Satirical magazine Private Eye, that eternal scourge of the establishment, this week resurrected the debate about LOBOs (Lender Option Borrower Option) within local government finance circles.
The pre-crash financial instrument still makes up the vast majority of local authority long-term borrowing besides the Public Works Loan Board (PWLB). But are LOBOs really, as the Private Eye article implies, a potential ticking timebomb for councils? Since the credit crunch, no councils have taken out new LOBOs, but during the early 2000s, they were all the rage.
They offered councils borrowing at teaser rates tantalisingly lower than the PWLB rate – even after juicy broker fees were taken into consideration. Additionally – as the name implies – LOBOs also provided for the seemingly fair option for both parties to reconsider the loan at pre-defined periods. Bhupinder Chana, principal finance manager, capital and treasury management, at Leeds City Council, explains: “If the interest rate is increased, the borrower has the option to continue at the new rate or repay the principal without penalty.
“If the borrower repays the principal then the borrower could choose from a number of options to raise funds ranging from its balance sheet, other local authorities, banks, pension funds or the PWLB at a rate and period that suits. This situation is no different to refinancing any other loan on maturity.”
However, the Private Eye article, titled “Council hosing crisis”, claims the deals “effectively tie the council…into higher rates later on”.
Another blog, by former hedge fund manager Rob Carver says that LOBOs “made no sense at all” and “ripped off councils”, whose treasurers were “under pressure to trim their short-term funding costs by a few fractions of a per cent, at any cost.” David Green, client director at treasury adviser Arlingclose, said that his firm “never favoured LOBOs, mainly because we felt that the small initial saving against PWLB rates wasn’t enough to compensate for the risk of interest rates rising in later years.”
He points out that, contrary to pre-crash expectations, interest rates have so far only fallen. PWLB rates are now below those at which LOBOs were taken out, leaving banks unable to negotiate rises. This has benefited councils so far, as they continue to pick up the small savings – which Green estimates at about 0.2% per year – over the PWLB rate at the time they took out their LOBOs.
Chana says: “It still is the case that for Leeds that the average rate paid on our LOBO portfolio is below that paid on our PWLB debt.” Mike Jensen, chief investment officer at Lancashire County Council, said: “Overall, so far, the local authority community has done very well from these deals. Most were written 10 years ago so councils have had a decade of cheap financing and most deals will continue to run efficiently for some years yet.” Green agrees that it is unlikely that banks will be in a position to request increases on their LOBO rates for between five and ten years. The problem, he says, is that most of the LOBOs were originally agreed for much longer terms – between 50 and 70 years.
He says: “Some still have another 60 years to run, so there is a substantial risk that rates will rise later on.” And once they go up, they won’t come down again. Some argue that, at such a point, councils could trigger the “borrower option” element to exit the arrangements using PWLB money to pay off the loan. Jensen says: “Banks cannot unilaterally raise the rates – they can only request a rate rise. The borrower can refuse new terms in which case the loan is wound up at par.”
However, Green says that banks are likely to make councils an offer they will be unable to refuse. At such a point that banks are able to propose a rise, interest rates will have gone up across the board – including those offered by the PWLB. Green says: “Banks will most likely pitch the rise at a rate that is higher than that originally agreed with the council but below the PWLB rate.”
The exact scale of LOBO borrowing among councils is hard to estimate. Figures compiled from the Chartered Institute for Public Finance and Accounting have identified £7.63bn of borrowing currently held via LOBOs in England and Wales (including police and fire authorities).
However, it concedes that “authorities that have not been identified as having taken out a LOBO are not included” in its figures.
So is this all good news for banks? Well, the story is not quite that simple. First of all, Jensen says that: “Local authorities have most definitely not lost money on these loans – in fact it is the banks that have lost fortunes on the loans – or would do if they mark them to market.”
This is because the banks had not counted on the credit crunch, and consequent low-rate environment. “When they were working out their expected profits, the banks expected their LOBO rates to rise more quickly than they have done,” Green says.
And they have been unable to compensate by reducing their liabilities – interest rates paid on bank accounts – for fear of losing the business, or by lending at higher rates elsewhere.”
Furthermore, the banks making the original loans are unlikely to benefit very much from rises in any future LOBO rates.
As each loan with a council was agreed, they lender sold interest rate options to investment banks at a profit, according to Green. So when interest rates do finally rise, any profit accrues to the investment banks, rather than to the original lender.
This complicated scenario could provide an escape route for both councils and banks at the sweet spot – still some way off – when rates approach levels at which the original LOBOs were agreed. Councils could pay off their loans before they rise to eye-watering levels. Banks could then use the cash to buy out the interest rate swap agreements they made with the investment banks.
Whether the process works smoothly in practice is another question, but Green is clear: “It is in the interests of both lenders and borrowers to exit LOBOs.”
Photo (cropped): “Lobo” by Santiago Atienza