Interest rate swaps linked to floating rate loans have triggered complications and a significant delay in the UK lending market’s turnaround after the global financial crisis. But, based on new evidence from recent out-of-court settlements, UK borrowers might be able to claim GBP 5-10bn in concessions related to their swaps

Introduction: Interest rate swaps have created problems for UK borrowers and lenders

Interest rate swaps have been widely used for many years in the UK commercial property lending market. This is because UK banks require borrowers to cover the risk of an increase in base rates on the floating interest rate loans they provide. When three-month LIBOR increases, but rents from properties do not, a floating-to-fixed rate swap will prevent the loan from a payment default. Floating rate loans dominate the UK lending market, unlike the US where fixed rate loans are more prevalent. However, the interest swaps put in place have had a significant impact on the UK lending market in themselves. As opposed to functioning as a risk management instrument, some have created problems for borrowers and lender alike. This was especially the case when the swaps were not properly structured. This article looks at some quantitative evidence on how some borrowers have been able to deal with problematic swaps.

Key view: UK borrowers might be able to claim GBP 5-10bn in concessions related to their swaps

Many borrowers might finally be able to enter into a more productive phase of discussion with their lenders, with respect of their legacy floating rate commercial real estate loans. This will require a close review of the exact swap terms associated with these loans. This review will need to assess whether the swaps were appropriately structured and/or sold. A number of borrowers are likely to have a strong enough case to convince lenders and swap providers to provide concessions in loan re-structuring and/or financial compensation in redress. This view is supported by new evidence from external partners. Based on this evidence and some key assumptions, we estimate that UK commercial real estate borrowers might be able to claim between GBP 5-10bn in loan concessions and/or financial redress related to their legacy swaps over the next few years.

FCA found that SME swaps did not comply with regulations, but expansion of scheme is needed

As a result, banks were forced into a full review of their sales of interest rate hedging products (IRHPs) to small businesses in January 2013. This will review individual sales of swaps with notional values below GBP 10m and provide redress to private customers based on principles outlined by the FCA and overseen by independent reviewers. Based on this, banks have already provisioned GBP 2bn to cover the scheme’s costs of compensation. But, the current scheme only covers swaps with notional less than GBP10m and parties that meet two of the following criteria: (i) small companies with annual turnover of GBP6.5m or less; (ii) a balance sheet of GBP3.26m or less; and (iii) less than 50 employees. As a result of these limitations, the FCA has faced pressure from legal firms to expand the scheme to include medium sized firms. This would be a welcome move for property investors, as most are excluded from the scheme under its current limitations. The argument that big companies should have sufficient expertise to enter into complex swap contracts seems somewhat misplaced. Of course, many property firms are not waiting for this inclusion and have already started work with specialist advisors and legal firms to make the claim.

Swaps have been a key impediment to the lending market’s turnaround

Floating-to-fixed rate swap contracts have been used to manage interest rate risk in the UK’s predominantly floating rate market. But, as LIBOR and base rates came down in 2009 and stayed down (as a result of central bank policies), swap breakage costs started to pose a big problem for many borrowers. The 2004-07 loan vintages show the worst results. This is because both loan and swap contracts were put in place near the peak of the cycle at high Loan to Value ratios (LTVs) and were up for refinancing in 2009-14. At this time lenders are offering much lower LTVs. However, if the swap’s term extended beyond the loan term, the swap breakage costs had become large relative to the collateral value. Also, they ranked senior to the lender’s collateral interest. The reduced property value was insufficient in many cases to pay both the swap breakage costs and the remaining loan balance. In other words, many borrowers could not refinance or restructure their legacy loans due to the swap. 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. The two court decisions related to swaps in commercial property are not a complete reflection of what has been happening in this area, in our view. Out of court settlements are much more numerous while still each a reflection of the outcome of negotiations between two parties.

Swap maturity mismatches are key problem

The sample of swap cases we have been provided with is relevant for the commercial real estate sector, as it includes over 71% of swaps by value above the GBP 10m mark, which are not eligible for the FCA redress scheme (Figure 1). Despite the limited sample size, we are happy to accept its limitations and look forward to expanding it in future. According to Collyer Bristow, the key to a successful redress claim is that the swap’s key features do not match the loan’s risk profile. For example, when the swap maturity is longer than what was required under the associated loan agreement. Also another issue occurs when the loan agreement did not state that LTV or other financial covenants could be triggered into breach based on changes in the calculated swap break costs. This is further aided, if the swap provider has a one-sided option to terminate the swap at regular intervals after the original loan agreement. This leaves the borrower with no control over break costs.

Based on our sample, most swaps have a maturity term mismatch. But, many also show a swap notional below the loan, which was unexpected (Figure 2). Apart from mismatches, Collyer Bristow also considers whether the borrower was sufficiently informed when signing up to the swap. If they were not provided with any indication of the magnitude of possible swap break costs under different swap maturities and/or future interest rate scenarios, this might be a red flag. If they were not made aware that the swap was an independent agreement, which might create a significant liability separate from the loan agreement, this could provide another argument that the contract was not properly sold. Finally, if they were not informed that a callable swap was likely to have a higher break cost than a non-callable swap, this could also pose a problem.

Even if we accept that it is not only term and notional mismatches that will provide relevant arguments in contesting swap contracts, it is still noticeable that based on our limited sample: the larger the swap notional value the higher the percentage with double (both notional and term) mismatches (Figure 3). Our interpretation of this is that larger swaps might have been even more poorly structured than the small ones, which were part of the FCA pilot study. This would leave the 90% non-compliance conclusion from that study conservative.

Figure 1

Sample of 41 swap cases of GBP 290mn


Source: Collyer Bristow Solicitors

Figure 2

Distribution of swap notional and term mismatch
(as % of loan amount and term respectively)


Source: Collyer Bristow Solicitors

Figure 3

Types of swap mismatches by size buckets


Source: Collyer Bristow Solicitors

Borrowers achieved actual redress in out-of-court settlements

Wide distribution of redress amounts

The data on actual out-of-court settlement cases provided by Vedanta Hedging Ltd. offers some interesting statistics. Again, we accept the sample size’s limitations and look forward to expanding it in future. Based on Figure 4, we can see a wide distribution of the redress amount when compared with the original notional amount of the swap. Please note that the chart excludes two large swaps. In aggregate, borrowers have been able to settle for an amount of GBP 104m in cash and cash-equivalent for these 67 cases. This is 18% of the total original swap notional value across these cases. This redress is limited to cash and cash equivalent compensation. It includes the cash equivalent amount of any release from future obligations (including swap breakage) under the swap. Please note that the redress also includes compensation for consequential losses. This might include business opportunities that the borrower was unable to profit from as a result of the swap encumbrance.

But, the GBP 104m excludes any concessions on loan refinancing and/or restructurings. According to Vedanta, beneficial financing terms are present in about two thirds of the cases. They typically involve a lower credit margin, a larger loan, a longer term, a capital repayment holiday or relaxed covenants. These concessions are too difficult to quantify consistently and have therefore been excluded. If we finally consider Figure 5, we get an unexpected result. One would expect a bigger redress for swaps with more mismatches, like with the larger swaps. But, larger swaps are in fact getting smaller relative redress amounts. This seems counterintuitive to Figure 3 where we showed higher mismatches for bigger swaps. In the Vedanta sample, we have no evidence to support this premise.

Figure 4

Sample of 67 settlement cases of GBP 575mn


Source: Vedanta Hedging Ltd.

Figure 5

Distribution of redress to borrowers and profits to desks


Source: Vedanta Hedging Ltd.

Market implication is that UK borrowers are in line for GBP 5-10bn in potential redress

We have carefully considered the evidence and attempted to estimate the overall market impact. In order to do this, we analyse possible loan refinancing and restructuring concessions and redress associated with borrowers’ existing swap positions. Therefore, we make the following assumptions:

  • 90% of the GBP 309bn UK lending market is floating rate, 75% of which are assumed to have floating-to-fixed rate swaps in place. The rest will have other hedging instruments, like interest rate caps.
  • One in five to one in ten borrowers in the UK commercial lending market will find significantly convincing issues with the structure or selling of their swap contract(s). This is conservative given the 90% from the FCA pilot study, but given the wider commercial interests with lenders not deemed to be unrealistic.
  • When successful, borrowers get 18% redress from banks in respect of their miss-sold and poorly structured swaps

These assumptions result in an initial estimate of GBP 5bn to 10bn in potential loan refinancing or restructuring concessions and/or swap redress payments from banks to borrowers.

As time progresses and swap contracts mature, the size of the mark-to-market on the swaps will reduce automatically. Also, if rates increase, there might be a reduction of the mark-to-market as well. Therefore, there is a level of uncertainty around the GBP 5-10bn estimate in future, depending on when swap breakage is crystallized. Apart from the impact on swap breakage costs themselves, timing also plays a major role in the legal process (where the swap does not qualify for the FCA compensation scheme).  In the UK, there is a six year statute of limitations on contesting the validity of any legal contract.  However, this statute might potentially be avoided in some exceptional circumstances.

Definitions of key terms

To avoid any misunderstandings, we provide below definitions of four key terms used in the article:

  • IRHP – Interest Rate Hedging Product (which incorporates an interest rate derivative)
  • Floating-to-fixed interest rate swap – This is one of the simplest and popular forms of derivative which allows a borrower with floating rate borrowing to convert this into borrowing at a fixed, known rate.
  • Mark-to-market position – The current market value of a derivative if it is to be cancelled or redeemed at the present time. This could be a positive value to the borrower ‘a breakage gain’ or a negative value to the borrower ‘a breakage cost’.
  • FCA – Financial Conduct Authority
  • SME – small and medium sized enterprises