was used to exclude huge numbers of mis-selling claims from SMEs claiming redress using COBs/ MiFID because they happen to be limited companies.
Finally, the implications of the Libor Mis-quote fraud must be mentioned.
Libor was quoted below actual, i.e. low balled. What is the impact of Libor being mis-quoted downwards?
It increases the value of the mis-sold IRS to the Bank and increases the SMEs loss.
Terry Mulvenna, 16 06 2014.