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ombudsman news

issue 112

September 2013

case studies - interest-rate hedging products

Businesses who want to protect themselves against the risk of their loan becoming more expensive - because of rising interest rates - sometimes take out "interest-rate hedging" products. These products are often sold to small and medium-sized businesses, usually at the same time that the business takes out a loan.

A capped or fixed interest-rate can be helpful for some small businesses, but some hedging products come with significant risks. The type and scale of the risk varies from product to product - and depends on the type of hedging, the length of the product and the amount hedged. But in general, many products that last for more than just a few years are likely to have very high break costs if the customer wants to leave the contract early.

In 2012 the Financial Services Authority - the regulator at the time - announced that it had found serious failings in the sale of interest-rate hedging products. This led to a small increase in the number of complaints we saw about these products. Since then, the banks have agreed with the regulator to look at the sales they have made to certain customers since 2001 - as part of a wider review.

In the regulator's review, it defined four main types of product:

  • swaps - which allow the customer to "fix" their interest rate;
  • caps - which put a limit on interest rate rises;
  • collars - which allow the customer to limit interest rate fluctuations to a specified range; and
  • structured collars - which are the same as collars - but also include terms that mean the customer might have to pay more interest if the "reference" rate falls below a certain point.

We have received complaints about each of these types of product, and have recently published two final decisions by our ombudsmen on our website (you can find these in our online technical resource).

In most cases we see, the business complained that they did not understand the product - and particularly the costs of early termination. In some cases these costs came to 30% or more of the amount of the business's original loan. Most of the businesses who brought cases to us said that they would not have taken out the product if they had understood just how much it might cost to get out.

If we conclude that an interest-rate hedging product has been mis-sold to a business, we have to think carefully about what the business would have been likely to have done if they had been given suitable advice - and/or had been given the information they needed to make an informed decision.

We might tell the bank to put the business in the position they would now be in if they hadn't taken out the interest-rate hedging product - or if they had taken out a different product that was more appropriate for them. But in some cases, we might decide that the business would still probably have gone ahead and taken out the product anyway.

issue 112 index of case studies

  • 112/1 - business complains they were mis-sold a long-term interest-rate swap that didn't meet their future needs
  • 112/2 - small business complains it was forced to take out an interest rate cap to secure a loan
  • 112/3 - business complains they were mis-sold an interest rate swap that exposed them to risk they weren't happy to take
  • 112/4 - business complain they were mis-sold a structured collar
  • 112/5 - business complains they were mis-sold an interest rate swap that did not match the duration of their loan
  • 112/6 - business owners complain that they were mis-sold an interest-rate collar

112/1
business complains they were mis-sold a long-term interest-rate swap that didn't meet their future needs

Mr Y and Mr J had taken out a loan to refurbish a hotel, which they then planned to sell. They had done this once before and had made a profit. While they were refurbishing the hotel, they decided that they also wanted to buy another property to let out as part of their business. So they got in touch with their bank to ask about borrowing more money.

The bank said it could offer them a larger loan - to consolidate their existing debt and to provide the additional capital they needed. The bank also said that Mr Y and Mr J would need to take out an interest-rate hedging product for a minimum of five years.

Mr Y and Mr J said they wanted to sell the hotel within six years - either to buy a different hotel or to move abroad. The bank noted down in its records that they planned to move on at some point within the next six years.

A team from the bank went to see Mr Y and Mr J to discuss the arrangements in more detail. This involved a presentation about interest-rate swaps. An adviser from the bank also spoke to Mr A on the phone about the product.

Following these conversations, Mr Y and Mr J took a 20-year interest rate swap - to match the duration of their loan.

Six years later Mr Y and Mr J sold their hotel. They asked to break the swap because they were leaving the country. The bank told them that the cost of breaking the swap would be around 25% of the original loan.

Mr Y and Mr J complained about this. They said they had not been made aware that it could cost that much. When the bank rejected their complaint, they asked us to investigate.

complaint upheld

When we looked at all the evidence, it seemed to us that the bank had advised Mr Y and Mr J to take out the swap. So we had to decide whether that advice from the bank had been suitable for them.

We noted that when the bank's advisers had visited the hotel and given a presentation to Mr Y and Mr J, they had only included information about that particular swap. They hadn't mentioned any other products. We therefore took the view that the bank had effectively recommended the swap to Mr Y and Mr J.

We also noted that Mr Y and Mr J had made it very clear that they wanted to sell the hotel within six years - and that there was a significant possibility they would need to cancel the swap early.

We looked at the bank's record of the phone conversation between the adviser and Mr Y. The record showed that Mr Y had asked what would happen if he and Mr J decided to sell the hotel or if they decided to move abroad. According to the bank's own records the adviser had said that the swap could be transferred to a different loan. She had also said that the swap could be closed, and that either Mr Y and Mr J, or the bank, would cover the cost - depending on the state of the market at the time.

We could see no evidence that the bank had explained how much it would actually cost to pull out of the swap within six years. The bank had known how high the break costs might be. And we felt that it should have recognised the possibility that these costs could have had a significant influence on Mr Y's and Mr J's decision to take out the hedging arrangement.

We decided that if Mr Y and Mr J had been given suitable advice - and been made aware of the potential break costs - they would not have decided to enter into a hedging arrangement for more than six years.

The fact that the swap was in place for 20 years - with the potential for very high costs if the arrangement was broken early - effectively denied Mr Y and Mr J any flexibility if interest rates were to fall significantly.

We told the bank to put Mr Y and Mr J in the position they would now be in if they had taken out a six-year interest-rate swap. Mr Y and Mr J had been happy with the idea of fixing their interest rate - and this shorter term would have met their needs at the same time as satisfying the bank's requirements.

112/2
small business complains it was forced to take out an interest rate cap to secure a loan

Mr and Mrs N ran a decorative homeware business. They rented their shop and warehouse - but they decided they wanted to stop renting and buy the properties instead. They also wanted to buy out a minority shareholder in the business. So they got in touch with their bank and applied for a loan.

In return for some additional security, the bank offered Mr and Mrs N a loan with a 12-month interest-only period.

Just before the interest-free period came to an end, Mr and Mrs N realised they were going to struggle to keep up with their repayments - which would increase because they would start paying the interest on the loan. They asked the bank whether it could extend the interest-only period. The couple also wanted to withdraw the additional security they had paid - so that they could invest it directly into their business.

The bank agreed, but only on the condition that Mr and Mrs N take out an interest-rate hedging product. The bank said this was to protect the couple if interest rates increased in the future - which could affect their ability to meet their loan repayments.

The bank talked through the various options with Mr and Mrs N. The couple were keen to keep the costs down - and they settled on a two-year interest-rate cap that involved their paying a relatively small premium. The premium was added to the loan, and they repaid it monthly along with their loan repayments.

Mr and Mrs N later complained to the bank. They said the bank had forced them to take out a cap that they hadn't wanted or needed. They pointed out that when they had originally taken out the loan, they hadn't been told that they would have to take out an interest-rate hedging product if they wanted to release the security at some point in the future.

Unhappy with the bank's response, Mr and Mrs N asked us to look at the complaint.

complaint not upheld

We looked at the evidence from around the time that Mr and Mrs N had taken out the original loan. It appeared to us that the bank hadn't explained that if the couple had decided to change the terms of the loan after taking it out, they would need to have an interest-rate hedging product.

However, we took the view that the bank had been entitled to require that the couple take out an interest-rate hedging product - based on their circumstances at the time they had asked to change the terms of their loan.

We also looked at the evidence from the time the couple took out the interest-rate hedging product. We were satisfied that the bank had explained the options to Mr and Mrs N in a way that was clear and not misleading. We concluded that Mr and Mrs N had been given the information they needed to make an informed decision.

Taking everything into account, we were satisfied the bank had not acted unfairly in the circumstances of this complaint. If Mr and Mrs N had not been happy with the new terms they were offered by their bank, they had had the option of looking elsewhere - or continuing with their current loan on its original terms.

112/3
business complains they were mis-sold an interest rate swap that exposed them to risk they weren't happy to take

Mr and Mrs O owned and ran a pub, guesthouse and restaurant. When their business relationship manager left their bank and moved to Bank B, they decided to move their accounts to follow him.

When they moved their accounts to the new bank, they were offered a loan to consolidate their debts. This new loan was repayable over 15 years.

At the same time, someone from the bank's treasury department rang Mr and Mrs O to talk to them about the idea of hedging their borrowing. They agreed to having another conversation about it, and a team from the bank came to visit them. The bank's representatives gave Mr and Mrs O a presentation that covered a variety of hedging options.

After the presentation Mr and Mrs O agreed to a 10-year interest-rate swap - that didn't include paying a premium.

Interest rates fell over the next couple of years. But Mr and Mrs O noticed that they weren't paying any less. So they got in touch with the bank to ask them what was going on. Unhappy with the position they found themselves in, and following a number of conversations with the bank, they said they wanted to pull out of the swap.

The bank told them they would have to pay a large sum of money to end the arrangement. Mr and Mrs O complained - saying that they had never needed the swap and that the bank had approached them about it in the first place.

When the bank rejected their complaint, they decided to ask us to investigate.

complaint upheld in part

We looked at all the evidence and listened to both sides of the story. We noted that Mr and Mrs O and their relationship manager had known each other for a number of years. The couple had even moved their accounts to Bank B so they could carry on working with him.

We also noted that the bank had decided what hedging option Mr and Mrs O should take out before meeting with them - and had actively recommended one particular course of action to them.

We concluded that the bank's advice had not taken into account the fact that Mr and Mrs O needed flexibility. The potential cost of leaving the swap meant that it was inflexible.

We noted that Mr O was in his late sixties - and the bank itself had recorded that Mr O's age was a consideration. We therefore took the view that the bank should have realised that the couple might need to leave the swap early.

The bank had also noted that Mr and Mrs O were particularly cautious - and were concerned about unexpected costs. The bank said this was the reason for introducing the idea of interest-rate hedging in the first place. But we decided that a product with an unknown - and potentially very large - exit cost was not suitable for their needs.

We also concluded that the bank had not given Mr and Mrs O clear information about the swap. They were not told about the potential size of the break costs. And they were not given any information about other options.

We decided that if Mr and Mrs O had been given suitable advice and clear information, they would probably still have chosen to take out an interest-rate hedging product. But given their circumstances, we thought they would not have chosen one with such potentially high exit costs.

We were satisfied that Mr and Mrs O would probably have taken a cap instead - which would have involved a fixed cost when taking it out and no cost to leave. So we told the bank to put Mr and Mrs O in the position they would now be in if they had bought a cap rather than the 10-year swap.

112/4
business complain they were mis-sold a structured collar

Mr and Mrs W ran a property business. They took out a loan with their bank - along with a three-year interest-rate cap. When the cap expired, they met up with their relationship manager at their bank to talk about other hedging options.

The relationship manager - and other advisers at the bank - presented Mr and Mrs W with a variety of interest-rate hedging options. The couple weren't sure what to do. After the meeting, someone from the bank phoned Mr W to talk through the options again. The adviser then sent the couple an email to explain how a structured collar would work - and how much it might cost. Mr and Mrs W subsequently took out a structured collar on a ten-year basis.

Some time later, when the base rate dropped rapidly, Mr and Mrs W noticed they were paying the maximum amount under the structured collar. They got in touch with their bank to ask why they were paying so much, but they didn't understand the bank's explanation. They complained to the bank - but it said it hadn't done anything wrong.

Mr and Mrs W decided to bring their complaint to us.

complaint upheld

We looked carefully at all the evidence sent to us by the bank and by Mr and Mrs W. We noted that one of the bank's advisers had recorded that Mr and Mrs W had wanted to continue with some interest-rate protection when their original three-year cap expired. And Mr and Mrs W themselves told us that they had been looking to protect themselves against interest-rate rises.

The bank had recorded that Mr and Mrs W were "most interested" in a structured collar. But we could see no evidence to suggest that the couple had had any strong view on what interest rates were likely to do over the next few years - or any inclination to speculate on them.

The structured collar that the bank had recommended had carried a risk that if rates went below a certain level, the interest-rate Mr and Mrs W would pay would actually begin to rise. From the evidence we saw, we decided it was very unlikely that Mr and Mrs W would have chosen such a complex and risky product.

Mr and Mrs W ran their business themselves. A business like theirs needed a degree of flexibility - just in case something happened that meant they couldn't run it any more. We noted that Mr and Mrs W had an exit strategy in place. But we decided that being tied into a product for a long period of time - with potentially high break costs - could have stopped them from putting that strategy into practice.

Taking everything into account, we concluded that the bank's advice had been unsuitable for Mr and Mrs W. The structured collar contained an element of interest-rate speculation that we did not believe fitted in with their objectives at the time.

We also concluded that the bank had not given the couple clear information about the risks of taking out the product. It had not explained the possible exit costs - which were extremely high. We decided that Mr and Mrs W would probably have acted differently if the bank had explained clearly the speculative risks and the potential break costs.

We could not be sure what the couple would have done if they had been given suitable advice and clearer information. They had wanted some protection against possible interest rate rises, and given their circumstances, a simple five-year collar seemed a reasonable alternative. This would have removed the speculative element of the structured collar - and mitigated the possibility of incurring very large exit costs.

We told the bank to put Mr and Mrs W in the position they would now be in if they had taken out a simple collar for five years.

112/5
business complains they were mis-sold an interest rate swap that did not match the duration of their loan

Mr F and Mr F - who were brothers - owned and ran a large garden centre and garden design business. They wanted to buy some land next door to the garden centre - to develop some of the buildings and sell them on after four years.

They got in touch with their bank to talk through their options. The bank offered them a four-year loan that was "repayable on demand". They also discussed the possibility of the brothers borrowing more money at the end of the four-year term.

In the same conversation, the bank talked about interest-rate hedging. The brothers subsequently took out a base-rate cap for two years, and a base rate swap for 16 years that would begin when the cap ended.

Some time later, the brothers came across a series of reports in the press about interest-rate hedging products. They looked into their own situation more closely and felt comfortable with the base-rate cap they had taken out. But they weren't happy with the swap. So they complained to the bank, saying that they felt that it had not explained the risks to them.

complaint upheld

At the point the swap was sold, neither the bank nor Mr F and Mr F could have known exactly how much more money - if any - the brothers might need to borrow at the end of the four-year term. In these circumstances we identified a clear risk that the duration of the swap might be longer than the term of their loan.

Because of the way the hedging products had been set up, Mr F and Mr F might have had to pay to pull out of the 16-year swap before it had even come into effect. This meant that the brothers were effectively entering into an agreement that would last for 20 years.

And if, after the four years, they ended up borrowing an amount of money that was less than the amount covered by the swap - or indeed, they ended up borrowing no more money at all - they might still have had to keep on making significant payments under the swap.

We could see from the evidence that the bank had mentioned an exit cost, but it had simply compared it to "having a fixed rate". We did not think the bank had drawn the brothers' attention to the potential cost of breaking the swap.

We concluded that the arrangements that the bank had recommended to Mr F and Mr F had lacked the flexibility they needed. The 20-year agreement had potentially involved extremely high exit costs - and it might not have been needed at all if the brothers had not gone on to borrow any more money.

We decided that if Mr F and Mr F had been given suitable advice about the swap - and had the potential risks explained to them - we decided, on the balance of probability, that they would probably not have taken it out.

To put things right, we told the bank to put Mr F and Mr F back in the position they would now be in if they had never taken out the swap.

112/6
business owners complain that they were mis-sold an interest-rate collar

Mr and Mrs M owned two large houses, which they rented out to students. They wanted to buy another house, and decided to look into changing their borrowing arrangements to release some equity. So they got in touch with their bank to talk about their options.

The bank offered them a loan, but said that they would need to take out an interest-rate hedging product. Mr and Mrs M took out a five-year interest-rate collar.

Two years later, when interest rates dropped, Mr and Mrs M noticed that their loan repayments did not fall. After reading an article in the press, Mr and Mrs M thought that the interest-rate collar might have been mis-sold to them.

They complained to the bank, but were not satisfied with its response. So they decided to come to us.

complaint not upheld

Mr and Mrs M felt that the bank had clearly advised them to take out the interest-rate collar. But the bank said it had simply given them information to help them make their own informed decision. So we looked at the evidence to try and get to the bottom of what had really happened.

We decided that, on balance, it was likely that the bank had advised the couple to take out the interest-rate collar. So we had to decide whether that advice was suitable for Mr and Mrs M's circumstances.

We noted that the collar had provided Mr and Mrs M with valuable protection against interest-rate rises. The collar had a term of five years, which we did not think was excessive in these circumstances.

We also needed to establish whether Mr and Mrs M had thought they might need to break the collar arrangement before the five years was up. The bank's notes from the time showed that the couple were looking to grow their property portfolio - and that they were unlikely to need to pull out of the arrangement early.

In these circumstances we decided that the bank had not given Mr and Mrs M unsuitable advice.

We also needed to decide whether the bank had given Mr and Mrs M information that was clear and not misleading - so they could make an informed decision about the product.

We checked that the bank had explained the main features of the product adequately. We concluded it had not given the couple enough information about the potential costs of leaving the arrangement early.

Having said that, we also noted that this would only have made a difference to Mr and Mrs M if they had thought they would need to break the agreement early - and we did not think that was likely. We were also satisfied that Mr and Mrs M would have been unlikely to have acted any differently - even if they had been given more information about breaking the arrangement.

So taking everything into account, we decided the bank had been entitled to make hedging a condition of the loan - and that it had not acted unfairly towards Mr and Mrs M.

image: ombudsman news

ombudsman news gives general information on the position at the date of publication. It is not a definitive statement of the law, our approach or our procedure.

The illustrative case studies are based broadly on real-life cases, but are not precedents. Individual cases are decided on their own facts.