Lifting the lid on interest rate swaps

By Nick Clark

Interest rate swaps have become a hot topic with a Commerce Commission investigation and an inquiry by Parliament's Primary Production Select Committee.

What is a swap?

An interest rate swap is a financial derivative that allows a borrower to manage interest rate exposure on their borrowing. Until around 2005 they were used mainly by corporate and institutional customers. After that, swaps were offered by various banks to rural and commercial clients with high 'corporate' levels of debt, but without the sophisticated financial expertise held by corporates.

How do swaps work?

Parties use swaps to exchange, or swap, interest rate payments with each other. The most common swap is where a borrower pays a fixed interest rate - the swap rate - to the bank, while receiving a floating rate indexed to a reference rate.

Each party has their own priorities and requirements, so these exchanges can work to the advantage of both parties. Borrowers can use swaps to hedge against interest rate volatility, especially when these are high and rising.

How do they compare?

A fixed-term loan is simpler than a swap, but the idea is the same; to hedge against volatility. Banks sell fixed-term loans to borrowers at a set interest rate for a set period, such as 6 per cent per annum for 24 months.

The issues

Swaps seemed to work quite well for borrowers until late 2008. In that high interest rate environment, some farmers were in net terms receiving payments from banks and there were not many complaints.

Problems were exposed when floating interest rates fell dramatically from late 2008 and a huge gap opened between the fixed swap rate and the floating reference rate. Farmers who had bought swaps were suddenly locked in at very high cost, with many not realising they had that 'downside' risk. Unfortunately they couldn't escape their swaps without paying high break fees.

What has Federated Farmers done?

Federated Farmers has always taken the approach that farmers need to be very careful when signing up to swaps. We advise people get professional independent advice on how swaps work and the pros and cons. The Federation believes strongly in individual responsibility, but is equally concerned swaps are not mis-sold and has been active on the issue.

Since 2008: Meetings with senior bank executives urging banks to pass on interest rate cuts and treat their customers fairly. Swaps have been discussed at these meetings.

August 2009: Submission to the Opposition's Banking Inquiry, which discussed the Federation's swap concerns.

March 2010: Submission to the Banking Ombudsman seeking an increase in the financial limit for compensation and enabling the Ombudsman to investigate complaints about a bank's 'commercial judgment' or its interest rate policies.

December 2010 and February 2011: Submissions to the NZ Bankers Association's Review of the Code of Banking Practice, which discussed swaps.

November 2012: Letter to the Commerce Commission encouraging it to investigate allegations of mis-selling of swaps.

What do the banks tell us?

Banks have assured Federated Farmers issues with swaps have been, or are being, worked through and settlements or new arrangements have been made where it was alleged that swaps were mis-sold or where there were genuine misunderstandings.

Banks seem to have learnt lessons. Although swaps are still being sold to farmers, their use is not as widespread as between 2006 and 2008 and more care is being taken to ensure people know the benefits and risks. Banks deny that rewards or incentives are being used to sell swaps.

Are all farmers unhappy with swaps?No, we get calls from farmers happy with swaps who find them a useful hedge against volatility. They do not want farmers denied swaps.

What happened in Britain?

A number of commentators have drawn a link between Britain and New Zealand. Many British farmers felt swaps were mis-sold to them by banks, typically between 2006 and 2008 when swaps were frequently sold as conditions of loans. Farmers complained bank staff were heavily incentivised to sell swaps with no warnings about downsides.

In July 2012 four major British banks agreed a settlement with the Financial Services Authority (FSA) over "serious failings" in the sale of interest rate swaps to small businesses, including many farmers. The FSA found a number of bad practices, including poor disclosure of exit costs, non-advised sales straying into advice, 'over-hedging' (where amounts and/or duration did not match the underlying loans) and using rewards and incentives to drive these practices. The banks did not always make sure customers understood the risks.

What could happen here?

In response to complaints, the Commerce Commission is investigating; primarily considering whether customers were misled about swaps' true risk, nature and suitability. Business found guilty of breaching the Fair Trading Act may be fined up to $200,000 for each charge.

Where more than one charge is laid, the court may impose a fine greater than $200,000. Only the courts can decide if a representation breached the Fair Trading Act.

What should I do?

Federated Farmers encourages farmers with allegations of mis-selling of swaps, or other poor treatment from their bank in relation to swaps, to make a complaint to the Commerce Commission (phone 0800 94 3600).

If you also wish to inform Federated Farmers about your concern please call 0800 327 646.

- Hamilton News

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