The banks

Until the 2011 Localism Act, councils were prohibited from using standalone derivatives contracts following a ruling in 1991 in the Hammersmith and Fulham vs Hazell case.

In the 1980s, 137 UK councils had entered into hundreds of interest rate swap agreements with banks. Hammersmith and Fulham Council was the largest player. It had signed hundreds of swap contracts with Goldman Sachs, placing UK taxpayers on the hook for £300 million in potential losses as interest rates moved against the council in favour of the bank.

Ultimately, the High Court ruled in 1989 that councils entering into standalone swaps and derivatives contracts was “ultra-vires”, or outside council’s legal powers. Despite an appeal by the banks in 1991, the House of Lords upheld the ruling, deciding it was not a council’s role to be speculating upon interest rates, and taxpayers should not be held liable. The contracts were cancelled, much to the anger of banks.

The ruling did not stop the banks from engineering a way around the legal restrictions by embedding the derivatives rather than providing them as a standalone contract.  In addition, with LOBO loans, the bank takes all the benefits of the derivative, the council all the risk.

Furthermore, the marketing and sale of derivatives is regulated and the products have to be carefully explained when sold, since they carry serious and complex risk and can be very costly to exit. Instead, regulation for the marketing and sale of loans is lacking and does not contemplate the embedding of complex financial instruments. It is possible that banks sought to avoid regulation with LOBO loans by asserting they were simply selling loans, not contracts containing derivative products. They appear to have done so successfully.

The following comment is from the Financial Conduct Authority (FCA) written evidence to the 2015 parliamentary inquiry:

“Because it is commercial lending, activities related to making these loans, including arranging, advising or entering into a loan agreement, do not typically constitute regulated activities.”

The council

No-one would rationally decide to enter loans that are so expensive and risky while having the option of borrowing more cheaply and at a lower risk from the PWLB. This could potentially mean that the council acted unlawfully.

The choice to enter the loans could have been based on incorrect or inadequate benchmarking of LOBO loans with respect to PWLB loans and/or lack of expertise and appropriate tools within the council to understand the terms of the contracts.

“I would categorically say that I do not believe you would be able to find a finance officer or a treasury officer in a council who would be able to accurately assess the relative risks and rewards of one of these LOBO products. I would even have to say that it does not matter if you are a qualified accountant or a chartered accountant at all. We deal with some very large corporates and even FTSE 250 businesses’ treasurers would not be able to analyse this on their own. They would literally need a specialist hedging advisor or for the bank to explain things in a very transparent manner to them.”

Abhishek Sachdev, derivatives expert, commenting in the 2015 parliamentary inquiry

In some cases, council officers should be held to account for the decision to enter LOBO loans. However, in most cases, local authorities relied on the private sector for advice and guidance on how to borrow and invest. Private firms not only charged high fees, but acted with significant conflicts of interest, encouraging councils to behave like short term, profit-driven companies.

The brokers

When councils take out a loan they do not always deal directly with the banks. Often they rely on brokers, who charge substantial fees to obtain and structure the deals. In the case of LOBO loans there were many brokerage firms involved but the most common were ICAP and Tullet Prebon.

Councils would pay a broker a fee corresponding to a percentage of the loan, typically between 0.06% and 0.24%. Given the magnitude of the loans, these were very large sums. For example in the case of a £10m loan a broker could receive up to £24,000 from the council.

At the same time, the brokers received undisclosed payments from the banks as they competed for deals. Commissions were exceptionally large since the brokers provided banks with such high margins on LOBO loans. Insiders have said it was unusual at the time that brokers should receive such high commissions from both sides of the deal.

“We were paying commissions to the brokers as well and this made me very concerned, because I did not see how the brokers could be giving their ultimate clients, the councils, independent advice when they were being paid by us. […] The brokerage fees were quite large compared with the fees we normally paid, and there was lots of pressure always to pay higher fees.”

Rob Carver, former Barclays trader, commenting in the 2015 parliamentary inquiry

The advisors

Due to the increase in complexity of local government finance, councils rely on external advisors to make decisions on borrowing and investment.

Companies providing this service to councils are called treasury management advisors (TMAs). When LOBO loans were being sold, the main TMAs in the market were Butlers, Sector Treasury Services, Capita Asset Services, Sterling Consultancy Services (SCS) and Arlingclose. Sterling Consultancy Services was acquired in 2012 by Arlingclose, while the three other companies are now operating under the name of LINK Asset Services. According to the data collected only Butlers and Sector Treasury Services were advisors to councils who took out LOBO loans.

TMA firms are generally contracted for several years and are paid an annual retainer fee for their advice. They are contractually obliged to provide independent advice in the sole best interests of their council clients.

However, the independence of TMA firms has been brought into question on more than one occasion.