LOBO loans and other derivative products connect local authorities with global finance and indicate a new management of municipal debt
Despite common perceptions of municipal finance being a boring and technical issue, local council borrowing practices in the UK (and elsewhere) have been transformed to bring town halls much closer to global financial market dynamics. Here, as in many other cases, the technical is political. Thus, political economy scholars, and, indeed, citizens, should care about how local authorities manage their (and therefore our) finances. Recently, this issue has become politicised due to a campaign by Debt Resistance UK and respective media coverage including a widely discussed Channel 4 Dispatches programme. This also triggered debates within the local government finance community at workshops, within professional periodicals such as Room 151, and in political communications by, and discussions within, councils.
Traditionally, UK councils that have sought loans have borrowed almost exclusively from the Public Works Loan Board (PWLB), an agency set up for this purpose by HM Treasury. The PWLB offered long-term loans on fixed interest rates that used to be under the market level. Moreover, the process of taking on a PWLB loan is straightforward and does not entail much more than one phone call. Together with the relatively strict regulation brought in after the Hammersmith and Fulham derivatives fiasco in the late 1980s, this public system of loan provision, for quite some time, disincentivised the entry of British or foreign banks to this market segment.
However, since the early 2000s, this started to change. Councils became much more interested in alternatives or supplements to PWLB lending while, at the same time, banks, treasury management advisory firms, and civil servants in local governments and within associations such as the LGA and CIPFA were discussing, developing, and, in some cases, promoting new loan products for town halls. In this context, so-called ‘LOBO loans’ emerged, a new type of loan that was embraced by many councils. The acronym, lender option (LO) borrower option (BO), already indicates that these are loan contracts with very particular characteristics, making them more complex and risky than their PWLB counterparts. Increasing PWLB rates, an uncertainty about the future of PWLB lending, and a general push towards the markets (originating both from within councils and central government) combined with the widespread financial market euphoria seem to have driven the transformation of council borrowing over the last 15 years. Simultaneously, financial innovation and competitive pressures in the liberalized banking sector as well as new business models of financial management consultancies also enabled the rise of LOBOs.
LOBOs are usually ultra-long-term (40–70 years) and often have a relatively small volume. The basic logic of such a loan is that the interest rate is fixed only for an initial period. Usually, this initial rate would be lower than the respective PWLB rate (a ‘teaser rate’), making LOBOs look quite attractive for council officials and politicians. However, the rate can be adjusted by the bank at predetermined dates (‘lender option dates’). If the bank wishes to exercise their lender option – which gives them the option to raise or lower the interest rate – they have to inform the council about the new rate (usually on rather short notice). In this case, the council can either accept the new conditions or repay the outstanding liabilities at once (the ‘borrower option’). The number of ‘lender option dates’ before the maturity date of a LOBO varies across contracts, with two in a year being quite common while some LOBOs only have one lender option date every five years. Apart from exercising their borrower option, councils can only get out of the loan arrangement by paying a penalty fare or as a result of renegotiations (that, indeed, recently have been conducted between Barclays and several local authorities). Regardless of the actual (and often low) volume of the loan and value of the option, LOBOs are attractive to banks as a potential gateway towards a longer term borrowing relationship with local authorities.
The rationale for the bank in adjusting the LOBO rate seems to be a) to generate extra profits and b) not to lose the LOBO through councils exercising their borrower options as a result of excessive increases. Due to the imbalance of financial market expertise between banks and councils, the bank tends to be in a much stronger position. Moreover, as a result of the high concentration in the market with just a handful of banks providing the vast majority of non-PWLB loans, banks might also know which dates are most unfavorable for councils to refinance a LOBO. However, the actual experience of many LOBOs shows that in an environment of shrinking market rates, lender options are rarely exercised. Still, there is a secondary circuit on top of the original deal since the bank usually sells or hedges their options. Also, there are more complex products than the simple ‘plain vanilla’ LOBO. So-called ‘range’ LOBOs and inverse floaters determine their interest rates as a function of the LIBOR rate (or another index). Those were the loans that caused the most trouble during and after the financial crisis when rates became more volatile, causing extra costs for some councils. In the London Borough of Newham, arguably the most prominent case and the council which has been most enthusiastic about LOBOs, this increased financial pressures on the council and led them to make spending cuts and to a council tax rise. Recently, however, Newham’s LOBO loans with Barclays have been restructured.
According to estimates, some 250 UK local councils currently have LOBO loans on their books which account for approximately £11bn of municipal debt (excluding housing associations). LOBOs proliferated heavily between 2004 and 2007 (with the remarkable exception of RBS selling inverse floaters loans extensively in 2010 and 2011), but have almost vanished in recent years due to falling PWLB rates, a new prudential framework, and decreasing borrowing requirements (a paradox result of austerity at the national level). The LOBO share of the overall debt portfolio varies considerably among councils with PWLB loans remaining by far the most important type of borrowing. Newham and Manchester city council stand out as the LOBO share of their overall municipal borrowing is in excess of 90 per cent. Contrary to Newham, however, Manchester has not experienced exploding borrowing costs (compared to the PWLB rates available at the respective times of taking on their LOBOs).
Irrespectively of their actual performance, LOBOs, as a type of embedded derivative, introduce new complexities and rationalities to local authority finances. They are in line with a new entrepreneurial spirit spreading across public administrations, changing the way practitioners perceive debt, and creating new social relations between local authorities, banks, advisors, brokers, regulators, and professional associations. Indeed, these complex interactions also facilitated the spread of LOBOs.
As for the banks, Barclays, RBS, and European banks like Dexia, Deutsche Bank and Depfa have played a significant role in the UK LOBO market. The engineering and calculating of the loan product usually takes place within the investment branch of big banks. Once a LOBO is on the market and sells well, the product proliferates quickly to other banks via various channels. Even more interesting are the intermediaries between banks and town halls. Financial management is often outsourced by councils and performed by a few consultancy firms who contribute to the spread and standardization of new products and practices. Before the 2007-08 financial crisis, among others, Capita, Butlers, and Tullet Prebon were highly engaged in promoting LOBOs. In recent years, the market has consolidated and, today, generally only consists of two providers, Capita Asset Treasury Solutions and Arlingclose, the latter being opposed to LOBOs. This high concentration is quite unusual for financial consultancy markets. The brokers, another type of intermediary in between advisory firms and the banks, are the only ones in this complex relationship who have all the available information on both demand and supply of council loans which puts them in a strong position.
It is important to note that this is not primarily a story of fraud or corruption, in particular because LOBOs do not automatically lead to losses for councils. Rather we can observe a more systematic development of the financialisation of local government which includes changing financial practices and perceptions of debt, the extraction of fees, outsourcing core functions of local financial management, and the prevalence of a new risk appetite. This trend, however, is by no means confined to the UK. In the context of so-called ‘active debt management’ policies, local authorities across Europe have engaged in a broad variety of interest rate derivatives including complex and risky swaps. As such, municipal budgets and local politics in general have become much more connected with the rules, performances, and rationalities of global financial markets. In many cases, the use of derivatives has led to huge losses for local authorities and prompted public contestation and new regulations.
Paradoxically, council borrowing seems to be less financialized in the UK than in many countries on the continent due to the rather constrained fiscal authority of UK councils and the high degree of centralization. Clearly, this shows how the dynamics of financialisation are much more differentiated and dependent on institutional settings than they are often conceived. Exploring the ‘next door’ impacts of rather abstract trends like financialisation, financial innovation, and financial globalization is a worthwhile endeavor. It sheds new light on global-local interactions and pushes the ‘everyday life of finance’ perspective a bit further towards municipal governments that, indeed, are highly interesting but often overlooked actors. Although LOBOs have largely disappeared in recent years from the UK´s local authority finance picture (in terms of new loans being taken out), the new logic of actively managing public debt remains a vastly unquestioned paradigm. Together with a new loosening of regulations in recent years and the unknown implications of devolution, this might lead to a return of “innovative” financial products (including derivatives) to UK town halls. Indeed, there is little to suggest that LOBOs will be just a one-off episode.