Hammersmith and Fulham in Sterling

interest swap loss of about £600

FIN 6264 - MANAGING RISK-FUTURES &

Prepared for :
Dr Salihin Ramli

Prepared by :
Noor Afzan Abdullah
G0910054
Background

Who or what is Hammersmith & Fulham?

The administrative areas in London comprises of 32 areas, called boroughs. Hammersmith &
Fulham is one of the boroughs, which are administered by the London Borough councils. These
boroughs are the principal local authorities and are responsible for running most local services in
their areas, such as schools, social services, waste collection and roads.1

Background of case

Hammersmith & Fulham, has been involved in the interest rate swaps since the year 1983. The
councils were using swap contracts supposedly to hedge their debts and liabilities from the
interest rate risk. The event that leads to the Hammersmith & Fulham scandal started in June
1988 when a member from the Goldman Sachs, a US investment bank, who was working with
the swap desks, alerted the Audit Commission of the massive exposure of Hammersmith &
Fulham to the interest rate swaps. Howard Davies, the officer from the Audit Commission
enquired the chief executive officer of the council regarding the matter and discovered that
Hammersmith & Fulham is indeed participating in the swaps market and the treasurer of the
council is making money out of the swap contracts with the outlook of interest rates going down.
Immediately, Audit Commission launched an action to an audit and investigates the matter.

Upon investigations, it was later revealed that the exposure covered by hundreds of
derivative contracts amounted to £3 billion with a notional sum of £6 billion signed with banks
all over the world. As of July 1988, Hammersmith & Fulham had 0.5 percent of the world’s
swap market. As a local authority, Hammersmith & Fulham had a bank debt of £308 million as
of 1st April 1988 and a capital expenditure budget of £44.6 million in 1988-89. The derivative
transactions were recorded in the books as a capital market funds. The exposure amount is
simply extraordinary for the council due to its huge shares in the interest rate swap (IRS) market
that amounted to 100 times of its debt, and due to the fact that the council’s position are all on
the same side of the market.

1
London borough- Functions, [Link] Retrieved 4th Oct 2010.

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 Anthony Hazell of Deloitte Haskins & Sells, the auditor for London Borough of
Hammersmith and Fulham, informed the council that, owing to the scale and nature of its
operations, some or all of its swaps transactions may have been entered into unlawfully. Despite
this, On 1 August 1988, the council’s Director of Finance informed the auditors that he was
suspending all swaps transactions but he would continue to manage existing swaps as part of an
interim strategy designed to reduce the council’s exposure to loss. During the period in which
Hammersmith pursued this strategy the council sought leading counsel’s opinion on the legality
of their transactions. To add to the situation, interest rate started to go up from 8% to 15% around
the same time. Hammersmith & Fulham, being a fixed receiver (floating rate payer) is at a loss
when the interest rates goes up. As of February 1989, the cost of closing out all of the derivative
contracts amounted to £300 million. Since the Audit Commission is responsible to the action by
the council, it needed to take necessary actions to alleviate the problem. By January 1989 the
commission obtained legal opinions from two Queen's Counsel. Although they did not agree, the
commission preferred the opinion which made it ultra vires for councils to engage in interest rate
swaps.

The case eventually ended up in the UK High Court in 1991, when all the swaps were
declared to be illegal. The court decreed that the city councils did not have the authority to enter
these transactions, which are found to be ultra vires (or “beyond the power” of the cities to
enter). All of the contracts were deemed void and hence the council was not responsible for the
losses. The court ruling had put the banks involved in a disadvantage because many of the swap
contracts were defaulted. Hammersmith & Fulham who was the floating rate payer had defaulted
because of the court ruling, leaving the banks, the fixed rate payers, at a substantial loss
amounting to £600 million write-off. The banks with the most losses include two of British
banks: Midland Bank and Barclays Bank, plus Security Pacific National Bank and Chemical
Bank of US and Mitsubishi Finance International. The banks had made appeal all up to the High
Court but failed in their appeal.

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Case problem

There are several issues with regard to the scandal. Firstly is the issue of lack of understanding
by the treasurer and the officers of Hammersmitsh & Fulham regarding their involvement in the
interest rate swap market and how the derivatives actually work. Hammersmith & Fulham was
exposing itself to such huge exposure without considering the impact of the changing interest
rate. They are taking the position that looks only at one side of the market, expecting the interest
rates to go down. As a fixed rate receiver, lower interest rate would of course enable the council
to make some money. However, they had failed to understand the risk if the interest rate were to
go up and the impact of such changes given the level of exposure they were having. True
enough, had the interest not go up, Hammersmith & Fulham would never know the risk that they
have imposed upon themselves.

Secondly, because of their own lack of understanding in the derivative instrument, they
have misuse the benefit of the derivative with regard to the actual intentions. Interest rate swap
was supposed to be used to manage their debts, for example to lower the cost of borrowings.
However, the fraction of the council’s debt only counts for about 10 percent of the contracts
worth, raising the question of whether the position of the council is to hedge against the interest
rate or as arbitrageurs with intention of making money. Even so, the amount of exposure is
simply too massive and the council is up for a catastrophic losses due its one sided outlook of the
market.

The third issue is the lack of good governance within the public sector. In this case, the
Audit Commission was responsible for the council’s action in the derivative market involvement.
The commission is not new to the information that many of the councils (not limited to
Hammersmith & Fulham) have been dealing with the derivatives market since the early 1980s.
The commission did raise some concerns to all councils regarding the matter, but attention was
truly not enough. Only after the disastrous failure of Hammersmith & Fulham, did the
commission really took a firmer stance. Additionally, the management of the council itself was
problematic. The leaders of the council and its elected members themselves had no idea what is
going on behind the finance department, giving chance for the exposure to accumulate to such
huge amount.

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 The fourth issue is related to the regulations related to the involvement of public authority
in the derivate market. During the court processes, some of the legal opinion oppose to the view
of the transaction being ultra-vires. The argument, known as ‘the Rolled Steel argument’,
suggest that it would be unreasonable for any other parties to nullify contracts that were entered
by the council on its own free will and even if the contracts would be unlawful, it was because of
the council’s own lack of responsibility on handling too many derivative contracts and had used
them for a wrong purpose. The legal definition related to the transactions was unclear whether
the council, as a local authority has any lawful rights to use derivative to manage its fund (or
even to enter the derivative market itself), or whether the transactions became unlawful when the
council is using it for the wrong purpose. On the other side of the coin, the banks were also
responsible for allowing Hammersmith & Fulham to take on the huge exposure. All of these
different arguments, including the court final ruling prove to be evidence that the involvement of
public authority in managing its capital fund is in fact allowable, given that it is used purely for
hedging. However, the ambiguity of the exact ‘punishment’ to Hammersmith & Fulham for their
somewhat ‘imprudent’ action raised questions of fairness and credibility of local authority.

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The aftermath of court ruling

The impact of the Hammersmith & Fulham case is most felt by the banks who had loss large
amount of money because of the court ruling that deemed many of the contracts to be illegal and
has to be voided. Should the interest rate had not gone up but the court would still rule the past
transactions to be voided, would the losses be at the council’s side? The ruling may turn out to be
different altogether, given the political link of the council as the public authority with the UK
government. The banks, following the court ruling issued a writ of outstanding payment of £3
million which was later appealed by the commission.

In order to maintain good relationship with the banks in the future, the commission, under
the blanket protection from House of Lords (the lower house of the parliament), worked together
with the British Bankers Association to establish an ‘interest rate swaps code of practice’. The
House of Lords decided that councils had no power to engage in any swap transaction. This
decision marked an end to the court actions revolving the Hammersmith & Fulham scandal.
However, the squabbles between the councils and the banks continued over their restitution
payment.

Lessons from the scandal

There a few lesson that could be learned from this case. As according to Hull(2002), below are
lessons for all derivative users be it from financial or non-financial institution.

1) Institution entering into derivative market should define their risk limit

It is crucial for any institutions to be clear of the own risk limit and set up guidelines and
procedure of managing the risk based on the defined limit. There should be a dedicated
management team dedicated in handling those risks based on the set guidelines. In the case of
Hammersmith & Fulham, there was no set limit or any set of guidelines for them to refer when
handling the swap contracts. Even the treasurer and the finance department were not clear of
their actions when doing business in the swap market. As a result, the amount of exposure
ballooned to be very risky given the tide of events leading to their losses.

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2) The risk limit should be adhered to

Eventhough this may not directly applicable to Hammersmith & Fulham case, it does gives
precaution for future transaction in any kind of derivative market that would be entered by the
council. Once a set of guidelines is laid out, it is important that it is strictly followed to avoid
misuse and unethical conduct.

3) The market is volatile and unpredictable

Surely enough, in the case of Hammersmith & Fulham, their initial position was on the one side
of the market. Their single-focused bearish outlook of the interest rates caused them to disregard
the impact if the situation reversed itself. As a result, the council was facing a huge loss and the
bank would gain handsomely. Had not the court ruling came into play and without the backup
from the parliament, Hammersmith & Fulham could go bankrupt simply because of their
recklessness in betting on the unpredictable interest rate market.

4) Importance of know-how knowledge

This is the most important lesson coming out from Hammersmith & Fulham scandal. Any
institution entering into derivative market should be well versed of the mechanism and the risk
that they are dwelling into. For Hammersmith & Fulham, it seems that their knowledge were
superficial, which resulted in the enormous exposure and eventually losses. For a non financial
institution with intention to enter into derivative market, it is important to know how to manage
the risks. Hammersmith & Fulham could have seek advice from an investment banks that could
help them analyze the market and advice their position.

5) Clear position in the market – hedging, arbirtaging or speculating

The council entered the swap market with initial intention of managing the interest rates of their
debt by taking a hedging position. However, through these activities the council seemed to enjoy
the gain which came out from the contracts and had recklessly entered to a number of swap
contracts that was far beyond their actual debt. As a result, their initial hedging position had
changed and this has proved to be disastrous. It is an important lesson then, that one who takes
the responsibility of managing the derivatives contract be well monitored of their transactions to
avoid a conflict in their position.

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Conclusion

In conclusion, the Hammersmith & Fulham case is a good example of how derivative risk, if
mismanaged could mean a disaster. In the case of Hammersmith, it is a time bomb waiting to
explode. What if the tip off from Goldman Sachs did not reach the Audit Commission? What if
the interest rate had not gone up? The chain of events that lead up to the scandal proves that we
could not predict what would happen in the future. These uncertainties are the important
considerations to those involve in the unpredictable market such as the interest rate make it even
more important to be aware of the risk involved and to manage it wisely and efficiently.

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References

Campbel-Smith, D. (2008). Closing the Swap Shop, 1988-91. In D. Campbel-Smith, Follow the
Money: The Audit Commission, Public Money and the Management of Public Services, 1983-
2008 (pp. 188-205). UK: Penguin Allen Lane.

Hammersmith & Fulham Swaps (UK). (n.d.). Retrieved Oct 4, 2010, from [Link]:
[Link]

Hull, J. (2002). Options, Futures, and Other Derivatives. In J. Hull, Derivative Mishaps and
What We Can Learn from Them (5th Edition ed., pp. 422-431). Prentice Hall.

Interest rate swap. (n.d.). Retrieved October 4, 2010, from Wikipedia:

Jorion, P. (2009). Financial Risk Manager Handbook (5th Edition ed.). John Wiley and Sons.

London borough. (n.d.). Retrieved October 4, 2010, from Wikipedia:

Loughlin, M. (1996). Legality and locality L the role of the law in central-local government
relations. Oxford University Press.