The wolves at the door

Tight budgets call for imaginative use of money, but the LOBO loan scandal shows why playing the financial markets is a dangerous game for councils.

City 23rd October, 2016

Lorna Stephenson

Tight budgets call for imaginative use of money, but the LOBO loan scandal shows why playing the financial markets is a dangerous game for councils.

Word: Lorna Stephenson
Illustrator: Mish Scott

“Unreasonable and irrational” were words used by Bristol resident Benedict Walmsley in a recent objection to Bristol council’s accounts. Every year, councils across the country open their books for a two-week period to allow for public inspection. As a constituent you can, if you feel it necessary, lodge a formal objection.

Walmsley was one of 24 UK residents who this summer used an accounts objection to protest their council’s use of a particular type of borrowing from private banks: LOBO (‘lender option, borrower option’) loans. These exotic products, for amounts up to £25 million, were signed for mostly between the mid-2000s and the early 2010s, with repayment periods spanning up to 70 years.

They’re controversial: last year researchers uncovered evidence that LOBOs had stung certain authorities with inflated interest rates, triggered by the contracts’ most risky and pernicious elements, which councils had failed to foresee. They also illuminated potential conflicts of interest in the chain of middlemen between banks and councils.

Nationwide, the scale of LOBOs’ use is huge. Research conducted by campaign group Debt Resistance UK and Channel 4 found the loans amounted to about £15 billion of public sector borrowing. The deals were estimated to have generated up to £1.5 billion in upfront profits for the banks – an enormous 10% margin.

Bristol council holds £123 million in private-sector loans, which make up just under 30% of its total long-term borrowing. The rest is from the state, via the PWLB (Public Works Loans Board). Intermittently between 2005 and 2010 it took out eight LOBOs, ranging from £10m to £25m, from banks Barclays, RBS, Dexia and Eurohypo. As it stares into its current financial abyss, the council will be seeking more borrowing over the coming years – from exactly where is unknown. It’s a good time to reflect on where and how the council borrows money on the taxpayer’s behalf.

Risk exposure

Recent history is littered with examples of banks mis-selling risky financial products to public bodies in attempts to undercut state lending institutions, only for borrowers to realise the risks too late. Local authorities in Italy, Germany, Belgium and France have seen the effects of misunderstood derivatives contracts sending them toward financial ruin in recent years. So for that matter has the UK – think of the Iceland debacle of 2008, when the country’s banks crashed, losing £798.95m of UK local authority deposits.

In terms of LOBOs, Debt Resistance UK harvested information through Freedom of Information requests from over 250 local authorities. The picture built up was one of mixed, sometimes alarming consequences.

Although the 2008 financial crisis caught almost everyone by surprise, the crash had a dramatic impact on LOBO borrowing. The contracts varied; with more straightforward varieties such as – luckily – Bristol’s, borrowers remained beholden to the banks through high breakage fees (money the council would have to pay to exit the deal) but didn’t face other immediate adverse effects.

Others were less fortunate. They’d been sold LOBOs containing embedded, high-risk financial derivatives and swaps, which were sensitive to financial markets and interest-rate changes. Before the crash, the global economy was expected to keep growing – and for these councils’ loan terms to stay favourable, it had to. Instead it veered into a ditch, and interest rates plummeted and stayed down. Rather than helping reduce repayment costs, councils such as Newham, which took out £150 million in risky LOBOs, found the changes in the financial climate caused their contracts’ low interest rates to balloon as high as 7.6%. LOBOs became millstones they couldn’t escape, because of the sky-high breakage fees written into the contracts.

Conflicts of interest

How did local authorities get sold loans so risky as to have “hedge fund managers waking in the night screaming” (the words of Rob Carver, a former Barclays LOBO trader turned whistleblower who appeared at a Communities and Local Government Committee discussing the loans in 2015)? LOBOs’ natures were so hard for non-bankers to grasp that a financial expert at the same committee resorted to describing their features as banking ‘jiggery pokery’ to bamboozled MPs (so, reader, don’t worry…).

Unable to confidently negotiate alone, local authorities rely on the independent advice of ‘treasury management advisors’ (TMAs). Councils, via TMAs, do not normally deal directly with banks but with middlemen – brokers – such as outsourcing firm Capita. Councils rely on these go-betweens to navigate the terrain – and they should be keeping councils safe from investing in products they don’t understand.

Debt Resistance UK’s investigations last year exposed something even more troubling about the banks’ dealings. Treasury management advisors were taking fees from both of their clients; the local authorities and the banks’ brokers, presenting a conflict of interest. The brokers were also charging high fees for their services from councils, racking up up to £75,000 in some cases. The fee for brokering a government loan, in contrast, is £75.

‘Sophisticated investors’

If this sounds like local authorities going maverick and getting fleeced, the government’s attitude to the use of private-sector banks has not been to urge caution but the opposite. The sector is not regulated: in 2015 the Local Government Audit Commission closed, and the Financial Conduct Authority considers local authorities to be ‘sophisticated investors’ able to competently negotiate complex financial arrangements. Likewise the Localism Act of 2011 under Eric Pickles gave more financial freedom to councils than ever before.

Last year, when Newham’s problems were exposed along with the scale of LOBO use by Debt Resistance, there was a period of media scrutiny including an episode of Channel 4’s Dispatches titled ‘How councils blow your millions’. It prompted the Local Government Committee’s inquiry into LOBOs.

The boat rocked, but nothing actually changed. Huge outsourcing firms like Capita maintained their firm grip on the lucrative playing field between the public and private sectors. The scandal prompted the second call to the Financial Conduct Authority to conduct an inquiry into brokers and treasury advisors to local authorities – the last time was in the aftermath of the Icelandic bank crash – but these calls were ignored.

Borrowing and the public interest

Many councils, including Bristol, survived the LOBO storm with little financial damage. The LOBOs they took out remain at interest rates similar to what PWLB loans taken out in the same period would have charged. Bristol, along with other local authorities that received accounts objections, has been advised to take legal advice around whether its LOBOs were taken out correctly, and to put a note in its accounts to that effect. Like other councils, it still has LOBOs listed as an approved borrowing option – although it is highly unlikely that any would be signed in the current low-interest climate.

But the issue is still live: not only for councils such as Newham now saddled with inflated interest rates, but for councillors and campaigners who want to see more robust regulation to prevent such mis-selling occurring again.

“We’d like the Treasury Select Committee to look into this. We’d also like some of the more problematic loans to be referred to the High Court,” says Debt Resistance UK’s Joel Benjamin, pointing to the 1989 Hammersmith ruling (see box). “We think there’s some legal avenue or some sort of government regulatory intervention possible whereby some of the worst value loans are declared illegal, and potentially the breakage costs could be removed or reduced under pressure from regulators or local authorities.” He also points to the possibility of TMAs and/or brokers being taken to court and some costs to councils being recouped. “There are various avenues that could result in a good outcome for local residents.”

In an open letter dated May 2016, a collection of MPs, councillors (including Bristol Green Stephen Clarke) and civil society organisations demanded a thorough inquiry – the third call in eight years – into LOBOs and the use of brokers and TMAs. The letter warns that, in the climate of severe local authority budget cuts and greater financial powers granted locally through the devolution agenda, “it has never been more important to stamp out market abuse along the financial advisory chain to town halls”.