LOBO's in pictures

You might follow this blog, or you might have come to it via google after watching the Dispatches programme on channel 4 which was broadcast on 6th July, about Lender Option Borrower Option ("LOBO") loans - loans with embedded derivatives made by banks to local authorities. You might want to read my original post on LOBO's or watch the programme if you haven't done so already (or read the press release).

I'm writing this post:

- To give people a more intuitive, pictorial understanding of why LOBO's are a bad thing
- To reiterate and explain in more detail, again with pictures, why the LOBO market didn't appear to be operating fairly for the local authorities and borrowers within it.

I also want to address the following points which were made in rebuttal by both borrowers and lenders during the broadcast, and in subsequent coverage. I've given each of these a catchy label:

Borrower option smugness: "If the lender raises the interest rate, so what? We've got the option to cancel the loan"
Unfair hindsight moan: "It isn't fair to look at these in hindsight"
Initial rate whinge: "These loans were cheaper than normal fixed rates at the time"
Current rate complaint: "These loans are cheaper than the rates we are paying on the rest of our portfolio"
Future hope: "In the long run they will be a good deal"
Portfolio excuse: "They should be looked at in the context of the local authorities overall borrowing portfolio rather than in isolation"

This will be a deliberately back to basics post so you won't need any technical background to understand it. Some, but not all, of it is a retreading with more pictures of my last post. If you didn't read that you don't need to. If you did  (and followed it) you can probably go pretty quickly through the first few pages until I get to the 'portfolio' arguments which is the new content here.

LOBO's in pretty pictures

Fixed and floating

Let's start with the basics. When you take out a mortgage you have two main options - fixed or floating rate. The same option is available to local authorities, who could borrow from the Public Works Loan Board (PWLB) at eithier a long term fixed rate (up to several decades), or a short term rate of just a year (which is as good as floating for the purposes of this discussion). Which is a good idea? Well, it depends on how things work out. 

This graph shows the average interest rate paid by the authority (LA) on the y axis, and on the x axis the average level of interest rates throughout the life of the loan. Here the LA had two options. They could have taken out a fixed rate loan at 5%, in which case they'd pay 5% for the whole period (red). Or they could have taken out a floating rate loan (blue). 

The line 'par', shows the current level of expectations of what average rates will be.

To repeat: what we're seeing here is the average rate paid by the LA. It might be that on the short term loan the initial rate was 3%; and that at the end they ended up paying 7%. However over the whole life of the loan they paid 5%. 

(technical note: I'm glossing over some stuff here about different discounting interest payments over the life of the loan, and the difference between expected forward rates and the evolution of spot; but these don't affect the main point).

It's important to note here that:

a) when the loan was taken out the expectation was that, given the information available at the time, the LA should have been indifferent between the fixed and the floating rate. 

b) With hindsight one loan would have looked better than the other.

Both the fixed and the floating aren't perhaps ideal. Although the fixed gives you certainty; it can look expensive, particularly as normally the initial floating rates are quite low.

Suppose you take out a 50 year fixed rate loan*, but then after a short period of time interest rates fell. The interest rate is now 3%, but you are stuck with 5%. What can you do? 

* Unlike mortgages LOBO's aren't limited to 25 or perhaps 30 years. Terms of 40,50 or even 70 years weren't uncommon.

You could:

- stick with the loan and hope that interest rates rise again

- ask the lender to 'tear up' the contract and repay the money

If you 'tear up' the contract then you have a problem and the lender has a problem. Your problem is that you will need to borrow from someone else to repay the money (assuming you don't have it down the back of the sofa). But that is fine because you can borrow at 3% - less than before.

Your lenders problem is that when you return their money they will only be able to lend it out at 3%. The lender won't let you do this. Most lenders have something called a 'tear up' clause. You will have to pay them the difference between what they would have earned if you'd kept the loan, and what they will earn at the lower lending rate. Rather than pay this every month, you have to pay a lump sum.

What if interest rates rose? Then there is the opposite problem. The lender would happily pay you to tear the contract up.

If we plot the value of these tear up costs depending on what has happened to interest rates we get this kind of plot

The y-axis shows the tear up cost. If you borrow on a fixed basis (red line) and interest rates fall you have to pay more - a bigger negative number. If rates rise then the lender has to pay you (a bigger positive number).

Note with the floating rate the tear up cost is always zero**. If you borrowed on a floating basis, and rates went down to 2%, because you're already paying 2% the lender can turn around and re-lend your money at the same rate.

* technical note: clearly simplified, removing the effect of convexity to make a straight line

** clearly this is a slight simplification because normally an administrative cost would be charged.

What about the lenders tear up costs? You'd expect them to be the reverse of the above; a flat line for floating rates, and a line sloping downwards for fixed rates.

In fact most lenders hedge their exposure so that they aren't unduly exposed to interest rate changes. The lenders tear up cost will be something like a flat, horizontal, line for both the fixed and the floating loans.* I won't bother plotting this.

* again this is a simplification; and most loans would be hedged as part of a portfolio rather than in isolation. It's my understanding that PWLB loans are hedged / funded with UK gilts on a duration matched basis.

Both fixed and floating clearly have advantages and disadvantages. Good advice for people borrowing money (like LA treasury officials) is to mix both fixed and floating; eg ending up with something like this (y axis is average interest rate):

I'll come back to this option in a moment.

Introducing the LOBO

Now let's move on to the 'lender option, borrower option'. We'll first discuss a basic LOBO, and then talk about the 'inverse floater' structure.

In case you missed the programme or my blog posts, the key point about a LOBO is:

- it's a fixed rate loan, at a slightly lower rate than normal
- the lender has the option to periodically increase the rate
- the borrower has the option to accept the increase or to repay the money (with no 'tear up' cost)

We get the following picture:

(again, technically there is a lot of evil path dependence missing in this simple picture which I come back to below)

The initial rate is 4.5%, which is 0.50% lower than the long term fixed rate.

If interest rates fall below the initial 5% 'par' line, then the lender won't exercise their option. The LOBO behaves like a fixed rate, albeit one a little cheaper than the vanilla loan would be. Fixed rates are lousy when interest rates have fallen. Unless you know with perfect hindsight that rates are going to rise it isn't a good idea to finance yourself entirely with fixed rates, or with LOBO's for that matter.

What if rates rise? (This is where we deal with borrower option smugness). If interest rates rise slightly then the lender will probably exercise their option to increase rates, but not to the current level (the green line is still below the blue line). This is because the LOBO is still more valuable than what they could get if they lent the money out again at the current rate; they want to keep you as a borrower.

As a borrower you'd almost certainly not exercise your option to cancel. If you did so you'd have to refinance the loan at the current level of interest rates, which would definitely mean paying more interest right now (eithier at a new higher fixed rate, or at the prevailing floating rate with no protection against further rate rises).

As interest rates rise the lender will keep exercising their option, and keep increasing rates but keeping them below the current interest rate. If you do decide at some point to exercise your option to repay you would end up having to refinance at the current interest rate - you'd jump from the green to the blue line.

The borrower option isn't some kind of panacea in an enviroment when interest rates are rising. At best you'll end up paying a higher rate than the initial LOBO rate (or what you could have got with a normal fixed rate loan). At worst you'll end up paying a lot more.

The lender option means that a LOBO doesn't give you the certainty of payments that a fixed rate loan does; and the inclusion of the borrower option doesn't change this one iota.

The nasty bit you don't see

This chart actually makes the LOBO look much better than it really is. Suppose over the 50 year loan rates are at 5% in year one, then rise to 7% over the next four years, and then after a year drop down to 4% for the rest of the loan period. The average interest rate paid over the 50 years will be 4.3%. What will you be paying on the LOBO?

When rates rise to 7% the bank will probably increase the LOBO rate to perhaps 6.8%. The borrower  probably wouldn't cancel the loan - they'd think they were still getting a good deal, 0.2% below current rate levels. However when rates drop back down the rate would stay at 6.8% for the rest of the loan period.

The average LOBO rate over the 50 years will be about 6.7%; 2.4% higher than the average interest rate over the entire period.

I'll ignore this quirk of LOBO's for the rest of the post, but it's worth bearing in mind that even with apparently LOBO's look good on the graphs I've shown, there are plenty of situations in which they will be terrible.

The nasty bit you can see

Note that:

- If interest rates fall then with hindsight you would have been much better doing a floating rate. The LOBO is slightly better than a normal fixed rate.
- If interest rates stay about the same - for the entire period of the loan - then with hindsight the LOBO is slightly cheaper than the alternatives.
- If interest rates rise then with hindsight you would have been much better off doing a normal fixed rate. The LOBO is slightly better than a normal floating rate.

LOBO's are sometimes described as 'heads I (the lending bank) win, tails you lose'. This is slightly unfair (but only slightly). Imagine you are tossing a large coin with a fairly thick edge. About one in ten times it lands on its edge. When this happens you (the borrowing local authority) will win. The rest of the time; whether heads or tails,  the I (the lender) will win.

Note also that the 'win' is generally quite small -  at best it is the 0.5% we save if interest rates remain about the same. Whereas the size of the loss can be very large indeed. If rates went to 9% we'd be paying something close to 4.5% more than we would with a fixed rate (if rates went above 9%... ouch...). If rates went to zero we'd be paying 4.5% more than we would have with a floating rate.

This kind of 'bet' is very dangerous. It has many technical names:

- short gamma
- short volatility
- negative skew
- downright dangerous

The key thing is this the worst kind of bet or trade; one with limited prospects for gains and virtually unlimited downside. It is the kind of trade that smart hedge fund managers and traders lose sleep over and avoid at all costs (Notice that the investment bank traders are on the other side of this deal...). This is the bet that a local authority is putting on when it does a LOBO.

Those huge tear up costs

Let's now think about the tear up value of a LOBO. An important point to note is that the day after the trade is done, if interest rates haven't moved, then:

- The tear up value of a PWLB floating loan will be zero *
- The tear up value of a PWLB fixed loan will be zero (or to be precise, very close to it) *
- The tear up value of a LOBO will be negative; and equal to the banks profit on the deal. Research done by http://debtresistance.uk/ and analysis by http://www.vedantahedging.com/ shows that on say a £20 million pound deal profits of £1 million were common.

* This was true when the majority of LOBO's were taken out. It's my understanding that subsequent to that however the PWLB has also introduced a spread on new loans which means tear up costs are much higher on day one. I've also been told that these have been applied retrospectively. Finally the margin on PWLB loans over the rate that central government can borrow at has risen from 0.18% to 1%. All this makes the PWLB loans look bad. All this amounts to in effect a hidden cut to local authority funding from central government. It doesn't however make the LOBO loans look any better given the information that was available when they were made.


I like to call this latter effect the 'headwind'. A LOBO deal is always fighting against the headwind of the large up front profit that has to be paid out of the deal.

What about the tear up value if interest rates move? I won't show you a picture, since it would be a complex one depending on the length of time that has passed (tear up loans on all kinds of loans reduce as we get closer to the maturity date). However we can say:

- if interest rates are low then the tear up value will be significantly negative for the borrower; usually, although not always, worse than the tear up on a fixed rate loan.
- if interest rates are about the same the tear up value would be negative; initially equal to the 'head wind' day one profit margin.
- if interest rates have gone up then the tear up value will be negative but gradually getting a little smaller as rates rise.

An important point here is that the tear up value is never positive (for the borrower). If at some point the tear up value was positive, and the deal was in the borrowers favor, then the bank would cancel it (by raising interest rates so much the borrower would be forced to repay the money). Since the bank effectively always has this option to cancel it for free the tear up value can't logically ever be positive.

What about the tear up value for the lender? Well as before they have probably hedged the exposure. But whereas before the hedged lender had a fixed zero tear up cost; this time they will have a fixed positive tear up cost - equal to the initial profit they booked on the deal. And to reiterate, these are pretty decent profits.

Rebutting the rebutters

We're now in a position to address some more of the rebuttals at the top of the post:

Unfair hindsight moan: "It isn't fair to look at these in hindsight" 

Perhaps. With perfect hindsight you wouldn't have done any fixed rate borrowing (LOBO or otherwise) if you knew interest rates would fall. If you knew interest rates were going to rise you would have done a standard fixed rate loan. Note that in neithier case, with the benefit of hindsight, would a LOBO have made sense!

However without the benefit of hindsight a LOBO will:

- on average lose money, because it begins with the 'headwind' of a large tear up cost.
- be slightly better than the alternatives if interest rates didn't change very much
- be terrible if interest rates moved too much

LOBO's are an awful prospect with or without the use of hindsight. They only make sense if you have a crystal ball telling you that interest rates will definitely remain within a certain, narrow, range.

Initial rate whinge: "These loans were cheaper than normal fixed rates at the time"

This is correct - it is after all the magic of LOBO's. However as we've seen that cheapness only comes because the LA is taking on a very horrible risky bet. Also LOBO's are more expensive than if that risky 'bet' could have been bought separately for the correct value - the difference being the banks profit margin.

Current rate complaint: "These loans are cheaper than the rates we are currently paying"

That might be correct. If for example your portfolio consists mainly of fixed rate debt, then as the previous (and next) plot shows the LOBO is slightly cheaper once interest rates have fallen than the other fixed rate debt. However all that means in practice is that you have picked the second worse, rather than the worse horse, in the race. It is no reason to be patting yourself on the back.

Notice how the first and third points are contradictory criticisms. In the first point the LA's and banks are saying it's unfair to compare LOBO's and floating rate loan rates, as they couldn't have known interest rates would fall so much. In the last point they're saying it's fair to compare them with their current fixed rates... given that interest rates have fallen so much.

The most charitable thing I can say about LOBO's they are at best slightly better than the absolute worst alternative in a given interest rate scenario.

Future rate hope: "In the long run they definitely will be a good deal"

Again this might be correct; if interest rates return to the happy medium point when LOBO's are slightly better than the alternatives. If rates remain low, then they won't be a good deal. If rates rise too much and end up above the happy medium, then again they won't be a good deal. Worse still if rates rise at any point in the next 40, 50.... 70 years; even if they then fall back again, they will be a terrible deal.

Essentially the local authority is saying 'yes we've put a large dangerous bet on, and our horse is currently in second to last place, but we're confident that it will win'. 

I've never seen convincing evidence that anyone, never mind local authority treasurers, can predict interest rates with such accuracy; particularly over the 40 to 70 year terms that LOBO's cover. Seventy years ago it was 1945. Who then could have predicted that (bank base) rates would go from 2%, to 17% in the late 1970's, then back down to 0.5%?! Yet without that ability to predict interest rates there is no way you'd want to take out a LOBO.

(Some background: I worked as a trader of exotic interest rate derivatives for an investment bank. The models used to price the derivative options within LOBO's assumed that interest rate movements are random.

I subsequently managed a multi billion dollar portfolio of interest rate related assets for a hedge fund. We tried to predict what would happen to the prices of those assets using a large and fairly complex system of forecasting models, for just a few weeks ahead. In a good year we'd get just over half of those predictions right. This was considered a very good performance.)

Some of you may know this quote:

"I am one of the largest investors in America. I know these things."

Robert Citron, treasurer of Orange Country California on making a prediction that interest rates wouldn't rise. A few months later Orange County was bankrupt after losing $1.6 billion on interest rate derivatives)

What should the banks have done?

If I was in the local authorities position, without the benefit of hindsight, then what would I have done?

Well I wouldn't have bought a LOBO:(a) because of the 'headwind', and (b) because of the potential for large losses versus fairly small gains. 

I don't think I can predict interest rates; and I certainly wouldn't have been confident making a forecast that they would remain within the narrow band required to make LOBO's the best deal (and I'm amazed that the 'experts' consulted by local authorities thought they could - of which more below).

Ironically LA's would have been better off if they'd been allowed to buy derivatives outright (had they not been sold with excessive profit margins) rather than hidden inside LOBO's. That would have allowed the imaginary me to hedge against interest rate changes in a safe way, rather than exposing myself to them in the most dangerous way.

Given I didn't know what's going to happen to interest rates, and because LA's can't use derivatives, then a 50:50 mixed portfolio of fixed and floating rates seems to give the best of both worlds:

Notice that if rates fall this is better than a LOBO (and a normal fixed rate), though not as good as pure floating. If rates rise then it is better than a LOBO (and a normal floating rate), but not as good as pure fixed. Only again in the narrow region where rates stay roughly the same does a LOBO beat a mixed portfolio; and the margin of improvement is fairly small.

If you don't have the benefit of hindsight then a mixed portfolio is better than all fixed, all floating, or a LOBO.

Callable inverse floaters

The above is for 'normal' LOBO's. Here is what happens when you have one of the infamous 'inverse floaters':

Again this is a huge simplification, but accurately illustrates the kind of payoffs involved

Here the borrower is paying 8% MINUS the interest rate. As rates fall they pay more (as has happened). If rates rise then they pay less - except they don't because the lender will 'call' (cancel) the loan, leaving the borrower having to pay a normal floating rate.

Like LOBO's these save money when interest rates are stable; but leave you exposed to rising rates; and when interest rates are low (as now) you have to pay much, much more than the going rate.

Inverse floaters are like turbo charged LOBO's. If rates remain the same they look even better. If rates rise enough they are as bad. If rates fall they look much, much, worse.

I will leave inverse floaters there, and for the rest of the post I'll focus on the slightly less toxic normal LOBO's.

Why LOBO's are still bad even in a portfolio

Let's now return to the portfolio excuse: "They (LOBO's) should be looked at in the context of the local authorities overall borrowing portfolio rather than in isolation"

Okay it's difficult to know what kind of portfolio the local authority has. Let's look at two cases. Firstly, the case when the portfolio was originally full of floating rate debt. The LA then take's half of that and puts it into LOBO's. What do we get?

It's true there is a small improvement here, but only (and this won't come as any surprise) if interest rates stay at roughly the same level. If rates increase, then the improvement diminishes as the LOBO rate gets closer to what we've already got on the rest of our portfolio. If rates fall then we won't see the benefit from them, as we're stuck paying a higher rate on our portfolio.

Contrast this with following my advice above and putting half the portfolio into fixed rate debt, so we end up with the mixed 50:50 option.

If rates fall then we'll be slightly worse off than with the LOBO product. However if rates rise we'll be much less exposed to the rising rate then we would be with eithier 100% floating or LOBO's.

(Note the perfect hindsight option - if you knew for sure that rates would fall - would be to keep all your portfolio in floating rate).

What if the starting portfolio was originally stuffed with fixed rate debt? Again we'll first take 50% of it and borrow in the form of LOBO's instead. We get this:

There is a small improvement here if interest rates fall. However if rates rise we end up paying much more than we would have done originally. This would only make sense if we knew in advance that interest rates would fall. To put it another way it only made sense to add LOBO's to a portfolio in hindsight (!)

Again suppose the LA followed my advice, and instead of putting 50% of their existing fixed rate portfolio into a LOBO, they instead took out a floating rate loan?

This gives us the purple (ish) line above. It's very slightly more expensive if rates rise. However if interest rates fall we get a much bigger fall in funding costs than with the LOBO.

(Note the perfect hindsight option - if you knew for sure that rates would rise - would be to keep all your portfolio in a fixed rate).

The conclusions for those with portfolio's are very similar to those when we look at LOBO's in isolation. In both cases turning the portfolio into a mixture of fixed and floating debt is eithier a little worse, or significantly better, than putting half of the portfolio into LOBO's. Overall, without the benefit of hindsight, the LOBO option once again looks bad because of (a) the headwind effect, and (b) because it generates at best a small improvement in return for being much worse if things move against you - the kind of horrible payoff that traders hate.

So someone with a portfolio containing mainly fixed rate debt can say

Didn't I do well using LOBO's, my funding costs have fallen in this low interest rate enviroment?

Yes, but it would have been much better to have put half your portfolio into simple floating debt.

It's very easy to say that with the benefit of hindsight.

Okay, but if we hadn't known in advance where interest rates are going then (a) on average you'd be worse off (headwind effect), (b) you'd eithier have been slightly better off with rates falling, or a lot worse off if rates had risen. That isn't a very responsible thing to do. You've taken a gamble, and ended up backing the horse that came second last only just ahead of the last horse....

Incentive problems in the LOBO market (I get 'commission', you receive 'extra contractual payments', they get 'backhanders')...

Here, in pictures, is how a LOBO gets arranged; or is supposed to be arranged:

Treasury advisors (featured here with interest rate forecasting crystal ball, owned by all treasury advisors) can be people like Sector (owned by Capita and mentioned in the programme) or Butlers. They provide general advice on funding, but for specialist products like LOBO's they will go to brokers. Brokers include ICAP, Eurobrokers, and so on. Incidentally Butlers is owned by ICAP...

The broker arranges a competitive auction, asking several banks to give them the contract terms for their proposed LOBO, given some parameters. The banks then bid, and the broker chooses the best deal for the borrower.

Here is how the fees flow:

Both treasury advisors and brokers (sometimes directly, or indirectly) get paid for their work. The LA is their customer. They are being paid by, and so should represents the best interests of, the customer.

However:

a) I know from my own experience that banks pay commissions to brokers.

b) We know from the butler report that brokers also pay treasury advisors commissions.

I've added these payments in red below. Notice both the broker and the treasury advisor are being paid twice. Once by the borrower (the LA), and then again by the lender (the bank). In the case of the treasury advisor the lender payment comes indirectly from the broker. This is a clear conflict of interest.

It's clear that the larger the banks profit on the deal (so the worse the deal is for the LA), the larger the commission they can pay the broker. The bank is pushed by the broker to pay a larger commission if the want to get the deal.

The broker here is scratching their head. Should they get the best deal for their ultimate customer the LA, or go for the bank paying them the biggest commission, which is likely to be the worst deal for the LA?

Would the LA even know whether they are getting the best deal or not? It isn't always obvious which of a series of proposed loans; with slightly different interest rates, up front teaser rates and maturities; would be the best.

What about the treasury advisors? Are they going to go to brokers who they trust to run a good auction and get the best deal, or to ones who are going to give them the highest commision? And the ones who give them the highest commission, well aren't they probably the ones getting the highest commission from the bank (which again is likely to be a poorer deal for the LA)? Interestingly in the vast majority of LOBO's the same brokers and treasury advisors were consistently working together (maybe they were just good friends); and there does seem to have been a tendency for certain banks and brokers to work together.

Are the treasury advisors correctly calculating the profits the bank is making on these deals, and telling the LA? Are they choosing to recommend LOBO's over and above simpler options, like mixed portfolios of fixed and floating, because they will get commissions from brokers on LOBO's and not on the simpler deals? Have they explained to the LA clearly what a LOBO is, and how dangerous the embedded derivatives within it are if their interest rate forecasts go wrong?

Are they telling the LA that they are being paid twice, and the brokers are as well?

It isn't just the broker who is scratching his head here. 

I am as well.

Clearing up some LOBO issues

There have been some interesting arguments trotted out against the “LOBOS are a bad thing” thesis, which in the light of the forthcoming documentary, I would like to talk about. If you haven't read my first piece on Lender Option Borrower Option (LOBO's) loans, by banks to local authorities and housing associations, you'll need to first.

Some of these arguments are irrelevant. Others I don't believe to be true.

First I'd like to make a couple of 'so what' points. So these are true, but irrelevant.

(This is quite a technical post. If you're new to LOBO's you might find this post, which also rebuts many of the arguments made in the documentary, more straightforward.)

Yes, true, but so what:

 

1: LOBOS are not derivatives - yes, but so what

Technically they are not. However they certainly sound like them (they have the word 'option' in the name, twice). And from an economic, if not a legal, perspective they contain derivative like payoffs, which can be priced with derivative pricing models.

But, so what? I don't personally have a problem with Local Authorities (LA's) dealing in derivatives, or things that sound like derivatives but actually aren't. After all consumers can buy fixed rate mortgages with the option to repay.

However this only works if the fixed rate mortgage, or LOBO, market is properly competitive. Because the consumer has no way of pricing the interest rate option in the fixed rate mortgage, they need to assume the market is pricing it correctly. See the 3^rd point.

2: Local authorities did not deal with investment bank traders - yes, but so what?

So the fact that a hard nosed investment bank trader wasn't talking directly to a local authority treasurer is considered a good thing. Instead the trader was talking to an investment bank sales guy, who may have been dealing with a corporate bank sales guy, who was probably going through a brokerage house, who might have been contacted via the treasury consultants, who were hired by the LA treasurer.

(Ironically although the trader knew he was dealing with an LA; it's quite possible that the treasurer had no idea that there was an investment bank trader making the deal happen.)

There is a curious myth that intermediation in the financial sector somehow automatically protects people from being ripped off. It doesn't. So most of the people who invested in Madoff for example didn't even know that is what they were doing. They were investing in a pension fund, which invested in a fund of funds, which invested in a feeder fund, which invested in Madoff.

(Intermediation does one thing for sure, which is add costs on. That is why there is such a trend now for 'fintech' companies that mediate directly between consumers. The economies of scale that the established players have seem to be swamped by the costs of multiple levels of mediation.)

The only thing that can protect people is properly competitive markets and/or good advice from people in the mediation chain who are properly representing the interests of the ultimate buyer. See the next point, 3.

A variation of this argument is that this is just normal bank lending, and the investment bank element was limited to an internal hedging function. This is semantics. The deals couldn't have happened without the investment bank desk pricing and hedging the risk on each individual trade.

Much more like an internal hedging function was the mortgage hedging busines I was also involved with, where every month a chunk of mortgage option risk would be hedged internally, and the desk faced the group treasury desk rather than individual mortgage borrowers. 

Again though this should only bother you if you automatically assume something bad is happening when an investment bank, rather than a cuddly retail bank, is involved. Tell that to all the people currently claiming on their PPI.

And now for the myths (things I don't believe are true):

3: Local authorities got proper advice in a competitive and functioning market

There are two arguments against this. The first is to say, if they did get such good advice, why did they still do the trades when the margins were so high? This assumes of course the trades were a bad idea; for which you can look at the next point.

The second point is to look at the mechanics of how the market worked. So local authorities got advice from two main sources. Firstly treasury consultants. Interestingly some LA's didn't use treasury consultants on certain deals and don't seem to have been any worse or better off. I don't know much about the competence or incentive of treasury consultants, but I will note that certain consultants said 'they wouldn't touch LOBO's with a barge pole'. Eithier they, or the other consultants, are wrong.

The second source was the brokers who were supposed to operate a competitive auction. What I found out only recently as that it was quite common for the brokers to be paid by the LA's. What I already knew was that they were also being paid, on the deals I knew about anyway, by the banks (I wonder if the LA's knew this?). And I knew that the banks were under huge pressure to pay commissions to brokers at a certain level to get the deals done. Brokers also paid treasury consultants a proportion of the commission they received from the banks.

The incentives are clearly wrong here. Now it might have been the case that the brokers always gave the LA borrower the best possible deal, regardless of which brokerage fee was being offered. I have no way of knowing. But a situation in which someone is being incentivised by both parties is.... interesting. When selling my house if I knew that the estate agent was getting a 'commission' (to use a polite word for a backhander) from the buyer whilst negotiating the price, I'd be...... interested.

As an ex investment banker I'm biased. I don't think the banks did anything legally wrong, although I personally had serious qualms about the whole business. But someone, somewhere, was giving LA's some seriously bad and/or biased advice; and if that was because they were being paid a commission from the wrong place then they would have been acting illegally.

4 - LOBOS were / are cheaper than borrowing from the Public works loan board (PWLB)

Short answer; yes, otherwise only an idiot would have done the trade but long answer not really if you compare like with like.

I'm afraid this requires a long winded, and slightly technical explanation. Suppose an LA in around 2004, 11 years ago, wanted to borrow £10 million for 25 years.

(Many LOBO's are much longer than this. However the curve is quite flat after this, the equivalent duration of the LOBO deals is similar to this; and it's also a liquid point which the PWLB quotes. The maths for longer deals is even more depressing for borrowers as well.)

From the chart above 25 year swap rates were running at about 5% in the early 2000's about 11 years ago, and the PWLB rate was about 0.25% above that; 5.25%. A very good LOBO rate would have been 4.75% (steeper discounts were available for longer deals).

The LA could have borrowed from the PWLB. They could have done so on a short term or long term basis. The long run deal would have cost around 5.25%.

The difference between the long run PWLB rate and the LOBO rate is that the latter includes the option. What was that option worth? At least the difference between 4.75% and 5.25% (which is worth around 15 x 0.5% = £750K, plus a conservative estimate would be that the bank made a £250K profit on this trade. Call it a round million quid.

(15 is roughly the "duration" on this loan)

Let's also pretend that the PWLB could offer LOBO's. Being a public body they wouldn't have charged the LA's anything (it's just moving money around in the government after all) over and above the 25bp spread they were charging on the loan. They could have offered the LOBO at 0.66% below their normal rate; 4.58%

(0.66% is the effective £1m value of the option turned into a reduced payment on the loan by dividing by 15).

So they could have:

a) borrowed from the PWLB on a short term basis, rolling over the loans

b) borrowed from the PWLB on a long term basis, at 5.25%

c) done a 25 year "PWLBOBO" at 4.58%

d) done a 25 year LOBO at 4.75%

Of course (c) and (d) are a like with like comparision; though (c) isn't really available in reality.

Fast forward to today. How have things turned out?

a) in retrospect was the best option. They would currently be paying about 1.6%, having paid an average of around 3% over the term. They could lock in a 3.45% rate for the rest of the remaining term (around 14 years) at no cost.

b) They are still borrowing at 5.25%. They could ask the PWLB to break the loan. Very roughly this would cost about 10 x (5.25% - 3.45%) = £1.8 million. They could then refinance at 3.45% for the rest of the term.

(10 is roughly the duration on the 14 year term that remains)

c) They are still paying 4.58%. The break up cost on the loan would be 10 x (4.58% - 3.45%) = £1.1 million plus the remaining value of the option. Let's assume the option has lost some of it's value, but is still worth £700K (given the length of the trade, and where forward curves are, this isn't unreasonable). So the break up cost would be the same, around £1.8 million. Again they could then refinance at 3.45%.

d) They are still paying 4.75%. The break up cost on the loan would be 10 x (4.75% - 3.45%) = £1.3 million. The option again is still worth £700K. The break up cost is £2 million. The difference between this and (c), £200K, is what is left of the banks profit margin (some of this they've effectively taken already in earlier years due to charging 4.75% rather than 4.58%).

Okay, so any form of fixed rate financing was a bad move, but we only know that in retrospect. Sensible borrowers use both fixed and floating financing; they do not make bets on interest rates in eithier direction. A 50:50 mixture of (a) and (b) would have a break up fee of £900K right now.

However any implication that doing a LOBO was some kind of genius move is wrong. The genius move would have been doing a floating rate deal.

So “It still is the case that for Leeds that the average rate paid on our LOBO portfolio is below that paid on our PWLB debt.” (http://www.room151.co.uk/treasury/does-lobo-gate-really-exist/) would only be true if they had a portfolio that overwhelmingly contained long term fixed rate debt.

With these slightly contrived numbers the LA is indifferent between the two PWLB loans (b) and (c). The LOBO option (d) is the worst move of all.

Okay, you can argue that my numbers could be a bit different, with say a lower option value of £400K (which is unlikely, but I'll let you have that for a moment); and the message would change:

a) Still has a break up cost of zero.

b) £1.8 million

c) £1.1 million + £400K = £1.5m

d) £1.3 million + £400K = £1.7m

Now the LOBO (d) is slightly better than (b), though not (c) or (a).

It depends on your term of reference. In retrospect the best deal was still (a), then (c) [which unfortunately was never offered] and then (d). However all this means is that the council has taken a gamble which happens to have paid off.

This would have only made sense if they could have predicted the future. But if they could do that, they would have gone with (a). I'll explore this more below in the next point.

However at the time of the initial trade (a), (b) and (c) had equal expected value; whereas (d) was £250K worse. So without predicting the future you would never have gone for (d).

To labour the point, how do you judge your treasurer? Do you look at their ability to predict the future, and look at how things have turned out? Then doing a LOBO was at best slightly better than two terrible alternative options for long term borrowing. Or do you look at what they did at the time and look at their performance with the information that was available then? Then the PWLB long or short rates were both equivalent, and the LOBO deal was definitely worse.

By the way all this analysis assumes a fairly conservative profit on the initial deal. Most of the research I have seen indicates profits were much larger than this. Also deals were generally much longer than this (again usually meaning larger profits); meaning options would hardly have fallen in value, never mind by 60%. In the vast majority of real cases the break up fee on the LOBO will be greater than on the long run PWLB loan.

This brings us on to the related point...

5: LOBOS were / have been a great deal for local authorities

Imagine a council finance committee meeting that probably never happened.

The treasurer (who understands LOBOs in great detail) has explained clearly that a LOBO consists of several things which economically add up to the LOBO as:

- a loan at PWLB rates fixed for a certain number of years (say 5.25% as above)

- an agreement by the bank to reduce the loan rate (by say 0.5% as above)

- a 'not a derivative' options contract where the bank has the right to raise rates, and effectively cancel the loan, in the future

The treasurer is then told by his councillors that they were seriously worried about the 3^rd component of the LOBO's. Effectively the council has taken on an uninsured risk (that the deals would be broken early, if interest rates rose enough) which is just as dangerous as not insuring their council buildings for fire risk. They ask the treasurer to find someone who would insure them, and pay an insurance payment annually to cover against this risk.

Of course the treasurer doesn't take on the insurance, because it's cost would have been too high*. It needs to be to cover the second component, and to make the bank's their profits (of which more in a second), and pay all the commissions due to the intermediaries. As we've seen the insurance payment plus the LOBO would have been more expensive than borrowing from the PWLB; the difference being the banks profit. If we use the numbers above the insurance contract would have cost about £1 million upfront, or 0.66% a year. The whole deal would have been costing 5.41%; more than the PWLB rate.

(* also ironically, this probably would have been viewed legally as a derivatives contract which the LA wouldn't have been allowed to do...)

Instead the treasurer crosses their fingers and hopes nothing bad happens. Let's now fast forward a few years.

The treasurer comes back to the committee, and tells them what a genius he is. Yes they have lost money by borrowing at a high fixed rate when interest rates were high, and they have since fallen (as we discussed above). However on the plus side they have saved some money by not paying the insurance premiums.

Now it might be that all councils are okay with this way of making money. If we take this argument to it's logical conclusion they probably shouldn't bother paying any kind of insurance; after all insurance companies make a profit on it, so in the extremely long run it would be the optimal thing to do. 

They should also boost their income by writing unhedged options contracts; which in the long run is a money making strategy, since (technical note) implied vol is normally above realised vol. Oh no, forgot, they aren't allowed to do that – it's a derivatives trade (they can only do it when it's inside a LOBO deal, at which point it is no longer a derivative). They probably aren't allowed to cancel all their insurance policies eithier. 

In reality this treasurer would have been sacked. They've done two things wrong. They've got their forecast on interest rates completely wrong. And they've taken on a potential risk which they should have insured against and didn't.

However let's suppose I'm utterly wrong. If LOBO's really have been so wonderful for local authorities then they must also logically have been dud trades for banks. This isn't the case eithier, and I'll explain that next.

6 -Banks have lost money on LOBOS

There are several ways to think about this.

The first is extremely simple. If banks currently have stacks of unprofitable LOBO loans on their books, then why aren't council treasurers besieged by calls from banks asking them if they would mind tearing up the trade, and the bank will even pay them. 

Are they receiving 'we are exercising our option to cancel these ' letters? (which under the terms of the deal, they can send at regular intervals). When council treasurers go to banks and ask what the tear up fees will be on these deals, do the banks say 'No, no, we'll pay you. Just get this stuff of our balance sheet'. Is any of this happening?

Of course not. Even in the most optimistic case in the example above the tear up cost for the deal isn't going to be zero. The banks would be nuts to tear them up for nothing,  or exercise their options, or pay the borrowers to walk away, when they would collect 1.7 to 2 million quid if the loan was cancelled at market value.

The second is slightly more complicated. It is perfectly possible that the LOBO deal will be showing a loss on the bank's balance sheet, even if it's not got a zero value, if the value has gone down. However these trades were hedged (to be technical, both delta and vega hedged).

Remember from above a LOBO is:

A- a fixed rate loan at the PWLB rate, which was the correct rate for the banks credit risk

B – an annuity (which we can ignore since it effectively just makes the fixed rate loan lower)

C- an option that isn't a derivative.

The hedge is:

X- an interest rate swap (receiving fixed)

Y- a sale of an interest rate option

X hedges A+B; and Y hedges C. The difference between the value of A+B+C and X+Y is the banks profit Z. As we've established Z is a pretty decent size.

Now when interest rates fall (as they have done, refer back to picture above) the value of A increases, whilst the value of B falls (for two reasons, because the option is less likely to be exercised, and also it loses some 'theta' – time value). Now it's extremely unlikely that the first effect is smaller than the second, at least at this point in the trade, but let's just assume that it is, and the bank really has lost money on the trade.

But against that the value of X increases whereas the value of Y also falls. The effect of this pretty much offsets the change in the value of A and B. So Z remains roughly the same. The bank hasn't lost money at all.

The third is even more complex. I've been told that banks have had to increase the discount rate on these loans, and the capital requirements. This has made the loans lose value. However: 

a) There are many types of trade that this has happened to; US 100% NINJA mortgages for example, that have now become impaired due to borrowers not being able to pay and house prices falling in value. Does this change that mean that the original deal wasn't seriously disadvantageous to the borrower at the time? 

(b) I will believe it when I see it. It's not like the fall in value on the bank's balance sheet has been passed on to the borrowers as a windfall profit for them. And it won't be unless the borrower really can get the trades torn up at the new mark and somehow crystallise this additional value. And again; I haven't heard about that happening.

Summary

Ultimately what is going on here is that someone has sold something (the option to cancel the loan) at a price which apparently makes both the LA and the bank happy. For this to work the option must be less valuable to the council than to the bank. But the value of something is the same no matter who owns it (we're not talking about modern art here). So more accurately we should say eithier unkindly that the council doesn't understand the value of the option; or that the council knows the value of the option to be lower.

This would only make sense if they were able to perfectly forecast interest rates; something the bank didn't feel it could do. 

And even then... let's go back to the imaginary meeting I talked about earlier.

“No we don't need this insurance. Because I know for a fact that interest rates are going to fall“

“So...” replies the switched on councillor “Why don't we just borrow at a 1 year and keep refinancing rather than doing this 50 year fixed rate?”

Good question.

Channel 4 to cover LOBO's scandal

Channel 4 reported on LOBOgate on Monday 7th July evening, in a program aptly titled "How Councils Blow Your Millions" (Dispatches, 8pm).

Read my posts on the subject here: http://qoppac.blogspot.co.uk/search/label/LOBO.

For more information on the program see here.

If you missed it, it's now available on demand here. (until early August 2015)

Here's a piece in the Observer from the day before:

Subsequent to the programme the UK parliament department of communities and local government held an initial enquiry session on the 20th July 2015, to which I was invited as a witness.

You can watch the full session here.

Inside housing did an article on the session here.

More publicity for LOBO scandal

Nice to see this blog quoted in private eye.

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 broker?  Around 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...