LOBOs and the confessions of an ex-auditor

A probe into the use of LOBO loans will today get under way by the communities and local government select committee of the House of Commons. The hearing follows the broadcast of a documentary by the Dispatches programme on Channel 4. Here former auditor Stephen Sheen offers his insight on LOBOs and the responsibilities of local authority finance chiefs.

By Stephen Sheen
There must be some small discomfort in the minds of directors of finance as they duck the LOBO beamers flung enthusiastically in their direction by Channel 4 rather than hooking them over the ropes for six.

The arguments that authorities that took out lender option borrower options (LOBO) loans are better off than if they had borrowed from the PWLB are somewhat disingenuous.  The big numbers being thrown around by the critics do have relevance, but not necessarily to illuminate the evils inherent in LOBOs.  Instead, the billions of pounds count the cost of committing to fixed interest rate borrowing generally.

As authorities are required to disclose the fair value of their loan portfolios in the annual statement of accounts, figures are readily available for the additional interest burdens that authorities will have as a result of fixing interest rates.  The estimates are imperfect, in that they presume that currently available interest rates will persist over the remaining term of the loans.  But the figures that result can be so substantial that the message prevails over the crudity.

It is not uncommon for a fair valuation to add 20% or more to the principal amount of a loan portfolio.  Many authorities are currently laying out millions more on interest payments than they might if they had borrowed at variable rates.

Whether there is any scandal in this depends on whether you consider that authorities gambled unreasonably that interest rates would not fall in protecting themselves against the possibility that they would rise.  You would probably also have to be able to say, “I told you so” rather than rely on the benefits of hindsight.  It was likely the case that with interest rates on the decline, minds were more on the prospect of them bottoming out rather than proceeding downwards to historically low levels.

As an auditor at the time, I recall that the questions being asked were also not focused on whether LOBOs had unlawfully sneaked Bermudan swaptions into the panoply of local authority treasury instruments.  The more basic issue was whether directors of finance understood fully at the time what they were getting into.

The immediate feature of most LOBOs was their unprecedentedly long term, leading to suspicions that they were intended as vehicles to spread the premiums that would be payable on redemption of existing loans over as long a period as possible.  PWLB loans would be repaid at a premium, and the charge spread over the term of the replacement loans.  This was at best a questionably unreasonable application of the accounting opportunity to spread premiums over future periods (where the remaining term of the replaced loans was the more obvious reference point).

For some LOBOs, the initial teaser rate (sometimes 0%) also provided the tempting prospect of revenue relief for the initial years of the loan.   Again, proper accounting practices should probably have nullified the effect by calculating an equalised rate for the loan.

In my view, LOBOs didn’t then deliver what was being hoped for.

So, two alternative views.  One promising short-term revenue relief and leaving the authority only marginally more exposed to the risk of rising interest rates than an alternative PWLB fixed rate loan.  The other relying on appeals to concepts of “substance over form” and the reasonable application of powers to reveal the cloth from which the new LOBO clothes were actually cut.

Unsurprisingly the debate at the time was not a long one.

So, why worry about it in 2015?  Because it is still the episode from my twenty-year audit career that I remember with most concern about the enduring question of the acceptance of advice without due critical reflection.  No matter how good advice might be, the person taking it on behalf of their organisation has a duty to be appropriately sceptical about its reliability.  My experience was that, for the substantial amounts involved in switching PWLB loans for LOBOs, authorities might have been too ready to accept guidance about what they could do as an instruction about what they should do.  Did officers engage sufficiently with the advice that they were able to conclude reasonably that this is what the authority ought to do?

Sometimes things are too good to be true.  But although this will not be so for the majority of cases, with such large sums potentially at stake, the onus on the director of finance is to have no reason to doubt that goodness.  Be respectful, be trusting, but never stop being sceptical.

Stephen Sheen is the managing director Ichabod’s Industries, a consultancy providing technical accounting support to local government.