Chickens coming home to roost?

Peter Hill examines the headaches for local authorities arising out of Lender Option Borrower Option (LOBO) loans.

An extended period of low interest rates has turned a once-attractive form of long-term borrowing for councils into a massive liability, leaving many to rue past decisions.

The terms of Lender Option Borrower Option (LOBO) loans enticed councils to borrow from banks rather than the Public Works Loan Board (PWLB) prior to the financial crash in 2008/09. Initial period teaser rates were offered on the assumption that interest rates would not fall.

But up to a year ago alarms bells were already ringing and the sustained downturn means those bells are ringing even louder now.

A Dispatches television documentary, How Councils blow your Millions, broadcast last July triggered an investigation by the Parliamentary Select Committee on Communities and Local Government, although it appears no final report or recommendations are to be made.

Prominent amongst submissions to the Select Committee was a distress call from Newham Council, the largest LOBO loan borrower with some £565m of LOBO debt. In the case of the “inverse floater” variable rate loans, in which the interest rate payable moves in the opposite direction to money market rates, Newham’s LOBO loan now looks like a particularly bad bet.

The Select Committee heard that council finance officers were not usually equipped with the sophisticated software pricing tools needed to run the analyses carried out by banks. Despite numerous FOI requests to other councils, none had produced evidence that it had ever been demonstrated by an external Treasury Management consultant that taking out a LOBO loan represented better value for money than PWLB loan.

Arlingclose Limited, a treasury management adviser (unusually for treasury management consultants) opposed to the use of LOBO loans, told the Select Committee that the value of the options sold by the council ought to be reflected in the transaction by an appropriate reduction in the interest rate payable. Further, since the terms typically offered by LOBO lender banks did not include a sufficient interest rate reduction, LOBO loans could not be recommended to councils as good value.

Key to such a long-term fixed rate for the borrower (40-70 years) are the “swaptions” (options for interest rate swaps) granted by the borrower to the bank, which are sold on to a swap counterparty where the bank is hedging its interest rate risk. Arlingclose commented that the value of the options is affected by the frequency and the length of periods between option exercise dates, the effect of which required detailed analysis. They also warned that exercise of an option (a call for increase of the loan interest rate, to which the borrower may respond with repayment of the loan) should be expected only when market interest rates are rising, and hence the cost of refinancing higher also. The options have no value to the borrower, only risk. This risk is magnified by the loss of control suffered by the council, as exercise by the lender will be driven by the swap counterparty, not the lending bank.

More risk for councils exists in the profile of early exit costs – significantly higher for a LOBO loan than a PWLB loan because of the longer loan period – and the need to repurchase the underlying options (unless made cancellable at a cost factored into the original pricing of the loan). Newham’s loans were taken out between 2002 and 2008. The Dispatches team suggested that exit costs on a £25m loan to Newham might be as high as £15m.

Cipfa’s evidence acknowledged that interest rate, liquidity and counterparty risks needed to be considered before taking out a loan, reminding the Committee that adherence to the Cipfa Treasury Management Code is a legal requirement under the Local Government Act 2003.

The conventional wisdom of council Finance Directors as savvy finance professionals came in a submission from Cornwall County Council, albeit with a note from one elected Council member (a former City lawyer) dissenting from the view that the risks of LOBO loans were well understood. In Cornwall’s balanced loan portfolio, LOBO loan average interest rates are 4.3% fixed and 6.2% variable in contrast to the PWLB average of 4.1% and the overall average for the whole portfolio is well within the fluctuations of the PWLB 50-year rate over the last 10 years. Cornwall’s September 2015 Treasury Management Update report reassured members that LOBO loans could be repaid without penalty fees, and that refinancing risk to the Council was mitigated by having several smaller loans and avoiding bunching of maturity dates. No reference was made to break costs. Things with LOBOs may not be currently quite for the best in the best of all possible worlds but that is life, and in the context of its overall debt profile, Cornwall could live with it.

So, opinion is divided. What is clear is that longsuffering councils like Newham, Manchester and the 20 or so others less cautious in earlier years will have to contend with LOBO issues for years to come.

Meanwhile the Financial Conduct Authority (FCA) investigation of manipulation by banks of LIBOR and other benchmark rates is continuing. Too premature to be explored by the Select Committee, it remains to be seen whether this will ultimately create a basis for challenge of LOBO loans, or at least a lever for renegotiation with lending banks.

Peter Hill is a Senior Associate in the Public Services Group of Geldards LLP.