A few weeks ago, I was with Channel 4 Dispatches reporter Antony Barnett speaking to Sheffield Labour MP Clive Betts. We were on a park bench in some gardens next to the Houses of Parliament and we briefed Betts about our findings on Lender Option Borrower Option (LOBO) loans to UK councils – findings that were seen by a Channel 4 audience of over 1 million last Monday.
Betts is chairman of the Communities and Local Government select committee and we knew he would be interested in what we had to say. As we explained our calculations of upfront profits earned by banks and break costs to him, Betts interrupted us.
“These remind me of swaps sold to small businesses in my constituency”, he said. “Is there any way the loans can be unravelled?” he added later on.
What was it that we explained to Betts? And what do his comments imply? Let’s start with the explanation. The point is that LOBOs were a bad product for councils. Former trader Rob Carver, whom we interviewed for the programme, has a blog article refuting the arguments that council treasurers make. Rather than repeat those arguments, I want to highlight some simple economic realities that emerge from the data.
Although LOBOs are loans, they contain embedded derivatives, which in practice were hedged by banks at the date the loan was agreed. The contract terms can be entered into a derivatives pricing model to estimate the upfront trading profit that would have been earned by the bank. Effectively, this is the amount that the market would have been prepared to pay for a derivative with the same cash flows specified in the LOBO contract.
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Doesn’t “truth in lending” apply to such things? It seems to me that the financial risks that are attendant to the exits of these LOBO contracts are not disclosed in a manner that a person of ordinary intelligence can understand them.
Although I am referring to how contracts are litigated in the US, it seems that UK contract law is probably pretty similar. That said, it seems to me that such a contract would be classed as an “unconscionable contract” and thus be void. And normally,, when there are lawsuits concerning contracts, the language or the interpretation of vague or not easily understood portions of the contract would be construed against the drafter of the contract. Also, it seems that the lenders/seller side of the contracts were significant beneficiaries and the councils, et.al. would, especially on exit, be greatly harmed. I cannot imagine how this would be solved, but it seems that the old adage “follow the money” will be the best policy.
These LOBO’s were not an accident and were not normal business evolution. The construction/formulation of these contracts was intentional by certain parties. Those responsible for these very wrong things ought to be made responsible for making it right in every way.
It also seems to me that, while it may give you less to research and write about, contracts such as these LOBOs or any contract that is fraught with complexity such that the contract signers, regulators, and, in general, people of ordinary intelligence cannot understand them, then those contracts, should be, by definition, ruled void. And when such contracts are litigated, the courts should declare them unconscionable. Let a few big cases be litigated, and it seems to me that contracts will get much more simple. After all, to have an exit cost to be equal or greater than the loan principal is completely absurd unless you are borrowing from an organized crime “loan shark” whose lending practices, while simple, are also illegal.