When I was in my twenties, I worked on a film being shot on location in the London borough of Newham. The film itself, which starred Jude Law and Sadie Frost, was forgettable, but one memory that stayed with me was the all-pervading smell of refined sugar from the nearby Tate & Lyle factory by the river Thames.

That factory may still be there but today a different smell is wafting out of Newham – the whiff of opaque finance and lender’s option borrower’s option (LOBO) debt. Figures compiled by the UK Treasury show that Newham is the largest LOBO borrower in the country, with £700 million of the loans measured by fair value according to the council’s latest accounts.

There the trail runs cold. When faced with a freedom of information request in December 2013, Newham would only list the names of the lenders and the dates the loans were taken out. Any further disclosure, the council said, “could affect the Authority’s ability to negotiate favourable rates with Banks in the future”, trumping the public interest¹⁾the FOI rejection is being contested by Joel Benjamin and Ranjan Kumaran of Moveyourmoney, and is expected to go to an Information Commissioner hearing. This puts the council in stark contrast to other local authorities, which have complied with similar FOI requests and revealed details of their loan portfolios.

Could Newham’s opacity be a red flag for something else? Fortunately, other councils’ disclosures give some insights into Newham’s thinking. They show how LOBO financing came about at the tail end of a high UK interest rate environment and appeared to provide a compelling ‘free lunch’ that flattered council balance sheets in the short term.

When rates kept falling, LOBOs turned into a relatively expensive, long-term form of financing that the councils never anticipated. It suggests that Newham’s ability to negotiate with banks may now be questionable, while the rates it pays on its LOBOs might be too embarrassing to disclose.

Let’s begin by going back to the period 2002-4. UK gilt yields and swap rates were steadily falling, and councils could borrow from UK central government (via the Public Works Loan Board) at a spread of about 20 basis points over gilts. LOBOs provided an even cheaper financing opportunity, at the cost of giving banks the option to refinance at a higher rate if yields rebounded.

Faced with this new instrument, what were council treasurers²⁾Strictly speaking, the role of council treasurer falls under the remit of Section 151 of the 1972 Local Government Act, by which so-called Section 151 officers carry out treasury management functions in addition to other CFO-type duties to do? A conservative bunch by nature, their initial response would have been caution. Yet the councils were also under pressure to improve performance, prompted in part by the UK Local Government Act of 2000, which separated executive and legislative powers for the first time.

These newly created executive bodies sought to diversify investments and funding away from central government, and brought in advisers to help them do it. It just so happened that the biggest adviser, Butlers, was owned by broker ICAP – which stood to earn fees if councils borrowed or invested with the private sector.

It was in this environment that Newham took out its first LOBOs in 2002 and 2003. These appear to have been small deals, akin to dipping one’s toes in the water, amounting to a small fraction of Newham’s long-term borrowing from the PWLB. Kent County Council was slightly more adventurous, borrowing £85 million from Barclays Bank in 2004, for terms ranging from 30-40 years. Both councils were advised by Butlers, and in the case of Kent we know that almost all its LOBOs were brokered by ICAP.

Now move on to the next period of time, 2005-7. Long-term yields drifted upwards, with swap rates and gilts heading back above 5 per cent, while the PWLB spread over gilts increased to 50bps. Conditioned by memories of higher borrowing rates, and growing more comfortable with LOBO products, council treasurers ramped up their activity. They began using LOBOs for dynamic treasury management, not just entering new deals but also refinancing existing ones that they had taken out only a few years earlier.

In 2005, north Yorkshire’s Redcar & Cleveland borrowed about £60 million of LOBOs using the proceeds to refinance existing debt “to reduce very steep interest rates”, according to the council (in this case the broker was Tullett Prebon). Meanwhile, Kent decided it was dissatisfied with its £85 million of Barclays’ loans from two years earlier, and refinanced them into new LOBOs in November 2006.

This refinancing is significant because not only did the new loans have increased maturities of 60 years, but Kent agreed to pay Barclays an annual coupon of about 50bps more than the PWLB rate and 80bps more than it was paying on other LOBOs at the time. Combining the effect of increased maturity and coupons, the new loans were up to £40 million more expensive than if Kent was borrowing from scratch.

Of course the reason for this extra cost is that the 2004 loans being refinanced had a repayment penalty. What was so bad about those 2004 Barclays loans that made Kent want to repay them so quickly? We don’t know. But by burying that break cost in a higher coupon and maturity on its new borrowing, Kent could claim to be saving money. Or in the words of a source close to the council, it was “part of a deal to avoid £millions in penalties”.

Since the penalties weren’t really avoided at all, one could take issue with Kent’s judgement, and its spokesman’s claim that the LOBOs “were right at the time for our borrowing needs”. It’s hard not to conclude that Kent bungled its financing in 2004 and then paid over the odds in 2006 to hide the problem.

A similar thing happened up at Redcar & Cleveland. In June 2007 – two years after its first LOBO foray – the council refinanced its portfolio for a second time (the council added new LOBOs as well). We know from FOI disclosures that on this occasion Redcar agreed to pay its lenders – mostly Barclays – rates of as much as 7 per cent for a period of 70 years.

These eye-watering coupons were around 2 per cent more than the government benchmark (the 50-year PWLB rate), probably because two rounds of swingeing early repayment penalties were being rolled up and kept out of sight. Or in the words of a council source, “these [LOBOs] then were rescheduled again into LOBO’s with longer call periods to make more revenue savings about two years later in 2007″.

As with Kent, the trick was to make the annual budget look good (on a one-year timescale) while burying the true cost in the balance sheet over 70 years. The Redcar source again: “The rescheduling was seen as good financial management by the managers involved at the time as it created significant budget savings“ [my italics].

What was Newham doing during this time? We know that of the council’s current LOBO portfolio, four loans were taken out between 2005-7, bringing the total size of such loans (measured by carrying value) to £128 million in March 2007 – less than half the amount that Kent had outstanding at the time. As for the amount of LOBO refinancing, the coupons or the maturity of the loans taken out, we don’t know, and Newham isn’t telling.

For Newham, the biggest was yet to come. With the financial crisis prompting a flight to quality, gilt yields and long-dated swap rates resumed their long-run decline. Between March 2008 and March 2011, Newham dramatically increased its LOBO borrowing to £590 million according to its annual reports, taking out 18 new loans during this period, with banks that included Barclays and RBS. Once again, Newham’s adviser was Butlers (which was sold by ICAP to Capita subsidiary Sector in 2011).

Did Newham use its LOBO splurge to bury earlier repayment penalties like Kent and Redcar appear to have done, or did it get a good deal? In the absence of disclosure, it’s hard to tell. In the words of Newham’s spokeswoman, “We believe that prudent borrowing decisions have been made and our portfolio puts us in a strong financial position. The average rate of the council’s LOBO portfolio is cheaper than the average rate of the PWLB portfolio”.

Since Newham stopped borrowing from the PWLB in March 2009, its average government borrowing rate is probably close to 5 per cent, so Newham’s claim isn’t particularly impressive ³⁾The claim is muddied by the fact that central government repaid £544 million of Newham’s PWLB debt in 2011, as a result of the reform of housing subsidies. So the borrowing benchmark Newham uses is the £65 million rump of PWLB debt it still has on its balance sheet. And we know that today, if Newham hadn’t locked itself into LOBO contracts, it would be able to borrow at a long-term PWLB rate of about 3.5 per cent. If Newham’s LOBOs have another 50 years to run, then that difference amounts to £440 million of additional interest costs on the £595 million loan principal.

How about trying to refinance that portfolio? Not so fast. Newham’s own calculation, audited by Price Waterhouse Coopers, gives a fair value of £703 million as of March using what Newham says is a “net present value approach” However, that may be an underestimate of the true mark-to-market repayment cost, which involves pricing the Bermudan swaption embedded in the LOBO.

In my previous LOBO article, I worked with derivatives consultant Gary Kendall to come up with a market valuation of Kent’s LOBO £442 million portfolio, which currently stands at £735 million. At Redcar & Cleveland they use “Bloomberg’s proprietary model for Bermudan cancellable swaps” which in the most recent accounts results in a 60 per cent premium to face value.

Applying the same markup to Newham⁴⁾this analysis assumes that Newham’s LOBOs are vanilla products similar to Kent and Redcar’s without additional structured features gives a fair value of £944 million, amounting to a potential £240 million hole in Newham’s audited accounts. Unless the UK National Audit Commission decides to investigate the council, we may never know the truth.

It’s just as well that Newham says “We have no plans to restructure our LOBO portfolio other than when required due to maturity”. Being locked into paying a premium over current financing rates without a viable exit route doesn’t look like great treasury management in today’s world.

With refreshing Yorkshire frankness, my source at Redcar & Cleveland was honest about the situation there: “Our view now on these is blinkered by the fact that the LOBO loans have high interest rates in comparison to the current interest rate environment, and the call periods of 5 years mean little opportunity of these being called.”

Meanwhile, Kent County Council now says that it is looking to dump its LOBOs if it can. In the words of a spokesman, “work is under way to restructure where this will be in the long term financial interest of the council”.

Things are done differently at Newham. “We have no plans to restructure our LOBO portfolio”, the council’s spokeswoman says. While attempting to brazen out criticism of its non-disclosure, the council seems to be hoping that a rise in rates will come to its rescue. Here’s the spokeswoman again:

“These structures are long term and are assessed on their whole life and risk management capabilities and not just on a period when interest rates are at a generational low. Our LOBO agreements provide a hedge against interest rates increasing which they are widely expected to do at some point.”

It would seem that Newham is unlikely to be receptive to the kind of analysis that economists such as Paul Krugman have done, arguing that today’s low rate environment could last for years. Instead they’re waiting for rates to rise. Perhaps it’s something to do with that funny smell coming from the Thames shoreline.