How much has your council lost on LOBOs?

How  much  has  your  council  lost  on  LOBOs?       Los  Lobos  were  a  popular  Spanish  band  that  shot  to  fame  in  the  1980s.  Another  type  of  loss   on   LOBOs   has   been   in   the   news   lately.   These   are   loans   taken   by   many   councils   and   housing   associations   that   are   known   as   ‘Lender   Option   Buyer   Option’   -­‐   and   were   recently   the   subject  of  a  Channel  4  Dispatches  documentary.     What   are   LOBOs?   These   are   complex   loans   that   often   appeared   cheaper   than   the   alternatives   being   offered   by   the   government   at   the   time   and   hence   were   attractive   to   councils   and   housing   associations.   LOBOs   are   not   normal   loans,   they   contain   complex   financial   derivatives   that   used   correctly   are   effective   risk   management   tools,   but   inappropriately  applied  contain  substantial  dangers.     At   its   simplest,   LOBOs   can   be   a   bit   like   a   fixed   rate   loan.   However   it   is   unlike   a   mortgage,   in   that  the  bank  can  cancel  it  –  this  is  the  lender’s  option  in  a  LOBO.  Why  would  you  agree  to   this?   Price   was   attractive   and   if   as   a   council   finance   officer,   you   could   show   you   were   getting  cheaper  loans  than  those  on  offer  by  the  government  –  you  were  a  hero.  These  loans   could  be  for  up  to  70  years  –  long  beyond  the  council  officer’s  pension  date.     There   are   further   features.   The   borrower’s   option.   The   council   actually   doesn’t   have   an   option;  they  have  sold  that  to  the  bank.  This  could  be  the  option  for  the  bank  to  cancel  the   loan   or   to   increase   the   interest   rate   paid.   This   could   mean   that   when   interest   rates   drop   yours   goes   up   (a   snappily   named   inverse   floater)   or   it   could   be   an   option   for   a   bank   to   increase  the  interest  rate  to  what  ever  it  wishes.     Think   carefully,   would   you   take   out   a   mortgage   than   had   a   teaser   rate,   but   could   be   cancelled   by   the   bank   or   they   could   increase   the   margin   at   anytime?   This   is   what   many   councils,  housing  associations  and  universities  have  done.     If  the  bank  cancels  a  loan,  break  costs  may  have  to  be  paid  by  the  borrower.  These  can  be   significant.   Channel   4’s   Dispatches   highlighted   a   council   loan   of   £25M   that   had   a   break   cost   of  £15M.    And  where  a  bank  can  raise  interest  rates,  the  borrower  has  then  effectively  an   unlimited  exposure.     In   the   late   1980s   at   the   time   Ricky   Valance’s   Los   Lobos   was   topping   the   charts,   there   was   a   landmark   legal   case   concerning   councils   and   derivatives,   between   Hammersmith   &   Fulham   councils   and   Goldman   Sachs.     Essentially   after   appeal   the   ruling   was   that   councils   were  

unable  to  enter  into  derivatives  and  the  137  councils  who  had  done  so,  were  effectively  able   to  walk  away  from  these  financial  instruments.     Eric  Pickles  MP  in  the  2011  Localism  Act  repealed  the  inability  to  enter  into  derivatives  by   councils   and   also   introduced   the   notion   of   ‘general   power   of   competence’   by   councils.   However,  even  if  this  power  is  thus  far  untested,  banks  were  able  to  effectively  enter  into   derivative  contracts  with  councils  through  the  use  of  LOBOS.     LOBOs   can   be   viewed   as   a   type   of   packaged   fixed   rate   loan.   Here   the   customer   doesn’t   directly   enter   into   a   derivative,   but   the   bank   enters   into   a   derivative   on   the   customer’s   behalf.   The   end   client   has   the   benefits   and   risks   of   the   derivative,   without   the   required   regulatory  paperwork  or  protections.  This  is  exactly  what  has  happened  with  LOBOs.  Banks   have   neatly   sidestepped   the   inability   of   councils   to   enter   into   derivatives   by   doing   it   for   them.     What   does   this   mean   for   banks,   councils,   housing   associations   and   others   that   entered   LOBOs?  There  will  inevitably  be  questions  as  to  whether  the  transactions  are  valid.  There   will  be  examination  as  to  whether  borrowers  have  been  negligent  and  wasted  public  money   and   whether   advice   they   may   of   taken   was   correct   and   possibly   conflicted   due   to   commission   payments.   There   will   also   be   questions   as   to   whether   the   LOBOs   have   been   mis-­‐sold  by  the  banks.     There  is  a  long  history  of  derivatives  entered  into  by  local  authorities  and  councils  ending   in   disaster.   There   is   on-­‐going   litigation   in   Italy   and   Germany   in   this   respect.  Orange   County   in  California  effectively  went  bankrupt  due  to  derivative  speculation.  It  may  be  that  councils   have   found   themselves   in   the   middle   of   another   well   known   1980s   show,   the   Dukes   of   Hazzard.   They   certainly   have   taken   huge   risks.   The   effect   of   LOBOs   can   be   a   very   real   hazard,  the  price  of  which  is  yet  to  be  realised.     Martin   Berkeley   is   FCA   Authorised   to   advise   on   derivatives   and   has   acted   as   an   expert   witness   in  many  derivative  cases.