Banks face potential liabilities of up to £10bn over the sale of long-dated interest rate swaps to property investors in the years immediately prior to the peak of the UK market, based on an analysis of out-of-court settlements reached by borrowers.
DTZ Research has analysed anonymous data provided by Vedanta Hedging, which consists of a sample of 67 separate interest rate swap cases – including legal challenges by borrowers over poorly structured and mis-sold swap– with an aggregate notional value of £575m.
Of this sample, the borrowers managed to secure £104m in out-of-court settlements by banks in cash and “cash-equivalent”, which effectively amounts to voiding swap breakage costs and paying borrowers’ legal fees.
This £104m secured in out-of-court settlements by banks reflects 18% of the notional value of the sample’s swap contracts.
DTZ Research has then aggregated the proportion of successful settlement by borrowers against the full outstanding UK property lending market, estimated at £309bn.
The scale of potential liabilities which banks’ are exposed to amounts to between £5bn and £10bn, based on DTZ’s assumption that 90% of the outstanding £309bn of UK property loans are written on floating rate terms, of which, three-quarters, or £209bn, uses interest rate swaps as a hedge against rising interest rates.
Of this total £209bn of notional swap contracts, DTZ assumed one in five to one in 10 would be successful in contesting their swap, and would secure 18% the outstanding loan balance in redress, which leads to the £5bn to £10bn estimate.
“Many borrowers could not refinance or restructure their legacy loans due to the swap,” wrote DTZ’s global head of research Hans Vrensen in the analysis published this morning.
“This triggered in many cases loan maturity extensions or a stand-still under the loan agreement. Ironically, it has also prevented lenders from enforcements on loan defaults and kept many borrowers in the game.
“As a result, swaps have become one of the biggest impediments for investors to constructively refinance or restructure their legacy loans.”
How did borrowers get in this mess?
Long-dated interest rate swaps have been the scourge of real estate finance markets in the post global financial crisis period, with the swap ranking super senior relative to the lender.
Property investors and developers commonly agreed an interest rate swap with banks when an investment or development loan was secured, with many of these hedging contracts running for considerably longer than the duration of the agreed principal loan.
Superficially, the motivation for borrowers to accept long-dated swaps was based on pre-global financial crisis belief that the then historically low interest rate environment would not exist for much longer and a longer-dated interest rate swap than the loan would allow borrowers to “lock-in” long-term protection against rising inflation.
The credit crunch, subsequent broader global financial crisis, prompted world central banks to keep inflation rates low to stimulate liquidity in an effort to revive markets and investor confidence.
As a result, these long-dated contracts expose borrowers to often enormous liabilities, which virtually all the time must be paid out to banks ahead of the investment or development loan.
It would be fair to say that blame for the consequences of the prevalence of long-dated interest rate swaps should be shared between three parties: the lending teams within banks, the swap teams within banks and the borrowers themselves.
Quite what the proportion of blame should be is difficult to say.
Certainly, there are examples of borrowers claiming they were mis-sold highly complex contracts without banks explaining their potential worst case impact in the event of sustained low interest rates at the maturity date of loans.
Indeed, in some banks, there might have even been a revenue-sharing model between the lending teams and the teams which structured and executed the interest rate swaps, aligning lenders’ interests with their swap selling colleagues.
Profits on long-dated swaps were considerably larger than for swaps co-terminous with the principal loan, and these profits could be booked on bank’s P&L at the start of the contracts, which, inevitably, motivated individuals to sell contracts to their clients.
“Sometimes banks provided highly complex, bespoke hedging contracts for their clients which were highly remunerative for themselves but which the counterparties, i.e. the borrowers, didn’t understand,” explained Vedanta Hedging’s Abhishek Sachdev.
He continued: “Unfortunately, there are lots of very large sophisticated property investors and developers, who although they are highly sophisticated in respect of their property businesses, do not understand beyond the basics of vanilla swaps.”
Banks have no real option, argued Sachdev, but to defend each case extremely robustly as the potential liabilities arising from successful claims against interest rate swap mis-selling can be very high, as a proportion of the outstanding loan, “even multiples higher than the profits booked on the swaps in the first place”.
Only two claims against banks over interest rate swap mis-selling have made it to Court, both against RBS, and both were quashed. Arguably, this is because RBS allowed those cases proceed as they were not credible claims, and were very small.
The UK’s legal system is stacked in banks’ favour to the extent that where a credible case against the bank emerges; an out-of-court settlement will always be sought by the defending bank, which will be agreed confidentially.
“The greatest tool banks have is not just their cheque book, but the confidentiality that comes with their cheque book,” explained Sachdev.
However, not every claim is credible. Often borrowers attempt to bring forward spurious claims against banks in an effort to secure some leverage in wider negotiations between borrowers and their banks.
Furthermore, back in the heady boom years, sometimes long-dated swaps were the result of decisions taken by property company or developer’s own finance directors, attracted to substantially lower costs of debt the longer the swap taken.
Banks’ worst fears receding due to ‘six year rule’
Borrowers which have a claim against their bank over a potential mis-sold interest rate swap have to do so within six years of the contract’s life, under the UK’s statute of limitations.
This effectively means that the number of potential claims made against banks – just over six years on from the peak of the UK commercial property market – is fast reducing, and further shrinking daily.
Banks are increasingly in confidence that the number of “time-bared” claims will restrict the entire scale of potential cases of mis-selling against them.
For the government, the timing of another potential bank mis-selling scandal could not be worse, given its motivation to sell shares of Lloyds Banking Group, and thereafter The Royal Bank of Scotland, back into the private sector.