LOBOs – negotiating a smooth exit

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Councils currently have a window of opportunity to rid themselves of some of their Lender Option Borrower Option (LOBO) loans. David Blake gives tips on how to get the best deal possible.

LOBO activity has gone through the roof as banks continue to market their loans portfolios and make prepayment offers, in a rush to exit positions.

Many authorities have already achieved fantastic value through early redemption, reducing cost and risk in the process.

These councils can shrug off much of the criticism surrounding the use these loans – many have ended up with a better deal than they would have from the Public Works Loan Board (PWLB) at the time the loans were taken out.

But there is an element of good fortune here, and savvy councils will heed the lessons of the great LOBO debate.

A smooth LOBO exit (Lexit?) won’t be possible for everyone.

Below, I set out a few tips for ensuring a clean break.

Council objectives

Start with the council’s objectives: what do you want to achieve?

You can reduce debt, reduce investments, make savings, regain control of debt, adjust your maturity profile and reduce refinancing, interest rate and reputational risks.

But you probably can’t do this all. How are objectives prioritised and how effectively will prepayment meet these?

You need a decent understanding of accounting regulations, particularly in Scotland and Northern Ireland where more restrictive rules apply.

For all authorities, some thought is required to avoid costs in the early years.

Don’t forget the housing revenue account too, particularly where general fund savings are the primary objective.

For me, the main issue with LOBO debt has been market risk, rather than the “call” options which have proved to be benign in hindsight.

When the yield curve inverted, many authorities borrowed long dated loans, including LOBOs.

Treasury portfolios became over-leveraged and heavily weighted towards long-term debt.

And we all know what happened following the global financial crisis.

LOBO prepayment brings the opportunity to rebalance this position – but be careful you don’t end up overexposed to refinancing risk if funding using existing resources or short-term debt: analysis of the liability benchmark is required.

Calculate the minimum discount rate required to achieve the desired outcome; indeed, it has acted as a starting point for many of our client negotiations.

Understanding the bank’s position

Of course, councils should understand the bank’s position and wider market perspective, in order to engage in effective negotiation.

The banks hedging arrangements, typically a callable Bermudan swap, will dictate their behaviour in terms of future rate risk and prepayment negotiations.

Understanding and quantifying the value of this will enable authorities to calculate the expected future cost associated with retaining LOBOs.

It will also help establish the bank’s “red lines” and identify when extra value can be squeezed out of a deal.

While IFRS 9 and Basel III mean banks are eager to dispose of these assets, breaking underwater swap positions still costs money.

They don’t have unlimited budgets to absorb losses and will have a reserve price, on both individual assets and portfolios.

That said, many are forced sellers with tight deadlines, giving local authorities and their negotiation team the upper hand.

Know the market

Another factor is how the market perceives your council from a credit risk perspective.

While pension funds will happily buy the loans of average authorities, credit spreads jump sharply for those with more strained financial strength metrics.

The advantage of being a below average authority is that there is less demand for your debt from third parties; it should be cheaper for these authorities to buy their loans back as a result.

In a similar way, very long-dated, or more controversial loans, such as inverse floaters, also trade at higher spreads in the secondary market.

While media reports on LOBO deals provide a guide on pricing don’t infer too much.

Spreads can range from gilts plus 0.50% through to over gilts plus 2%.

Audit trail

Once you have done your research and analysis, document it, setting out how you arrived at a particular discount rate and why you think prepayment is appropriate.

LOBO critics have focussed on individual loans that look expensive and irrational in isolation.

But these may have made sense in the context of managing portfolio risk, or maximising overhanging debt payments following Large Scale Voluntary Stock Transfer.

(Remember this? It made sense at the time…).

So provide some explanation and cover all the usual angles required by the Treasury Management Code, Prudential Code and the council’s approved strategy.

Explore alternative options too.

Reliable advice

Take care when seeking advice, a quick search on the internet or the MHCLG select committee’s  Inquiry into Local Council Bank Loans will tell you what to avoid.

Usual selection criteria apply, relevant local authority expertise, authorisation to provide advice from the Financial Conduct Authority and suitably qualified and experienced personnel.

Look for a decent track record and strong peer recommendations.

“Execution only” services are no longer relevant; the bank will require councils to close transactions directly. “comparative information” services are of limited use.

Look for credible companies that have signed up to a treasury management advisors “code of conduct”, or similar – you can make this a contractual requirement.

Price & value

Now, I know it’s not the done thing to mention fees in these blogs and I risk editorial censorship, but LOBO fees (or brokerage) have formed a large part of the debate.

This is a specialist area and the products are complex.

If you need to, pay for advice.

Avoid payment on single outcomes, no deal might be better than a bad deal.

Pay for delivery of reports and analysis at key milestones.

Success fees can be performance related, but performance needs to be clear and agreed and defined in advance (not always easy, particularly when pricing inverse floaters).

Consider price and value.

On a typical £10m, 50 year LOBO, an increase in the discount rate of just one basis point will reduce the settlement sum by around £34,000.

Thoughtful, well informed and well-practiced negotiation can shave hundreds of thousands of pounds off settlement amounts.

A poorly conceived proposal or badly executed transaction could result in unbudgeted costs, a sub-optimal settlement and just add to the on-going controversy.

In summary, there are great LOBO repayment opportunities out there, but careful due diligence is required.

Move with speed and precision, avoiding the pitfalls of the past, to maximise the benefits.

David Blake is strategic director at treasury adviser Arlingclose