Trust a bank like a fox in a henhouse

CHALKIE

Last updated 05:00 14/11/2012

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People are credulous beings. We are prepared to believe anything made by bees has healing powers, that we understand what "potentiated" means, or that bankers have our interests at heart.

How else to explain the apparent popularity of interest-rate swaps - financial instruments so complex you would expect the total market to comprise only deeply indebted maths graduates?

Yet it seems the big banks managed to persuade a whole bunch of farmers these things were useful enhancements to their woefully simplistic business plans.

As a sales achievement, it's right up there with shipping snow to Eskimos.

Unfortunately, interest-rate swaps have done serious harm to many farmers. The sale of swaps in New Zealand mirrors a scandal in Britain where banks have reportedly put aside £630 million (NZ$1223m) to compensate clients wrongly sold interest-rate swaps.

There, a parliamentary committee on banking standards was formed to consider the issue and the Financial Services Authority stepped in to help customers get redress.

Here, Federated Farmers president Bruce Wills has said farmers who suffered from using swaps have only themselves to blame. "At the end of the day I'm a great believer in buyer beware and personal responsibility," he told interest.co.nz.

Wills should get a new job.

Chalkie reckons the farmers were screwed over - that the interest-rate swaps were sold primarily to protect the banks, not the farmers, and that the detrimental effects on farmers were predictable.

Since the scandal emerged it has been regularly remarked that farmers did not understand what they were getting into, and no wonder. Thinking about interest-rate swaps for even a short time can cause pain and dizziness.

Basically: Party A has borrowed $1m at a fixed interest rate; Party B has borrowed $1m at a variable rate. For whatever reason, A decides it would rather pay variable and B decides it would rather pay fixed.

Accordingly, they agree to swap. Because each has borrowed $1m, no capital changes hands - all that happens is they contract to pay each other's interest.

In terms of cashflows, while each keeps the original debt obligations, the swap is achieved by each paying or receiving the difference between the two rates.

In swap contracts, the "swap rate" is the fixed rate a counterparty requires in exchange for their variable cashflows.

But why would they want to swap? The reasons might go something like this:

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A business has a borrowing facility linked to the 90-day bank bill rate, which has been rising. It would like to ensure its interest costs don't get out of hand, but it can't alter the terms of the borrowing facility.

Another business has a fixed-rate term loan. A break fee prevents it exiting the fixed deal, but it thinks the variable rate has peaked and is likely to fall so it could save money by changing to variable.

Those reasons are hypothetical, but it should be apparent that an interest-rate swap is a two-way deal where, in the end, one side may do better than the other.

If interest rates fall, the one with the fixed rate is paying more than they otherwise would. If rates rise, the fixed rate payer has successfully limited their costs.

However, that's just the basic scenario.

In one example Chalkie has seen, the farmer's counterparties were ANZ National Bank, as it then was, and its subsidiary NBNZ Rural.

In a 17-page powerpoint document attempting to explain the swap deal, the bank's salesman presents it as a hedge to keep the farmer's interest costs fixed.

The pitch emphasised the upward trajectory of interest rates and said the contracts were "tradable [sic] instruments and provide a quick entry and exit from the market".

It appears the bank made money by charging a spread on the swap rate, while its rural lending unit took a margin on the variable loan. Another way to describe this is to have one's cake and eat it.

But while there's nothing unusual about a bank figuring out another way to clip the ticket, Chalkie reckons there is something unusual about the timing.

According to reports from the farming community, these swaps were sold mainly in 2007 and 2008, which is odd, because that means even as banks were stressing the value of hedging against the risk of rising interest rates, their own forecasts saw rates falling.

For example, ANZ's quarterly economic forecasts dated February 2007 saw the 90-day bill rate peaking that June and falling thereafter. The two-year and five-year swap rates were seen on a falling trajectory from that March.

The Reserve Bank's interest rate forecasts in March 2007 were also for falling 90-day rates, although it was uncertain whether the downward trend would begin before the end of the year.

The wholesale interest rate curve, which looked at how the market was pricing money over longer periods, showed a downward curve more than one-year out - that is, it was cheaper to borrow for five years than for one or two. This implied a market expectation of lower interest rates in future.

While it's now clear that rates were close to the top of the market at the time farmers were being encouraged to fix, contemporary forecasts suggest banks were cynical to play on farmers' fears of ever-rising rate costs.

Why would banks sell farmers on fixed-rate deals when they knew rates were likely to fall? Perhaps other factors contributed to the sales push.

Banks, of course, are borrowers as much as they are lenders. They pay close attention to how the costs and terms of the money they borrow relates to the price and terms of the money they lend out.

One aspect of our relatively low savings rate is that banks must borrow big chunks of money from overseas to meet demand for loans, using complex swap contracts to convert the foreign-currency borrowing into fixed-rate New Zealand dollar debt.

In 2007, the banks had to repay a large amount of overseas borrowing, which they did by borrowing more on overseas markets. These debts incurred fixed-interest obligations at rates higher than before - between September 2006 and June 2007 wholesale interest rates increased about 0.5 percentage points.

With banks knowing rates would fall thereafter they had a strong motive to cover their new fixed-rate obligations - which they did partly by selling swap contracts to farmers.

Admittedly this is just a theory, but Chalkie finds it compelling.

Maybe some people think it would be fine for banks to behave that way. However, banks have ongoing, close relationships with their borrowers and play on their position of trust.

Their customers expect them to make a profit, sure, but they don't expect banks to profit from their disadvantage, deliberately.

So in one sense at least, Wills has a point. Banks are not our friends, never will be, and should be trusted the way we would trust a fox with a henhouse.

- Chalkie is written by Fairfax Business Bureau deputy editor Tim Hunter.

- BusinessDay.co.nz

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