Hedges: not all bad news
A reply to the recent article on interest rate hedging products: while there has been mis-selling, not all deals are “toxic” to borrowers, and some borrowers have not taken enough care
Hedging products, or derivatives, do not have a good reputation. Warren Buffett memorably described derivatives as “financial weapons of mass destruction”, and the article “Hedges: a financial plague” (Journal, January 2014, 20) planted its colours firmly in Mr Buffett’s camp by describing interest rate hedging products variously as “toxic”, “unsuitable”, and a “gamble”. The aim of this article is to introduce some balance to the discussion.
How the products work
Within the Scottish business world, the most common hedging transactions are interest rate or foreign exchange based. For present purposes, we will look only at interest rate hedging products, as they are by far the more common, though the principles are the same for forex products. We will also assume that the lending bank is also providing hedging, as this remains the norm. It is not for this article to look at pricing or the vexed subject of breakage costs.
January’s article summarised a typical interest rate hedging product thus: “A swap operates by the bank and customer entering into a contract to agree to exchange one set of cashflows for another, typically floating and fixed interest payments. The bank invariably agreed to pay the customer the floating variable interest rate (base or LIBOR), and the customer agreed to pay a fixed interest rate and the bank’s commercial loan margin.” In other words, one party agrees to exchange an obligation to pay a floating (and therefore unpredictable) rate of interest for an obligation to pay a fixed rate of interest.
The article also noted, correctly, that a swap “is an entirely separate contract from a customer’s borrowing arrangements”. So, strictly speaking, the borrower will continue to pay the floating rate, plus the applicable loan margin, under its loan agreement while, under the swap contract, the borrower will pay an agreed fixed rate and receive the contracted floating rate (i.e. the loan agreement floating rate) from the bank lender. Reducing this to a simple set of payment flows demonstrates that the two floating rate payments, by and to the borrower, cancel each other out, leaving the borrower paying a net amount made up of the fixed rate plus the bank’s margin.
Of course, depending whether floating rates rise or fall, one party will end up owing money to the other. But this risk alone does not turn a hedging transaction into a gamble: just as with an insurance product, hedging offers the purchaser protection against the occurrence of possible future events. And just as house buyers often appreciate the certainty offered by fixing the rate applicable to their home loan, corporate financial directors (FDs) often crave certainty as to their borrowing costs. The mere fact that a particular deal may look expensive with the benefit of hindsight does not mean that it should be characterised as unusually risky. Nor does it mean that a deal was inappropriate or mis-sold.
Once the basis of hedging transactions is understood, what do they look like on paper?
Most documentation recording the terms of interest or forex hedging transactions is published by the International Swaps & Derivatives Association (ISDA). ISDA documents have been the standard for more than 20 years, so are well established documents which are very familiar to market participants. Until relatively recently, the most commonly used master agreement was the 1992 version; the 2002 edition is now becoming more common and is increasingly the preferred form for UK clearing banks.
The documents themselves are not particularly long. A 2002 master agreement is less than 30 pages long, and the related schedule may only run to a further 10 pages or so. However, ISDA documents are unavoidably complex, given that they are constructed to allow payments between parties to hedging transactions to be made on the net basis described above. Netting is so central to hedging transactions, and so extensive is the reach of the documentation, that ISDA has now obtained legal opinions on netting from around 60 jurisdictions. These documents have not only stood the test of time, they have done so globally.
It is important that practitioners remember that these documents create a contract between lender and borrower which is related to, but quite separate from, any loan documentation. Equally importantly, while an ISDA master agreement is a pre-printed document whose text is never amended, the related schedule allows for amendments. The master agreement and schedule can therefore be negotiated in exactly the same way as any other contract, so much so that there are books devoted solely to the negotiation of ISDA schedules. Since ISDA documents contain warranties, undertakings and events of default, a degree of negotiation is almost always necessary to ensure that the ISDA documentation is consistent with the related loan documents. Banks’ treasury legal teams are quite accustomed to agreeing (sometimes quite extensive) borrower revisals.
The master agreement and schedule, once agreed and signed, create the contractual basis under which hedging transactions can be carried out: they do not effect any hedging transactions.
The only other documents practitioners may have to deal with are so-called credit support documents. These are not particularly common in corporate debt transactions in the Scottish market, but it is important to understand what they do (and what the master agreement therefore does not). ISDA’s Credit Support Annex is another standard, pre-printed document which can be negotiated in the same way as a master agreement. A credit support annex allows one or both parties to a hedging transaction to require the other party to provide collateral (usually cash or cash equivalents, but possibly other assets), as cover for the provider’s exposure to the collateral taker. It is worth mentioning credit support documents to emphasise the fact that the ISDA master agreement alone does not allow one party to demand cash cover or any other collateral for actual, or notional, exposure. It is misleading, therefore, to link banks’ demands for payment of hedging liabilities to the hedging contracts.
Making a trade
Once all relevant documents have been signed, the parties can proceed to agree the hedging transactions themselves.
It is important to understand how hedging transactions are agreed and recorded. Assuming again that the lending bank is also providing hedging facilities, the lender’s treasury sales team will generally meet with the corporate borrower to discuss hedging strategies while loan terms are being negotiated. These meetings may happen before or after ISDA documents have been prepared and circulated by the bank. The meetings are most often two-way discussions of the various approaches which might be taken to mitigate interest or foreign exchange fluctuations. The treasury sales team will provide illustrations to demonstrate the economic effect of the proposed transaction against market fluctuations. Those illustrations, more detailed now than they were prior to the credit crisis, will demonstrate that a particular hedging transaction will offer protection against upward or downward market movements. Whether these illustrations are simply a “generic PowerPoint presentation” or more carefully tailored for a given situation is less important than the fact that they demonstrate the risk inherent with fixing a rate in a fluctuating market.
As January’s article also pointed out, the illustrations invariably contain risk warnings and other “small print”. FDs ignored these illustrations and their warnings at their peril.
Trades themselves are closed over the phone, with phone calls being recorded and the tapes stored and retained. Banks’ treasury desks will be able to recover these tapes if specific trades are challenged. The tapes are an important part of the evidential armoury at a bank’s disposal. The trade should then be confirmed by a written “confirmation”, setting out payment dates and interest rates and completing the documentation chain.
So where were mistakes made?
All of the foregoing is not a whitewash defence of some of our banks and bankers. It is clear that many treasury products were mis-sold, but an uneconomic contract is not necessarily one which has been mis-sold or one which will allow an unhappy purchaser a degree of recourse against their bank lender. Having said that, there have been failings on both the lender and borrower side of the market. On the borrower side:
- FDs are often frighteningly ignorant of the terms of their hedging contracts. FDs will pay their legal advisers to negotiate loan documents, but for years seemed reluctant to ask for advice on much more technical swap documents.
- Many borrowers did not seek specialist advice from treasury advisers prior to agreeing a swap arrangement. This left borrowers unable to market test or benchmark the pricing being offered by their bank.
- Other than firms with specialist finance practices, legal advisers seldom volunteered advice on hedging documents, sometimes advising that they were simply “standard” documents.
On the bank side:
- Banks and bankers were guilty of separating ISDA documents from the negotiation of loan documents. In many cases ISDA documents were simply handed over, as if an afterthought, during completion meetings.
- Many bankers themselves did not understand the relationship between hedging documents and loan documents, leaving inconsistencies running through both.
- Undoubtedly some products were mis-sold. Most mis-sold products are not simple fixed-rate deals, but deals in which a borrower believed that they were buying one type of product, but were in fact buying another. Often those products look like fixed-rate deals but have options built into them which fundamentally alter the economics of the transaction (and make the calculation of profit, loss and cost much more complicated). The identification of those inappropriate products is a task for an appropriately qualified treasury adviser rather than a legal adviser.
In conclusion, there are undoubtedly many instances of borrowers being sold inappropriate treasury products. In many cases, however, the borrowers themselves have contributed to the problem by failing to take appropriate advice before agreeing treasury deals. In many others, banks and bankers have sold inappropriate products or have failed to give the right advice to their customer. But to treat all treasury deals as “toxic”, or to give the impression that all businesses which have purchased hedging products have some right of recourse against their bank, is a gross exaggeration.
Andrew Meakin is a partner, Banking & Asset Finance, with Morton Fraser LLP