(Semi)public organisations are dabbling in derivatives and it is storing up trouble for the future, writes Patrick van Gerwen.

The public hearings held during the parliamentary inquiry into housing corporation practices have provided an additional insight into the use of interest rate derivatives by (semi) public organisations.

This extremely risky interest rate product is proving popular with housing corporations, care organisations and local councils alike. The attraction lies in the fact that, initially, interest charges are low. But organisations may have to pay a high price for this perceived windfall later which could endanger their very survival.

Extendable loan

This type of finance construction, called an extendable loan or a loan with embedded swaps, is not compatible with responsible risk management. The interest charges that await organisations are time bombs waiting to go off.

This is how it works. An organisation engages in a combined interest rate derivatives transaction with the object of covering the interest risk on the underlying finance. That can be done be effecting a 15-year interest swap.

At the same time the organisation sells a 10-year swaption (the option to swap) to the bank which only comes into effect after the 15-year interest swap has run its course. The swaption gives the bank the right to agree an interest swap with the organisation against a fixed interest. It is up to the bank to use this right.

Premium

The organisation, by selling a product to the bank, receives a premium. This premium increases by agreeing on a relatively high interest rate. It is that premium which is used to depress the interest rate artificially during those first 15 years.

The impression is created that the organisation has done a good job covering its interest risk. In many cases the accountant will qualify it as an ‘effective hedge’ and this is how it will end up in the annual report. Everything seems to be okay – on the surface

The name of the construction – an extendable loan – is misleading too, because it suggests the loan can be extended. What organisations often don’t know is that this is the exclusive right of the bank.

Time bomb

The future impact of this construction is left out of the picture completely and could become a ticking time bomb. After 15 years the organisation in the example is suddenly faced with a big increase in interest charges. This is the price they pay for the initial advantage. In other words, payment on interest charges is left to the future. This is not responsible or sustainable interest risk management.

The low interest scenario in particular can make these constructions very expensive indeed. And that will affect budgets. Care organisations, local councils and housing corporations which are facing enough challenges as it is because of changing rules, could buckle under the strain.

Patrick van Gerwen heads financial advisory agency Cadension.

This article appeared earlier in the Volkskrant.