In my research for Channel 4 Dispatches, I broke through Newham council’s wall of secrecy and learned that the council had at least £150 million of inverse floater LOBOs (believed to be with Royal Bank of Scotland), along with other councils such as Cornwall, Edinburgh and Newcastle that disclosed these RBS products in response to Freedom of Information requests. As discussed on the programme, these loans involve councils paying a variable coupon which goes up when market rates go down – coupons that recently have gone above 7 per cent. To understand these products, I priced a £25m Newham deal on a Bloomberg terminal, which allows the underlying cash flows to be modelled – from today until 50 years in the future. This is important because the concept of fair value involves combining all of a loan’s future cash flows into a single number.
Click on the play button to see the animation evolve.
The animation shows at different times what the market expected Newham to pay on the inverse floater, with each bubble representing a coupon date (the dark blue bubbles in the bottom left hand corner represent the initial fixed teaser rate of 3 per cent), while the far right is the maturity date of 2060. You can see that when the loan was taken out in July 2009, markets expected the coupons to stay fairly low, which is why most of the bubbles are green or yellow. However, by 2014 market rates had plunged and the expected coupons on Newham’s inverse floater were well into the red zone above 6 percent. The fact that the market expects the coupons to stay high for so long explains why the break cost of Newham’s inverse floater portfolio is currently more than double face value. And there is a sting in the tail: if market rates go up, bringing the expected LOBO coupons down, RBS could exercise its option to increase the interest rate, which Newham will either have to accept or find the money to repay the loan. In financial terms, this makes the inverse floater even more valuable for RBS, and more painful for Newham.
Combined with an additional mix of standard and exotic ‘range LOBOs’, this explains why the fair value of Newham’s LOBOs is estimated at more than £1 billion.
