June 26th, 2014
By Rob Carver (guest blog)
First we had PPI. Then Libor. Then the misselling of interest rate swaps to SMEs. Now, ladies and gentlemen, I give you LOBO-gate: how banks ripped off local authorities and housing associations from someone who was there.
Cast your minds back to the early 2000s. Life was good. Both the public and private sector in the UK were doing well. But for treasurers of local authorities or housing associations, money was still tight on occasion. It was still necessary to borrow money.
One might have thought that local authorities could borrow very cheaply since in practise, if not legally, they are backed by the UK’s central government. Indeed, they are able to borrow from central government via the Public Works Loan Board (PWLB) at rates only slightly higher than the spread on UK government bonds. But, to a treasurer encouraged to make their department behave like a profit centre, even these rates were too high.
It would of course have made no sense for the local authority to approach a bank. Even in the halcyon days of the early 2000s, banks generally had worse credit ratings than the countries that hosted them, which meant they could only borrow money at higher rate than the sovereign nations; and that in order to make a profit, they had to lend out at a little more again.So, borrowing from a bank was inevitably going to be more costly than borrowing from the PWLB.
It would have made no sense at all…..and yet that is exactly what the local authorities did. And they were able to borrow more cheaply than from the PWLB. And the banks made huge profits, but not as much as some individuals working as money brokers did, for intermediary firms and brokerages such as ICAP and Tullet Prebon.
Welcome to the magic of the Local Authority Lender Option Borrower Option – otherwise known as LOBO loans. Surprisingly what little fuss has been made about these “too good to be true” deals to date has focused on their tenuous connection to Libor-gate. In fact this is a completely different scandal. Banks and brokers sold local authorities at least £7.63bn of such loans by 2014.
Let’s say I offer to lend you £40 on which I will charge you an interest rate of 3% over five years. Someone else comes along and offers you the same deal, but with the twist, that he wants to option to demand repayment in full whenever he chooses. You wouldn’t borrow money from him because he is clearly offering a worse deal.
Suppose he sticks to his guns but as a concession he will lend you the money at only 2.9% interest. Would you take that? What about 2.5%? 2%?
Essentially what I am asking you to do is to value the option of the lender wanting their money back. Why would the lender want their money back? There may be all kinds of reasons, but the most likely is that interest rates have risen to say 4%; and they would rather lend the money to some other person than have your 3% coming in.
Of course, as a borrower, having to suddenly repay the entire loan when interest rates rise is the worst possible thing for you. I assume you haven’t got the money to repay it. Unless you have hidden reserves, you’re going to have to repay the original lender and then borrow from someone else at 4%. Ouch.
There is nothing unethical or unusual about this (but don’t worry, the unethical bit is coming….).
In the LOBO deals, the lender has the right to ask for the loan to be repaid early. So they will charge less interest because they own a valuable option. The question still remains, how does the borrower value that option?
Enter the middlemen
To weigh up the merits of the mortgage option versus the repayable loan option you just need a Bermudan swap-tion pricer, to know the relevant volatility surface, some kind of interest rate model calibrated to the appropriate processes and the full forward and spot curve.
However it is unlikely that you have access to this kind of thing at home. 99.9% of people don’t. Which is why many of us use IFAs and mortgage brokers.
In the retail financial services market, the incentives were until recently skewed. Customers were reluctant to pay large upfront fees for advice, so advisers were paid through commission from the firms whose products they were recommending.
Likewise, in LOBO deals, the local authorities did not deal directly with banks, but were put together by middlemen known collectively as ‘money brokers’. The reason this was being done was supposedly to protect the local authorities…
Why keep the banks away from local authorities? Well, there was a landmark case in the early 1990s after the London Borough of Hammersmith and Fulham became embroiled with the trading of interest rate swaps (derivatives) in an attempt to reduce their funding costs (oh the irony!). It was decreed that they had exceeded their legal authority in signing these deals, and the judge concluded the deals were ultra vires (null and void). Local authorities were deemed to be too unsophisticated to trade these complex derivatives and were banned from doing so.
They were not allowed to trade swaps and certainly not Bermudan swap-tions, an even more fiendishly complex form of derivative. A Bermudan swaption is a right to cancel a swap… you can guess where this is going. Yes the kind of option embedded in a LOBO deal is a Bermudan swaption.
So what exactly is going on here? Is it okay for local authorities to take out cancellable loans (or cancellable fixed rate mortgages) which embeds a complex derivative, just as long as them directly?
Mechanics of a trade
Let’s examine a trade of which the author may or may not have had intimate knowledge whilst working on a bank’s derivatives trading desk in the early 2000s. (This is a ‘composite’ story with elements of things which really happened)
First, housing association B asked the broker to get them the best deal on a cancellable loan; say a 40-year loan, first cancellable in two years, and then every subsequent six months. Not many banks can do this kind of deal because the relevant derivatives market isn’t particularly liquid (because loans over 30 years are quite). The broker probably rang round three or four UK-based banks and at least one German bank.
Unable to do the deal themselves, the German bank called up one of the British banks to get a price for hedging the risk. This led to a situation where the relevant trading desk had requests for pricing an identical hedge from two different parts of the bank. The request made directly would have made the bank more money so the trader told the German sales guy not to mess around with letting the Germans try and undercut them and steal their business. One might imagine the Germans were given a quote that was sufficiently high to deter them from making a competitive offer to the broker. (This may border on cartel-like behaviour, but I’m not a competition lawyer so I don’t know.)
So the quotes come in from the banks. The broker chooses one.
I don’t know how he chooses the quote, I wasn’t there (I never even met the guy, all deals being done via bank salespeople). What I do know is that the quotes would have included a negotiated commission for the broker (remember the banks are paying him for arranging the loan). I know that the commissions on the deals we won (and we seemed to win quite a bit) were often very high compared to commissions on other brokered products.
Would the broker have chosen the best deal for the local authority or the best deal for himself? It might be harder to make the right decision if the commission was very large…
So, for example, most products brokered bank-to-bank had commissions of fractions of a basis point, or perhaps one basis point (1 basis point is 1/100 of a per cent). Whereas on some LOBO deals, the commissions could be approaching 1%. Although these deals are more unusual and complex than many other products, this is still a very large commission. In money terms we are talking £20m to £50 million dollar deals, on which six-figure brokerage commissions were not uncommon.
On this particular deal the commission was so large in percentage terms that it exceeded internal limits. Even the most rapacious traders on the trading desk were feeling pangs of…. well not guilt perhaps but fear their gouging of local authorities might one day be exposed. But the broker agreed to take half of the commission spread over subsequent deals, so that was okay.
The commission that the banks’ traders were personally earning on the deal would have been much lower than those the brokers were earning but, although not large in the grand scheme of things (billion dollar bond issues are not uncommon, though with much lower % profits), the deals were certainly making a healthy contribution to the derivatives trading desks profits.
This chart below, illustrating a £10 million Lobo loan taken out by the London Borough of Brent on 11 August 2009, should gives a taster of how local authorities got taken for a massive ride. The red line indicates the rate that at which the Royal Bank of Scotland told Brent it would be borrowing. The blue line is the Public Works Loan Board (PWLB) rate at which it could readily have borrowed. The green like is the actual LOBO rate that the London Borough of Brent is having to fork out — to the massive detriment of its finances and the services it is able to offer its council tax payers.
Here is what Joel Benjamin of Move Your Money wrote about this particular LOBO loan following an FOI request in March 2014.
The recent FOIA disclosure of a 2009 loan agreement between RBS and Brent Council in London to Move Your Money has raised fresh questions of ICAP’s ‘market making’ activities, and the lack of regulatory oversight of UK local authority finance.
The loan agreement known as a ‘lender option borrower option’ or LOBO, is noteworthy for several reasons.
Firstly, the firm that advised Brent Council to take out the loan in 2009 was Butlers, a subsidiary firm of ICAP – noteable for losing half a billion of council cash in Iceland when the banks crashed in 2008.
The loan deal was executed by Garban International – another ICAP subsidiary, earning tidy profits for ICAP on both sides of the trade.
Finally, the structured loan signed in August 2009 features a fixed “teaser” rate, reverting to a floating interest rate which can be “called” higher by RBS at regular intervals, references not just the manipulated LIBOR rate, but the suspect ISDAfix rate as well.
How far does it go?
What I don’t personally know is the extent of this. It could just be a few isolated trades with one UK bank that I personally know about over a couple of years. I have absolutely no proof that this is a major problem. But I’d bet that it goes much further than this.
The immoral food chain
While none of this may been strictly speaking illegal, no-one comes out smelling of roses. The money brokers are the worst offenders; their behaviour was downright immoral and they personally benefited the most. It’s very easy to blame the bankers and they certainly should have behaved differently, but their incentives were to either pay the commissions or lose some very profitable business.
(What the bankers involved should have done was leave their jobs in disgust and go and work somewhere else more ethical. Then just when they had the moral high ground recaptured they should have spoiled it all by going to work for a hedge fund. It worked for me!).
But it isn’t just them. Just as naughty, I think, were the people who put pressure on the local authorities to trim their short term funding costs by a few fractions of a per cent, at any cost. The treasurers themselves. The well meaning people who through the law of unintended consequences prevented the local authorities from getting quotes directly from banks which could have improved things a bit. (This happens all the time. For example the use of financial advisors, investment and pension consultants to protect investors from being ripped off just adds layers of fees and in my opinion adds no value. But that’s a whole different story.)
This post is written by Rob Carver – visit his blog ‘Investment Idiocy’