Renowned major banks and savings banks lead inexperienced treasurers and managers of municipal companies into an interest rate trap with billions in losses. This is a brilliant business for credit institutions – an estimated 40% of local authorities are affected.
Allegedly exclusive concepts from the bank product department
Speculation with foreign exchange works in principle in such a way that, for example, a foreign currency is bought today (spot transaction), and at the same time a sale of the foreign currency is made for the future (closing out transaction). The expert then speaks of spot exchange with closing out transactions per term1). One variant is the interest swap, in which interest and/or repayment obligations are exchanged between parties. Or more generally: “A swap is an agreement between two parties to exchange mutually dependent cash flows periodically during the term of the contract – irrespective of any underlying transaction²).
Very wealthy private investors also affected
The business of interest rate differentials has been around since the 1920s, even if pretty PowerPoint presentations are supposed to suggest an exclusive novelty. Due to the risks involved, some of the Länder ministries of the interior³) have urged local authorities not to invest capital investments and reserves in swap contracts – with reference to the ban on speculation in accordance with the local authority regulations. Meanwhile, the customer presentations at some banks were passed on to Wealth Management4) for adaptation in order to create dubious tax saving models for very wealthy people.
Nationwide loss-making transactions of various municipalities through interest rate betting
Numerous cities and municipalities – including municipal companies – believed that they could profit without risk through “derivatives” in interest and debt management: The fact that reality looks different is now also known from cities 5) such as Neuss 6), Dortmund 7), Würzburg8) and Hagen9) – Interest rate derivatives turned out to be a considerable financial loss. With such products, the treasurer will always need “an assessment of the future development of interest rates”, and therefore uncertainty in the future, i.e. speculation, is involved. However, one thing is always certain, the costs or margins of the bank.
4. Municipal interest and debt management: fee trap also at savings banks
Derivatives, such as swaps, are among the products of the highest risk class – but the bank seller recommends such products “for risk management”. It is often not clear to employees of municipal companies that apparent temporary cost reductions in the credit sector are in fact leveraged by swap contracts: The consequences of such speculation regularly result in losses running into millions – unless the municipalities employ a clairvoyant with a sure look into the future to see how “the markets” will develop. Such transactions can be useful if foreign currency loans exist
Information obligations of credit institutions
Banks are subject to a multitude of information obligations – wrong advice leads to liability.
5.1 Strong reference to public law restrictions
According to a judgment of the OLG Naumburg10), of 24 March 2005 (Case No. 2 U 111/04), a credit institution infringes its obligation to provide advice that is appropriate to the investment and the investor if, prior to agreeing a currency swap with a company operated in the legal form of a GmbH, the shares of which are held 100 % by a municipality, it does not point out possible restrictions under public law on the municipality and does not insist on an examination of the permissibility of the transaction.
5.2 Investment and property-specific advice: focus on currency risk
In that judgment, the Court stressed that when a currency swap is recommended for the first time without foreign currency loans, the mere mention that it is an instrument “for hedging currency risks” is not sufficient: On the contrary, the bank must make this the focus of its advice.
In the opinion of the LG Magdeburg11), there is no general obligation to advise municipal companies against such interest rate bets if the customer is sustainably engaged in financial risk management or interest rate management
5.2.1 Advice on forecasts: Prohibition to present too short periods of time to the customer.
The Regional Court of Würzburg12) also recently stated that the credit institutions had a considerable duty to provide information in proceedings against a major bank, not only because of the general ban on speculation but also because in this case the development of interest rates was “accelerated by two levers”. Advice on forecasts of future “spread developments”, which is based on historical experience, must not be based on excessively short comparative periods.
5.3 Lack of transparency: colourful pictures and opaque formulas at customer events
In its judgement of 31.01.2008 (AZ.2-04 O 388/05), the Frankfurt/Main District Court judged a swap transaction to be non-transparent because the mathematical formula presented suppresses “the customer-burdening effect”. According to the German Securities Trading Act (WpHG), the customer must also be able to easily grasp the “meaning and scope” of the contract in the case of financial futures transactions. Because without knowledge of the profit opportunities, no client can assess the appropriateness of the associated loss risks. This alone was sufficient to judge the contract as ineffective.
5.4 Compensation for damage due to conflicts of interest: Market value kept secret
In the same judgment, the Court of First Instance criticises that the Bank was in a conflict of interest and should therefore have disclosed the market value of the derivatives: Pursuant to Section 31 of the German Securities Trading Act (WpHG), the bank must enable the client to assess the bank’s interest in sales itself, in particular by disclosing its own margin, a “reimbursement” or “front-end load”. The bank may not keep its knowledge lead for itself out of interest in secrecy.
Conclusion
The bank apprentice learns “Mr customer, we want your best – your money! When dealing with financial futures transactions, it is also advisable to take a double hedge – on the one hand, a fee consultancy for risk analysis that is independent of banking practice. because the Bank will normally pursue its own commercial interest. On the other hand, the commandment requires not to waste money, to check the contract samples for gaps and cost traps. Last but not least, as in the case of CBL contracts, the delicate question of embezzlement may arise.
Comments:
1) Uszczapowski, Igor, understand options and futures. Munich 1999. p. 307 f.
2) Loretan, Michael, The Swap Contract. Zünch 1996. S. 32
3) e.g. in Brandenburg: Circular in municipal affairs of the Ministry of the Interior No 2/2000
4) In private banking, this is understood to mean investment advice and management.
5) according to Manager-Magazin of 27.08.2007, Flensburg, Sulingen and Göttingen are also affected.
6) EUR 14 million damage
7) EUR 6.2 million in damages.
8) 2.6 million Euro damage
9) 51 million euro of damage. 5-6 million for subsidiaries.
10) More than 0.5 million Euro damage
11) Judgment of 21.01.2008. Az. 9 01989/06
12) Judgment of 31.03.2008. Az. 62 0 661/07
published in “Der Gemeindehaushalt” 03/2009, pages 69-70
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Dr. Johannes FialaPhD, MBA, MM
Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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