Banks Will Pay for Misleading Customers

Ongoing litigation in the U.K. means that banks will likely be on the hook for mis-selling products to small business and individuals. According to the U.K.'s Financial Services Authority (FSA), the banks may have mis-sold up to 90% of the products under review. Claims have been coming in for over a year, and banks are just now undertaking a review of their sales, to determine which customers need to be compensated.

The banks facing the first wave of investigation are Barclays (NYSE: BCS  ) , Royal Bank of Scotland (NYSE: RBS  ) , HSBC (NYSE: HBC  ) , and Lloyds Banking Group (NYSE: LYG  ) . These companies are going to pay out something, as they've already admitted that rules were broken. The question remains -- how much will it cost?

Swaps explained
The charges related to rate swaps that the banks tacked on to variable rate loans in the middle of the last decade. Customers who wanted -- or were urged -- to hedge against interest rates going up could agree to a "cap" and "floor" -- together forming a "collar" -- on the rates. If interest rates rose above a certain amount, the cap rate would come into effect, with a customer paying only that rate, not the higher, actual rate.

If rates fell below the floor, then customers would pay the floor rate plus the difference between the floor and the actual rate. Clearly, the banks were selling the collars under the pretense that rates would be rising, as they did until 2008 -- when they suddenly fell.

Mis-selling to consumers
Once rates started to plummet, customers began to see their costs rise. Ironically, the very thing causing them to rise was a move designed to help borrowers. As the rates collapsed, customers approach their banks to cancel their coverage, only to discover that there was an often massive fee associated with cancellation. 

The key to the litigation is not the product itself, which is relatively straightforward -- it's the selling of the product. Claimants believe that they were not given a choice when purchasing a collar, not fully made aware of the fees to cancel the product, or not given enough explanation to fully understand the risks involved.

Now the FSA believes that over 40,000 of these products were sold in the last decade. While many of these will have expired, or be of such low value that banks won't be harmed, many are likely to result in repayments. As an example, Barclays announced that it has set aside $1.3 billion to repay harmed customers. 

While the final tally won't be known for some time, it's a sure bet that this is one more hurdle for the banks to overcome before they can return to respectability -- investors beware.

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