Risky Finance has updated its database of Lender Option Borrower Option (LOBO) loans, a form of structured loan which were once popular products for UK councils and public housing associations.1)The database has been compiled using 788 loan contracts to 49 different councils, obtained by Freedom of Information requests. Pricing was done with the help of Vedanta Hedging Ltd. Data on PWLB borrowing and council tax revenues is sourced from the Department of Communities & Local Government and the Scottish Government
LOBOs are characterised by their very long maturity, as well as their trademark feature which allows banks to periodically raise the interest rate and councils to repay the loan at par. This option to terminate the loan before maturity is most valuable when market rates are high, but since rates moved lower instead, the option is currently worth little.
2016 was the year that UK long-term interest rates reached all time lows. Long-dated gilt yields sank to 1.21% in August – their lowest level since records began in 1703. The ten-year swap rate – a benchmark for private sector loan rates – ended the year at 1.33%. The Public Works Loan Board (PWLB) 20-year rate – a benchmark for the borrowing costs of councils from the government – was 2.55%. In both cases, these are also record lows.
The question that observers of local government should ask is, how much of this is a surprise. Council officers and their advisers talk about the unprecedented low rate environment of quantitative easing. Rates of 4.5 or 5% – typical during the boom in council LOBO borrowing ten years ago – might have seemed low back then compared with the double-digit rates seen between the 1970s and 1990s. However, focusing on this period is myopic in the context of a 300-year timescale, over which median long-dated UK interest rates are 3.6%.
How important is debt to councils? This question can be answered by comparing the annual interest cost of the debt with the amount of money the council has coming in. Almost two thirds of the money that UK local authorities spend is given to them by central government in the form of grants, so it is best to focus on council tax revenues which they can raise directly from residents.
The data show that out of our sample of 49 authorities, 20 of them pay more than 10% of annual council tax receipts in interest on borrowing from central government. 10 authorities pay more than 10% of their council tax to banks in the form of LOBO loan interest. For these councils, debt really matters: the interest burden constrains their freedom and forces them to cut services to local residents. As an extreme case, consider Newham council, which pays more than 50% of council tax receipts to LOBO lenders such as Barclays or Royal Bank of Scotland.
The figures are summarised in the chart below, which shows LOBO and PWLB interest cost as a percentage of council tax revenues for each local authority.
Debt is a burden for many UK local authorities, and also one that they are shackled to because of break costs.. This the amount that councils would have to pay – in addition to the notional or face value of the loan – to prematurely exit the contract with the lending bank or central government. When rates are low, the value of long-dated fixed cashflows above the market rate becomes extremely valuable, and this value sharply increases with loan maturity. In 2016, the total break cost of LOBOs in the Risky Finance database increased by 43% to £10 billion.
PWLB loan break costs also increased in 2016 as a result of declining bond yields. However, the impact on UK councils was much smaller, because the average maturity of PWLB debt is much lower. For example, Glasgow council pays a quarter of council tax revenues to central government as debt interest, but the average maturity of this debt is only 13 years compared with 43 years on its LOBO portfolio.
Councils were enticed to enter LOBO contracts because the banks could offer fixed rates lower than the UK government was charging at the time for benchmark PWLB debt. This discount was possible because of the LOBO option together with its longer maturity. Many councils got an additional sweetener in the form of a ‘teaser rate’, an introductory low rate lasting a few years before the official rate kicked in. And for the most adventurous councils, there were exotic LOBOs such as inverse floaters, where the loan rate increased if a market rate (such as swaps or Libor) went down. Today, the councils that made heaviest use of teaser rates or exotic LOBOs are now paying the most, led by Newham council which now pays a rate of more than 6% on its LOBO borrowing.
To understand whether LOBO loans did any harm, one must ask the question: would the councils be better off if they had borrowed from the government? One can explore this counterfactual because the FOI disclosures include the date that the LOBO loans were taken out. To ensure the comparison is fair, Risky Finance used the benchmark 20-year PWLB rate prevailing at this time.
The results are interesting. A decade ago, almost all councils saved money in interest costs compared with PWLB borrowing – they had to, because otherwise the LOBO wouldn’t have made any sense at the time. And some councils are still saving money today, measured against this historic benchmark. For example, Leeds council saves £2.6 million a year. It’s important to qualify this, however. PWLB rates were around 5% at the height of the LOBO boom, more than twice their level today. Rather than borrow from banks, councils would have done much better if they had borrowed from the government at shorter maturities, so that they could now refinance at today’s low rates. In any case, if rates stay low over the next decade, all councils will be losing money on LOBOs.
Then there are other councils that are losing money today versus the 20-year PWLB loan benchmark. These include authorities such as Wirral or Devon that entered into unwise teaser rate deals – deals that were too good to be true. But the worst councils are those like Cornwall or Edinburgh that took out exotic LOBOs such as inverse floaters or range LOBOs. An extreme example is Newham, which currently loses £8.2 million a year compared with PWLB borrowing: clear evidence of the financial incompetence of its leadership.
Any focus on LOBO borrowing has to look at the role of the bank lenders. In this chart they are ranked according to the fair value of their LOBO loans to the 49 councils in the Risky Finance database. Leading the pack is Barclays with £5 billion in fair value, which scales up to £9.6 billion in total LOBO fair value across all UK councils, or around £4.5 billion in notional terms. Barclays last year waived the LOBO provisions on all its loans, and the impact of this change is included in Risky Finance valuations. Barclays is now seeking to sell its portfolio of UK local authority loans.
Other leading LOBO lenders by value are all troubled or defunct European banks: Depfa (now being wound up by the German government), Dexia (also being wound up), RBS (majority owned by the UK government) and Eurohypo (owned by Germany’s Commerzbank).
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|1.||↑||The database has been compiled using 788 loan contracts to 49 different councils, obtained by Freedom of Information requests. Pricing was done with the help of Vedanta Hedging Ltd. Data on PWLB borrowing and council tax revenues is sourced from the Department of Communities & Local Government and the Scottish Government|