Miss-selling: a Problem of Product or Process?
I guess it would be nigh-on impossible now to find anybody who would speak in favour of the quaint concept of lending money to people who are already seen to be very unlikely to repay the loan without a significant change in circumstances; that, of course, was the sub-prime mortgage proposition, with the hoped-for significant change being a never-ending upward spiral of property prices. Likewise, I suspect that not too many would support the concept that staff remuneration should take precedence over that of shareholder reward – but that’s the basis behind years of compensation in the banking (but not only banking, of course) industry. And, let’s face it, there’s not much doubt that much of the PPI business done by the various UK retail banks was miss-sold.
However, I do seem to get a feeling that while there has clearly been egregious behaviour, at some point it becomes necessary to look beyond the villain of the piece and see to what extent some of the suffering of the victims is self-induced. Take the alleged miss-selling of interest rate swaps to businesses in the UK. This is an issue that has been extensively reported in the press, and many complaints are under investigation. Crucially, though, the mainstream press does not in general make the distinction between the selling and the product. How negotiations between bank and customer were conducted, I obviously have no idea. What I do know, though, is that the product is a reasonable one; interest rate swaps have been around for a long time, and they can be a very useful tool in making long-term capital plans. The word “swap” also features prominently in the title, and what that should suggest, to anyone with a reasonable grasp of the English language, is that there are two sides to the transaction. In other words, if somebody offers to “swap” a fixed forward interest rate for a floating one, and if you accept the deal, then there are three possible outcomes. Interest rates don’t move, so effectively nothing changes; they go up, so the fixed rate you have taken is beneficial versus the prevailing floating rate; they go down, so your fixed rate is more expensive than the actual floating one. Now, as far as I can tell, the complaints are largely based on the third of those possibilities, with the suggestion that somehow it’s unfair. But, again with the proviso that I can’t speak for the sales method, it’s difficult to understand that problem. Most of these deals were taken out prior to the 2008 crash, at a period when higher rather than lower interest rates were anticipated; that’s why borrowers wanted the protection. If they’d expected rates to drop as they did, then they wouldn’t have traded that product. The fact that events turned out differently from expectations is a a far cry from a product being unfair.
There is another example I saw, reported by ‘Private Eye’ September 5th. Apparently, some local government authorities have taken out an “inverse floater” loan, where the interest rate goes up as LIBOR goes down. Private Eye ends that sentence with an exclamation mark, just to make sure we understand how outrageous it is. Well, that’s a strange sounding product, for sure, and presumably it’s origin is in the current very low interest rates; at historically high rates, it wouldn’t be very interesting. The magazine’s article is not very clear, but presumably the premium over LIBOR is relevant as well. Still, I don’t know the details. But that doesn’t necessarily make it the work of the devil.
Process or Product?
My point, though, is that it’s not the products themselves that are necessarily the problem, and by failing to differentiate between product and process of selling, we all do ourselves a disservice. Sub-prime mortgage lending was a accident waiting to happen; it imposed obligations on borrowers with which it was irrational to expect they would be able to comply for the entire duration of the loan. In that case, the product was wrong-headed and the selling appears to have been so as well. But interest rate swaps – as the example I’ve used here – do not fall into the same category. In a world of often violent swings in borrowing costs, they offer the opportunity to fix a major unknown; the fact that some takers do not appear to have thought through the logical consequences of the deals seems to me to be a poor reason to threaten the possibilities they offer. The object of regulation should be to enable people to do things in an ordered environment; but at the same time, those people need to understand that they bear the responsibility for their actions. By all means discipline and punish miss-selling, but don’t throw the baby out with the bathwater. In most of these cases, it’s the selling process not the product which has been the problem and that’s where the focus needs to be. Not all financial derivative products are evil; many of them have a perfectly legitimate use in oiling the wheels of our economic system.