Friday 28 March 2014

LOBOs - The next banking scandal?

First we had PPI. Then LIBOR. Then swaps miss - selling. Now Ladies and Gentleman I give you LOBOgate. Or How The Banks Ripped Off Local Authorities and Housing Associations From Someone Who Was There.

(I am open to suggestions for a better name)

Cast your minds back over a decade to the early 2000's. Life was good. Both the public and private sector in the UK were doing pretty well. However as a treasurer for a local authority or housing association money was still tight on occasion. It was still necessary to borrow money.

You would have thought that a local authority could borrow cheaply, since in practise if not legally they are backed by the UK central government. Indeed they can borrow from central government via the PWLB at rates only slightly higher than the governments own debt issuance. But to a treasurer encouraged to make their department behave like a profit centre even these rates were too high.

It would of course made absolutely no sense for the local authority to approach a bank. Even in the halcyon days of the early 2000's banks generally had worse credit ratings than the countries that hosted them, and had to borrow money a little more expensively; and to make a profit lend out at a little more again.So borrowing from the bank was obviously going to be more costly than borrowing from the PWLB.

It would have made no sense at all..... but 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.

Welcome to the magic of the Local Authority Lender Option Borrowing Option - LOBO deal. Surprisingly what little fuss has been made about these deals has focused on their tenuous connection to LIBOR-Gate. In fact this is a completely different scandal.

A little introductory financial alchemy

Lets say I offer to lend you £40 and charge you 3% interest for 5 years. Some other guy comes along and offers you the same deal; but the twist is he will have the option to ask for his money back whenever he likes.

You wouldn't borrow money from him because its clearly a worse deal.

(By the way if you don't think its a worse deal then I have some double glazing and PPI insurance to sell you; plus did I mention that I am distantly related to a member of the royal family and there is $40 million in escrow with my name on it, 10% of which is yours if you send me your bank details...)

 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 reason would be 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 having to suddenly repay your loan when interest rates have risen to 4% is the worst possible thing for you. I assume you haven't got the money to repay it. Your wealthy aunt hasn't suddenly died has she? You don't have a spare kidney, or spare first born son you could sell? No? Then you're going to have to borrow the money from someone else. At 4%. Ouch.

[To be pedantic LOBO deals allowed the lender the option to increase the interest rate. The borrower then had the option pay the new interest rate or repay the money. 

If interest rates fall: The lender wouldn't increase the interest rate if it was already high. If rates fall to 2% and the borrower is paying 3% the lender will stick.

If interest rates rise: The lender could increases the rate in line with market levels eg up to 4%, and the borrower decides to continue paying. 

The lender always has the option to increase it to 'silly' levels eg 10%, at which the borrower would have no choice but to repay the loan. To make things simpler I'll treat the loans as if the latter always happens when rates rise; but this is gives a conservative valuation of the lenders option]

There is nothing unethical or unusual about this (but don't worry, the unethical bit is coming....). If like me you have a fixed rate mortgage then you probably have an early repayment charge (ERC) on it. Again this is just the value of the option that I have to repay the mortgage early.

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 middleman

To value the mortgage option or the repayable loan option you just need a bermudan swaption pricer, the relevant volatility surface, some kind of interest rate model calibrated to the appropriate processes and the full forward and spot curve.

You probably don't have this kind of thing at home. I didn't when I took out my mortgage; I didn't really spend time pricing the various rates, upfront fees and ERC against each other; even though I could have done if I could be bothered - 99.9% of people can't do that. That is why a lot of people use mortgage brokers to get the best deal.

(Actually I didn't use a mortgage broker, but it kind of spoils the story if I mention that. And I used a calculator, a pencil and the back of the nearest envelope to do the calculations.)

Who should pay the mortgage brokerAround this question the UK regulator changed the entire way the financial system not so long ago. It is generally a good idea to align incentives. So when you sell a house you pay an estate agent to get the best price for you. Suppose that when you sold a house the estate agent rather than taking a commission from you, instead took one from the buyer. There would be a strong incentive for a dishonest agent to take the cheapest offer for the house, if its was coupled with a fatter commission for them personally.

(Okay this can still happen. Its not unusual apparently for estate agents to be offered bribes by desperate or unscrupulous buyers when the housing market is particularly hot. But we shouldn't make it easier for people to behave badly, should we?)

In the UK financial consumer world until relatively recently the incentives were distorted. Customers didn't want to pay large up front fees for financial advice, so instead advisers were paid through commission from the people supplying the financial products. If you don't know what happened as a result you can probably guess by now.

It will be no surprise if I tell you that the LOBO deals were not done directly by Local Authorities with Banks, but via middlemen known collectively as 'money brokers' (a rather old fashioned term, but I like the the Dickensian overtones, don't you?). Interestingly in my opinion the main reason this was being done was to protect the local authorities... although as we shall see it had the opposite effect.

A brief history of local authority mismanagement

Why keep the banks away from Local Authorities? Well there was a landmark legal case in the early 1990's when the borough of Hammersmith and Fulham had got themselves involved with trading interest rate swaps (a kind of interest rate derivative)... to reduce their funding costs (oh the irony!!!). It was decreed that they had exceeded their legal authority in signing these deals so therefore the deals were null and void. Local authorities were not allowed to trade these derivative products.

They were not allowed to trade swaps and certainly not bermudan swaptions, a more 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 its okay to have a cancellable loan (or a cancellable fixed rate mortgage) that embeds a complex derivative but not to trade them directly. Interesting viewpoint, isn't it?

A not so brief history of an example trade

Lets give an example of a trade which may or may not have occurred which the author of this post may or may not have had intimate knowledge of whilst working on a bank trading desk in the early 2000's.

(This is a 'composite' story with elements of things which really happened; oh let's not be coy you can google me - at Barclays Capital; though they were no means the only bank doing this)

First the housing association B asked the broker to get them the best deal on a cancellable loan; say a 40 year loan first cancellable in 2 years and then every subsequent 6 months. There aren't many people who can do this kind of deal because the relevant derivatives market isn't very liquid (because loans over 30 years are quite rare, even to the UK government). They probably rang round 3 or 4 UK based banks and at least one German bank.

The German bank can't do this deal themselves so they called up one of the British banks to get a price for hedging the risk. Interestingly this resulted in a situation when 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. Probably the Germans were given a quote high enough to prevent them from making a competitive offer to the broker.

(Actually come to think of it this is probably bordering on cartel like behaviour but I am 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 sales people). 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 that 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 for himself? It might be harder to make the right decision if the commission was very large...

So for example most products broked bank to bank had commissions of fractions of a basis point, or perhaps one basis point (1 basis point is 1/100 of a percent). Wheras 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 £20 - £50 million dollar deals, so these 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 hard nosed traders on the trading desk were feeling pangs of.... well not guilt perhaps but fear that this kind of thing might one day be written on a blog. But the broker agreed to take half of the commission spread over subsequent deals, so that was okay.

As a point of fact the commission that the traders themselves in the bank would have personally earned on that would have been much lower than the brokers but these deals although not large in the grand scheme of things (billion dollar bond issues are not uncommon, though with much lower % profits) were certainly a good contribution to the desks profits.

(To be pedantic traders don't normally get paid a fixed commission of a deal but a percentage of the profits made by the trading desk over a whole year; the percentage isn't fixed of course and depends on many other factors. So its much harder to pin down exactly what a bank employee would have made from an individual deal like this)


How far does this 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 money that it goes much further than this.


No laws broken?

Of course none of this was illegal. That isn't a formal legal opinion and I may subsequently be proven wrong. But nobody comes out of this smelling particularly well. The money brokers for me are the worst offenders; their behaviour was downright immoral and they personally benefited the most. Its very easy to blame the bankers and they certainly should have behaved differently, but their incentives were to either pay the commissions or lose what was a 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 spoil 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 treasurers to reduce their funding costs by a few fractions of a percent, 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 another story.)

It will be interesting to see how this story develops...

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