Expensive and risky loans

LOBO loans are expensive and risky loans.

  • They are expensive as they are usually very long term (40-70 years) and have interest rates that are 2-10% higher than current PWLB interest rates.
  • They are risky as they contain embedded derivatives in the form of options as indicated by the name LOBO which stands for Lender Option Borrower Option.

A derivative is a complex financial instrument that can be described in simple terms as a bet on something happening in the future. For example, a common derivative is an interest rate swap which can be described as a bet on future changes to interest rates. In the case of LOBO loans, the derivative is more complex and is embedded in the loan contract.

With a LOBO loan, at pre-agreed option dates, such as every six months or five years, the bank (the lender) has the option to increase the rate. The council (the borrower) then has the option to either accept the new rate or repay the loan in full. If the bank does not use its option, the council can only exit the loan by paying a high exit penalty which is at the discretion of the bank.

At first sight this might appear as a fair deal. However, it’s not – it is so unfair that financial experts have defined it a lose-lose bet with the banks.

A lose-lose bet with the banks

“So heads the lender wins and tails the borrower loses. Only if the coin lands on its edge every time, and rates remain broadly flat for decades, does the local authority win.”

Arlingclose, a treasury management advisor, commenting in the 2015 parliamentary inquiry

Whether a bank uses its option or not will depend on varying PWLB and market rates, but fundamentally, the bank will only use its option when it is most convenient to them.

  • If PWLB and market interest rates go up, the bank is likely to use its option with the intention to lock in a new higher interest rate. If the council wants to exit the loan, it will have to pay back the loan principal. To do so, it will most probably have to borrow new funds from the PWLB or other lenders. To keep the council trapped in the LOBO loan the bank will offer a new interest rate just below the rate at which the council could borrow from the PWLB or the market, making it slightly cheaper and more cost effective.
  • If PWLB and market interest rates go down, the bank will keep the LOBO loan rate as it is. In other words it will not exert its option and the council will be paying a higher interest rate than those available at the time. If the council wants to exit the loan, it will have to pay a high penalty fee that is at the discretion of the bank. 

As a result, some councils are locked into 11% interest rates, while they could be borrowing at 1-2.5% from the PWLB. The current low interest climate also means it is very unlikely banks will use their option to change the interest rate, as they would risk the council exiting the loan deal without paying a break penalty.

Bank vs councils

The longer the term of the loan, the more interest rate risk the loan will carry. In other words, it is harder to predict how much money the council will be losing as a differential between the LOBO interest rate and the market and PWLB rates over the lifetime of the loan.

When issuing a loan, a bank will hedge against the interest rate risk with an interest rate swap. A large borrower would usually do the same, but local authorities, were prohibited from taking out standalone swaps between 1991 to 2011,  and therefore have not had the same capacity as the banks to protect themselves from interest rate risk.

Banks have sophisticated software to predict how much they will earn from a loan. Due to the way they account for loan and derivative sales, on the day a deal is signed, they book upfront the profits they expect to make over the lifetime of a loan. It has been estimated that on £15bn of LOBO loans banks booked an upfront profit of £1.5bn. Profit margins on LOBO loans were huge compared to those for sales of loans or derivative products to corporate clients, showing just how bad the deals are for councils.

“By any standard of derivatives, because we advise corporates on derivatives, even corporates that do hundreds of millions of borrowing, that was a phenomenal profit margin to generate. That profit margin effectively rips out so much profit on day one that it is expected to work against the best interest of the authority over that 60 or 70 year period, regardless of what happens to interest rates.”

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

“The actual money comes in over a number of years […], but the economic value of the deal can be booked to the bank’s trading income on day one, under accrual accounting.”

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

“The bank would have reported it in its annual accounts at that year and it would have paid out bonuses to all its investment banking staff at the end of that financial year, based upon the income for the whole 70 years, taken upfront on day one.”

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

On the other hand, due to the optionality and length of LOBO loans, the overall cost to the council over the life of the loan is very difficult to price without sophisticated pricing tools that the majority of local authorities do not have direct access to. To monitor the risk and expenses associated to the loans, councils have to rely on private sector advisors, who are not always independent and add additional costs to council budgets.

Furthermore, due to lax accounting standards, councils have only recently been obliged to account for the risk associated to derivatives in their financial accounts. The true cost of LOBO loans remained hidden off balance sheet for years and many officers and councillors were unaware of the potential impact on their council’s finances.