IRHPs are a type of derivative, ie. complex financial instruments. IRHP contracts were sold alongside business loans, supposedly to protect the customer against interest rate rises.
The most widely sold type of IRHP is known as a vanilla swap, sometimes referred to as Interest Rate Swap Agreements (IRSAs). With this product, if interest rates go up payments under the IRHP contract go down. Likewise, as the interest rate goes down, the IRHP payment goes up accordingly.
The net effect of this is that the customer effectively ends up paying the same amount each month or quarter, rather like having a fixed-rate loan. There are also many other types of IRHP such as caps and collars of various complexity, some of which are structured and particularly dangerous as they cause payments to rocket dramatically as rates go down.
Who were they sold to?
IRHPs were sold by banks to business customers who were entering into new or renewed loan facilities. Nearly 30,000 IRHPs were sold to SMEs in the UK between 2001 and 2012. These businesses were often told by their bank that interest rates would rise and that they needed protection.
What is wrong with IRHPs?
Despite the supposed purpose of the IRHP being to protect customers from interest rate rises, IRHPs exposed customers to huge risks when interest rates fell. This is because a feature of the product is that it has a ‘mark-to-market’ break cost.
This means that if a customer exits the product during the term they are liable to pay potentially enormous fees, sometimes up to 50% of the loan’s value. The banks knew they were exposing the customer to the risk of this ‘contingent liability’ but customers did not have this properly explained to them.
In many cases the bank made the purchase of an IRHP a condition of new or continued lending, often introducing it at the last minute so the customer had no choice.
The condition of lending was often not legitimate as the customer did not need any interest rate protection. So, whether the risks of an IRHP were not adequately explained or the IRHP was a condition of lending, customers were denied the opportunity of making an informed choice when entering into the IRHP.
It is now widely accepted that IRHPs are inherently unsuitable products for SMEs. This is explained in this document (link to Nick Stoop doc).
What is the consequence of having an IRHP?
While the banks advised that interest rates would rise, rates in fact fell to historically low levels.
This meant that those customers who entered into IRHPs did not enjoy the benefit of these low rates, but instead were stuck on substantially higher rates under the IRHP they had entered into. Businesses have therefore been unable to refinance, left facing crippling monthly repayments and/or exorbitant breakage costs to extricate themselves from their IRHP.
The knock-on effects vary in severity. Businesses have been starved of cash during a recession due to paying high interest rates and have stagnated because of an inability to refinance or sell assets.
Others have suffered hardship after paying large break costs. Many failed to meet repayments, or were found in default because of a loan-to-value (LTV) breach which led to them being put in ‘Business Support Units’ such as RBS’ Global Restructuring Group which charged crippling fees. Many businesses became insolvent and were pushed into administration and many individuals have been bankrupted.