Friday, 21 September 2018

The only perfect hedge is in a Japanese garden

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ANOTHER MIS-SELLING SCANDAL hit the news in the UK last week. It seems high-street banks have been flogging interest rate hedges to unsuspecting small and medium-sized businesses.

Anthony Peters, SwissInvest Strategist

There is a story circulating about a fish and chip shop proprietor in Scarborough on the North Yorkshire coast getting into hot water (hot fat?) on a collar he had bought from a UK clearers in order to protect himself against rising rates.

The great zero-cost collar – much loved by all and sundry, but especially Landesbanken – is of course only zero cost so long as you remain within the corridor. You buy the cap and sell the floor; simple. But in buying your hedge against rising rates, you are selling someone else a hedge against falling ones.

As with all hedging products, they look dandy if you get them right and cost you your shirt if you don’t.

Slightly perchance, I had dinner with a friend this week. No, the perchance wasn’t that I still have a friend, but that the friend in question is global head of something important with a major firm.

I’ve known him for over 25 years now and in one of his more junior incarnations he worked in what is now known as the “rates space” at Bankers Trust. We giggled like Japanese schoolgirls as we cast our minds back to the disasters of Gibson Greetings and Orange County in their dealings with Bankers.

In the late 80s and early 90s, Bankers Trust was the benchmark in interest rate derivatives, just as Salomon Brothers was in bonds.

Anyone who wanted to do any serious rates hedging beat a path to Bankers’ door and in the same way in which Prue Leith – there’s one for the teenagers – could serve a bowl of hot water and be complemented on the quality of her soup, so anything that came out of Bankers that had an interest rate swap attached was assumed to be an act of pure genius.

That the trading desk had taken three or four points – or more – out of the trade up front and not amortised them over the life of the deal meant that the bid, should one be required, would result in a stonking loss for the client. The more bells and whistles that were built into the structure, the more obscure it became and the more difficult to track the risks.

A HEDGING STRATEGY has the habit of being the result of the buyer’s brilliant analysis when it works out and of the bank’s mis-selling when it goes wrong. However, as already noted, the more ingenious the hedging strategy, the bigger the pile of brown stuff it leaves behind when things don’t develop as planned.

If a trained capital markets banker is lost, what chance the middle-market banker? And if he can’t work it out, think of the poor chap who makes his living frying fish

Banks love to refer to rate derivatives as risk management tools, but they are no such thing – what they do is to replace one risk with another one.

That aside, how much of what goes wrong in “risk management” is mis-selling and how much is mis-buying? In the case of the SMEs and the UK high-street banks, I suggest that it is six of one and half a dozen of the other.

The real mis-selling is probably between the structuring groups at head office and the middle-market bankers in the field. I can’t imagine that the latter have too much of an understanding of the pay-off curve on the options which are embedded in simple-looking structures that promise to make life so much easier for the buyer.

I RECALL A friend of mine (now a head of credit sales, heaven forbid) who worked on the ABS desk at Bear Stearns, from where any amount of subprime-backed product emanated and who, once it had all gone horribly wrong, quite happily admitted that he never really had much of a clue about what he was selling.

If a trained capital markets banker is lost, what chance the middle-market banker? And if he can’t work it out, think of the poor chap who makes his living frying fish.

A hedge strategy is like any insurance; if it looks like it may be making more money for the insured than it does for the insurer, it won’t exist. However, if it comes cheaply, which zero-cost collars do (though I’m sure the lesser-spotted retail buyer didn’t get it at “zero cost”), then there has to be a hitch.

PT Barnum coined the phrase that there’s a sucker born every minute. Derivative desks have no problem leveraging that number up and creating one every 15 seconds.

I spend much of my life defending bankers from excessive criticism. However, when it comes to flogging structured rates products to small business owners who can neither understand nor value the risk they have acquired, there is no case for the defence.

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