The Bankers’ Lethal Deceptions – Tailored Business Loans
By Terry Mulvenna, Financial Specialist, For, and on behalf of, NAB Customer Support Group. © Terry Mulvenna, May 2013.
A. Defining a Tailored Business Loan TBL:
A Fixed Rate Loan (FRL) where the “fix” is derived from an Interest Rate Swap which is embedded within the Loan Contract.
B. Premeditated Deceptions By Bankers & Their Unforeseen Consequences:
B (1). Bankers’ Deliberate, Premeditated Deceptions:
1.1. The embedded Swap Contract (an insurance policy based on a Derivative Product) is hidden within the Facility Letter (the Contract) and therefore is included within the SME’s Banking Security! The presence, and intrinsic structure of the Swap, turns the Fixed Rate Loan into a lethal Time Bomb Loan.
1.2. The FRL is often one of several purported options, including an option of variable rate facilities, which are offered within the Facility Letter. Interest Rates are quoted at very fine margins, even teaser rates. HOWEVER, interest protection/ insurance is mandatory. THE SWAP/ IRHP THEREFORE BECOMES A PREDICATED SALE, i.e.the Swap MUST be taken! Therefore, the variable rate option is removed, post signing.
1.3. The “embedding” of the Swap within the Facility Letter ensures that the liabilities associated with the Swap are part of the Contract between the Bank and the Customer. The Courts therefore “rubber stamp” Foreclosure Proceedings by the Banks. The contractual relationship between Bank & Customer is based on the Facility Letter: The cornerstone of Banking Stability & Viability is a Bank’s ability to Foreclose on its Security.
1.4. The FSA/ FCA refuses to differentiate between Standard FRLs & TBLs which is a Sleight of Hand by the Regulator: Swap contracts are highly regulated and are only tradable between Professional Investors and Eligible Counterparties under the FSA/ FCA rules. Swaps are the basis of TBLs. Therefore, the Regulator’s approach is logically inconsistent within its own rules and policies.
1.5. Due to the embedded Swap, TBLs can only be sold by “Authorised Individuals” but can be sold to anyone. The Bankers’ response (get out of jail, card) to this is for the customer to “seek independent financial advice.” However, this highly specialist (and regulated) financial advice, was not available before 2010. Again, the Regulator’s position is illogical within the terms of its own rules, regulations and policies.
1.6. SMEs did not know that they were entering into a Swap agreement by signing a TBL as it is hidden and NOT declared by the Bank.
1.7. Did SMEs know they therefore became a Counterparty to a Derivative Product (Swaps used in Fixes are OTC – Over The Counter – products and are therefore Derivatives), which are highly risky and therefore highly regulated products (MiFID and COBs), except in THIS instance?
1.8. Were SMEs aware, that by signing the TBL, they were electing to be classed, by default, as a Professional Investor or Eligible Counterparty? These are the only Regulatory Classes of Investors who can Trade in this Class of Derivative Investment.
1.9. Were SMEs aware that Breakage Costs under Swap contracts were based on a “no loss clause” to the Bank (i.e. Heads the Bank wins, Tails, the customer loses) as determined by the Swap Market Contractual Terms and supervised by the ISDA as it is an OTC product?
1.10. Were the SMEs aware that by signing the contract (Facility Letter) their property, pledged as security to the Bank, became security for the Counterparty Deposit for margin calls if the bet went against the SME?
1.11. The Banks’/ Regulator’s Review of IRHPs is a distraction from the Core issue of TBLs: an attempt to divert attention from the damage being done by TBLs by saying that the IRHPs used to hedge interest rate risk were regulated and hence grant SMEs some means of recompense for the mis-selling of these IRHPs.The review is a smokescreen.
All Swaps / Contracts for Differences are Regulated Products: they are intrinsically dangerous (and therefore regulated) for investors even when they are aware of the risks.
1.12. The Bank relies on the small print in the T&Cs to enforce the embedded Swap: hide the Swap and then enforce it by relying on obscure clauses in the T&Cs which in many cases were not supplied in advance, or at all, to the SME.
1.13. NO Formulae of the underlying Swap were provided as part of the Facility Letter (or the T&Cs), nor mentioned at all. Reliance is made on recovering “economic/ breakage costs” clauses in the T&Cs. No worked examples are provided.
1.14. The Breakage Cost of the embedded Swap is determined by the market rates applicable at the date of breakage. The Breakage Cost is therefore indeterminable, even via estimate, on a pre contract, consummation basis!By signing the Facility Letter (Contract), the SME is taking on immense but unquantifiable risk. Scenario creation and Termination Matrixes are necessary if the SME was to even comprehend the risks associated with the Swap.A post graduate degree in Financial Mathematics and subsequent professional education in Actuarial Studies/ Association of Corporate Treasurers is required to understand the risks.
1.15. Even if the educational background is present, the customer needs access to, and massive experience using, the relevant Blomberg Screens. The only proof of this particular pudding is extensive proven experience in Swaps or other CFDs.
1.16. By forcing the SME to buy a Swap, the bank is forcing the SME to take an unlimited (and unhedged) risk ‘vis a vis’ downward movements in interest rates, save if interest rates drop to zero. Every Spread Better knows about Stop Losses, an SME does not.
1.17. By embedding the Swap in the TBL and within the Banking Security, the Bank is knowingly forcing the SME into becoming a CFD trader/ Spread Better, without alerting the SME to this fact and the risks involved.
1.18. By making the SME a Spread Better by default, and without making him aware of this fact, no Stop Loss strategy was put in place. The impact of this risk during the current downturn meant that the Swap would prove to be lethal to many SMEs. By signing the Facility Letter and Legal Charges, many SMEs have accidentally signed their own Death Warrant.
1.19. The size, and longevity of the interest rate collapse was unforeseen in the original RF plan: many customers have been busted by the consequences of the RF; many more are drained of cash, demoralised and on the verge of collapse.
However, the Bank is not Breaking the Swap at the point of Foreclosure, nor after the Point of Crystallisation. The TBL is still being serviced post Foreclosure. Why? How is it being serviced? The answer to this is alluded to in B (2) No 3 below, but this is the nub of the matter: the Banks have stopped claiming micro hedges existed and some are denying they were ever taken. If this is so, what is the basis of the Breakage Charge?
Before accusing the Banks of Enron Accounting on a massive scale, further investigation is required. This will be covered in my next report.
1.20. TBLs are sold as Loans when the most critical (predicated but hidden) component is an insurance contract – for the management of interest risk via a Derivative Contract. However, the basis of selling an Insurance Policy – Uberrima Fides – is completely ignored!
B (2). Unexpected Consequences of the Banks’/ Regulator’s Deceit/ RF.
1. By forcing the SME to buy a Swap, the Bank is forcing the SME to make a continuous bet on one (of many) future outcomes, for one of many important business variables. This forces the SME to make a continuous bet on possibly the wrong horse in the wrong race.
2. To repeat (B(1), 2sic.): The embedded nature of the Swap and the establishment of the Contractual Relationship, via the Facility Letter (i.e. the need for Interest Rate Hedging and its Method) and the associated Banking Security, forces the Swap onto the SME. The embedded Swap/ IRHP is therefore a Predicated Sale which increases the risk to the SME (and its unquantifiable Contingent Liabilities) exponentially.
Is this desirable?
Most SMEs are averse to risking their capital. The Contingent nature, and the Capital Risk of the Swap, is not mentioned at all! Most companies (including Quoted Companies) are totally unfamiliar with the management of Contingent Liabilities, especially when they are totally unaware they have signed up to a Contingent Risk in the first place!
3. The Losses on the swap are serviced from the Fixed Interest Rate Payment. The shortfall on the interest is capitalised into a Contingent Liability which, if crystallised, becomes the Breakage Cost.
Due to the collapse in interest rates brought about by the current economic catastrophe, the Contingent Liability for most Loans is huge relative to the size of the loan, e.g. 20 – 25% of the remaining Loan Value! The size of the Contingent Liability is also unexpected!
This raises many interesting issues:
3. (a) How is the Loan Servicing being kept current?
3. (b) How is the Loan accounted for under the FRSA accounting rules?
3. (c) Where is the Contingent Asset for the Bank hidden?
3. (d) Where is the Contingent Liability for the Customer quantified?
3. (e) Why hasn’t the customer been informed of this Contingent Liability?
3. (f) Given that the Contingent Liability arises out of a naked, and highly geared, Spread Bet, why wasn’t this Contingent Liability data available, real time, to the punter?
3. (g) If I am wrong concerning keeping the servicing of the Swap current, the issue is simply inverted: how are the losses on the Swap being serviced and being accounted for?
3. (h) As at least one or other of the Swap Costs, or Interest Costs is not being serviced by the Customer in cash, what provisions for B&D are being made under the FRSA?
3. (i) How many customers are in Breach of their Debt AND Swap Servicing obligations?
3. (j) Where are the provisions arising from these Defaults in the Bank’s Fiduciary Accounts?
3. (k) Are “bucket” accounts being used to keep both the Swap and Loan Servicing current? If so, where are these customers’ liabilities hidden? Are other Derivatives or synthetics being used to hide this lack of servicing?
3. (l) IF the lack of cash servicing of either the Swap or the Loan Interest is occurring, as it must be, how is the credit risk associated with the now overwhelming Counterparty Risk being accounted for?
3. (m) How are the Banks reporting these Contingent Liabilities internally, to Credit Reference Agencies and other Banks under customer referencing and Fraud Prevention Schemes?
3. (n) Some Banks are not providing customers with their Interest Paid Certificates for the preparation of their Fiduciary Accounts. Why is this? They are forcing customers into breaches of their accounting and taxation responsibilities as well as their Banking Covenants. These breaches invite investigations by the HMRC.
4. By forcing unsuitable and highly risky TBLs on SMEs, the Bank is Ossifying the SMEs’ existing Assets, eliminating the essential flexibility that the SME needs to mange its business to the benefit of ALL stakeholders, including the Bank. The Breakage Cost reduces flexibility and significantly increases the cost of restructuring. This is not beneficial to any party, especially the SME’s staff, customers, suppliers, taxman, owners and Bankers.
5. EBITDA (Earnings Before Interest Tax Depreciation & Amortisation) is the prime means of measuring corporate performance and operational cash generation capacity. EBITDA and asset structures drive financial structures, including the gearing decision. EBITDA is the residual between two large figures driven by the market and the cost/ asset structure (i.e. Operational Cash Inflows and Operational Cash Outflows).
Business success is normally driven by the management’s ability to manage these revenue and costs. By hiding a Swap, with unlimited downward risk and high leverage, within a Loan, the Bank forces the tail to wag the dog: as losses occur under the TBL, the SME is drained of cash and ends up running the business to pay the TBL.
6. When the Bank sells the TBL to the SME, the Bank is turning a Semi-Variable Cost into a Fixed Cost – for the duration of the Fix. This prevents the benefits of reduced interest rates reaching where it is needed. TBLs increase the risk profile of the SME as the composition of cost changes (more costs become fixed) and costs cannot be shed as turnover decreases. The Operational Gearing of the Company is therefore increased, a per se bad outcome to ALL parties, especially the economy, as Losses increase as a downturn occurs in turnover.
C. The Solution and a Historic Perspective.
The current TBL debacle is simply déjà vu. The mis-sale of Interest Rate Swap Contracts to Local Authorities in the mid 1980s was virtually identical to the current debacle: the perpetrator is the same (The Banks); the product is the same (Interest Rate Swaps) and the financial naivety of the target is the same – in this case the SME.
Local Authority Swap contracts were declared illegal in the 1980s via the Audit Commission’s (Howard Davidson) intervention: the Swap Contract was declared illegal, by being ultra vires, for Local Authorities. By utilising ultra vires, the Government found a silver bullet to protect the public purse and the naivety of its employees.
In the case of TBLs, a similar silver bullet is required. In this case, simply declare TBLs void ab initio (void from the outset). The rationale is simple: See deceptions above sic, but the Cost of the Collapse of SMEs will be borne by the whole society in the form of loss of jobs, loss of investment, loss of tax revenue, etc., as well as by the totally expropriated SME owners!
Essentially, by failing to act on TBLs, the Government is suffering a Double Whammy:
1. Cash Support for Banks. The Government has bailed the Banks out at a massive cost to the taxpayer by funding: capital injections; emergency liquidity injections; Open Market Operations; QE; Lowest Interest rates in History; Funding For Lending scheme; destruction of saving incentives; over target inflation and now the Support For Home Buyers Scheme.
2. Losses Under Swap/ CFD Mis-selling: The Government, as a consequence of the demise of SMEs, now has to suffer and fund further massive losses via reductions in: employment; VAT, NHI, PAYE, self assessed income tax; corporation tax; macro demand; macro supply of goods and services; Capex; and the reduction in economic growth brought about by the skinting and demise of long established SMEs.
The poor SME owner also loses his property, his pension and in many cases his home via bankruptcy!
SMEs employ 40% of the working population and are currently being eviscerated by Swaps and the abdication of Regulatory Responsibility!
D. Note About The Author: Terry Mulvenna.
My background is Mathematical Economics at first degree, followed by a 2 year MBA at Manchester Business School (MBS). After MBS, I had intended to become a Corporate Treasurer: my education and background are therefore inclined towards the Trading Approach to markets and capital allocation, including operationalising the Capital Asset Pricing Model for trading and investment purposes.
Instead of working in a Treasury function for a MNC, I developed MBS’s courses for Commercial Bankers from Developing Countries. Having perfected the product, I then internationalised it for MBS. In the early 1980s I then established a joint venture with the Chartered Institute of Bankers in the UK and other Banking Institutes around the world facilitating their post qualification, professional development efforts. My courses were then run mainly in-house based on the Banks own Default/ Problem files and were very “hands on.”
My speciality is Problem Loans in Problem Banks, especially Banks and their subsidiaries’ which are technically insolvent – at best. Given the nature of the Banker (worldwide) I am akin to the Bridegroom with Syphilis: no one wants me (at least, initially) unless they have no choice! Bust Banks wishing to reinvent themselves (and having usually changed their Senior Management) have no choice!
I have worked in 23 countries over 25 years and have 800 banks in my Client List, including most British Banks which operate internationally. Literally thousands of bankers have attended my courses, some many different courses.
The more senior courses were built around the Bank’s own cases and files. My approach emphasises effective appraisal and control of the lending process and the symbiotic nature of the Banker/ Customer relationship. Within Problem Loans the emphasis is placed on identifying/ establishing viability via the Turnaround Process and then Debt Equity Swaps and loan restructuring including CULS to enable Workout. The use of “under the water” options to incentivise management to facilitate corporate revival is demonstrated.
My pension is a portfolio of 53 properties in Manchester which operate like an inflation proof annuity/ Gilt. I have built the portfolio over twenty years and have built out the Blocks as Project Manager. I manage the portfolio myself.
I have been dragged into the TBL debacle by my Bankers extorting (RFed) a five year TBL from me in June 2008 on a £1,420,000 loan: I said “over my dead body” as I knew the markets had frozen in July 2007 and the Governments finances were in such a diabolic state that interest rates would collapse, the alternative being hyper inflation; but, they said that they would place me “on demand and call” the following day; plus, would freeze my account. As I was building, and spending £20K a week in cash, I was given the choice of going bust by the end of the week or probably 2 years later! Truly, Hobson’s choice?
Had this choice been extorted from me 12 months earlier, I would simply have: sacked my contractors who were about to start a new, but huge refurbishment; diverted all undrawn funds (£380,000+) and rental cashflow; defended the flat portfolio; and then frozen the account myself!
Life does not have to be like this! However, to change the current legal reality, politicians have to start to manage the consequences and aftermath of 15+ years of regulatory abdication of responsibility, in a business friendly manner. A New Magna Carta For Business is required!
30th May 2013 (updated 28th February 2014)