Derivatives demolition: how UK local government was hoodwinked by the banks

Derivatives demolition: how UK local government was hoodwinked by the banks

Posted on July 18, 2015 by Joel Benjamin — 1 Comment ↓

In his 2006 book Traders, Guns and Money the former banker and corporate treasurer Satyajit Das explains the central role that complex derivatives and financial products played in the global financial crisis. Over 340+ pages the author provides a dizzying introduction to the world of financial alchemy, illustrating how ‘these arcane instruments can be used as mechanisms for mitigating risk but have, over the last two decades, become creators of risk.’

The exacerbating effect of derivatives on the global crash was plain for all to see: through the collapse of major banks and insurance companies; and through the huge taxpayer funded bailouts that were used to fill the holes left behind by exploding derivatives like CDOs and CDSs. The fallout continues to this day as governments throughout the world prioritise repairing bank balance sheets over stimulating the real economy and use high public debt as an excuse to implement draconian austerity policies.

Unfortunately it wasn’t just banks, hedge funds and other financial services companies loading up on complex derivatives in the run up to 2007-08. It has recently come to light that derivatives are endemic in the public sector too. The use by UK local authorities of complex financial products (in the form of LOBO loans) expanded dramatically between 2003 and 2008 and has left many Councils facing higher interest costs and significantly greater financial risk than they would if they’d borrowed from central government.

But how have Councils fallen into the trap of becoming embroiled in complex derivatives? And is it even legal for public bodies to enter into these kinds of deals? After all, this is public money they’re playing with. To answer both these questions it is first necessary to understand how derivatives work.

Derivatives are bets

The simplest way to think of a derivative is as a bet on the outcome of some future event. You could think of any financial investment as a bet – to buy shares in say, RBS, is to gamble on the fact that the price of RBS shares will go up – but derivatives fit this description better since they, like bets placed with a bookmaker, always need someone on the other end.

One of the easiest derivatives to explain is an option. An option contract, as the name implies, gives one party the option to either buy (a call option) or sell (a put option) a particular asset at some specified price at some specified time in the future. If they exercise their option then the person on the other end of the contract is bound to enter into the transaction.

Imagine you’re an airline and you’re worried about the price of oil going up. You might enter into a contract which gives you the option to buy a certain amount of oil at a particular price (perhaps today’s price) six months from now. If six months from now the price of oil has gone up you’d exercise your option, buy at the cheaper price, and enjoy your savings (minus however much the option cost you). If the price has fallen then you’d leave your option alone and buy at the new low price, again enjoying the savings (again, minus the cost of the option contract).

In essence then, if the oil price went up (by more than the cost of the option) then you’d make money, if it fell then you’d lose money (the cost of the option). You’ve effectively placed a bet that the oil price will be higher in six months time.

There are many different varieties of derivative and they can be combined in various ways to make all kinds of complicated bets. A large modern airline would in fact have modelled countless scenarios about what will happen to oil prices and placed lots of different bets according to how likely they think each scenario is.

But an airline is a private corporation. Its objective is to make a profit. There is an implicit understanding between the management and the shareholders that such activity is taking place and the management are held accountable if it all blows up in their faces.

Public institutions are an altogether different beast. When citizens pay their taxes they expect to receive services in return, they do not do so with the implicit understanding that government will be gambling with their money in search of profits. Yet that is exactly what UK Councils have done in the past, most remarkably in the case of Hammersmith and Fulham.

Hammersmith and Fulham’s swap fiasco

Duncan Campbell-Smith tells of how the London Borough of Hammersmith and Fulham entered into hundreds of derivative contracts in the late 1980s in his book Follow the Money.

The vast majority of these deals were interest rate swaps, effectively bets against interest rates rising. The council’s finance officers were effectively trying to use the treasury as a profit centre. By April 1989 the council was party to contracts with a total notional value of over £6 billion and, because interest rates nearly doubled at around the same time, they were facing losses of over £300 million.

Luckily for Hammersmith and Fulham the Audit Commission (the public body with responsibility for appointing local authority auditors, dissolved in March this year) backed a challenge to the legal power of UK councils to enter into such deals. A subsequent House of Lords ruling in 1991 removed all ambiguity: interest rate swaps, used for whatever reason, were ultra vires for local authorities. The swap contracts were unwound, Hammersmith and Fulham didn’t go bust, and UK local authorities were, for a while at least, safe from the machinations of bankers brandishing exotic financial products.

The rulings in the Hammersmith and Fulham case were based on the Local Government Act 1972. Unfortunately it seems that further Local Government Acts introduced by parliament since 1989 have repealed the sections of the 1972 Act on which the legal judgements rested and so the present legality of local authorities entering into derivatives contracts is unclear.

‘Financially sophisticated’ or amateur gamblers?

Traders, Guns and Money opens with a brilliant scene in which Das recollects his experience of acting as expert witness in a lawsuit between an Indonesian noodle manufacturer and a large investment bank.

The noodle makers are suing the investment bank over a series of swaps contracts that went badly for them. The President Director and Chief Financial Officer of the noodle company clearly never understood the nature of the derivatives contracts they were signing (‘Bank advise us. They tell us no risk.’) The strategy devised by their legal team aims to convince the court that the bank fraudulently misrepresented the nature of the deals to the company’s officers who were ‘financially unsophisticated’.

In the end the bank and the noodle company end up settling out of court, but in the meantime Das provides a revealing insight into how the bankers got the noodle company on the hook for huge losses in the first place. He recalls how, when he was a trader, his mentor told him how to land big clients:

‘“Give the guy a win first up. A nibble. He’ll be hooked. Then, you reel him, real slow. That’s how you land the big ones.”

‘The essence of the advice was remarkably accurate. The clients I dealt with fell for the trick every time. They put on a trade. They made money. Then, they kept coming back for more. Even if they lost money they kept coming back.’

The Hammersmith and Fulham fiasco shows that noodle manufacturers aren’t the only kinds of financially unsophisticated actor who can be convinced by banks that complex financial products are a source of easy money. Finance officers at local authorities can be just as susceptible.

Little option but to lose

Lender Option Borrower Option loans have been around for decades but they didn’t really take off in local government finance until the early 2000s, when interest rates were at historically low levels.

Local authorities in the UK, by law, aren’t allowed to run budget deficits so, in order to carry out large projects like building hospitals, homes or schools they need to borrow money. There are essentially two ways for them to borrow – from the government (via the Public Works Loan Board) or from private sources like banks.

When authorities borrow from the Public Works Loan Board they’re charged a rate of interest which is slightly above the rate at which the government itself can borrow via the bond market. They get charged a nominal fee for arranging each loan and can repay them early, albeit with a penalty.

The low interest rates of the late 90s and early 00s made council treasury officers worry about interest rates on their long-term borrowing going up. This was the opportunity for the banks to step in with long-term fixed rate LOBO loans, which seemingly offered an in-built hedge against rising interest rates.

A LOBO contract has an exotic derivative called a swaption embedded within it. This swaption allows the lender to reset the interest rate at fixed intervals. The borrower has the option to accept this new rate or to repay the loan. Crucially, this is the only circumstance in which the borrower can repay the loan early.

A council that took out a LOBO in say, 2003, when interest rates were very low, with a fixed rate of 5% could feel pretty good about its decision as rates crept slowly up over the next 4 years. Indeed, LOBO contracts obtained by Debt Resistance UK, from just a small subset of local authorities which have agreed to hand them over, show how over £4bn was lent to councils via LOBO loans during this period.

To councils the loans were doubtless very good value over such a short time frame. The truly toxic nature of the LOBOs would only become apparent in 2008 when the global financial crisis sent interest rates plummeting. Now that rates were low, and set to stay low for the foreseeable future, the councils with LOBO loans were trapped paying over the odds and with no way to repay the loans early (at least not without incurring huge ‘breakage costs’).

For the councils who took out LOBOs before 2008, their one-way bet on rising interest rates didn’t pay off and has left taxpayers hugely out of pocket. Barclays, counterparty to over 30% of the loans signed during this period, booked a tidy profit.

Abhishek Sachdev of Vedanta Hedging has analysed the LOBO loan contracts obtained by Debt Resistance UK for a Channel 4 Dispatches documentary and believes that banks booked over £1 billion in profit from selling LOBOs to UK local authorities.

Predatory lenders

Barclays isn’t the only culprit. The Franco-Belgian bank Dexia and the German bank DePfa also entered into hundreds of LOBO loan agreements with UK local authorities over this period. Those banks both had to be rescued by taxpayers in their respective countries after the 2007-08 meltdown. (Which, along with the fact that Barclays has had to write down large portions of its LOBO debt in recent accounts, perhaps indicates that the only real long-term beneficiaries of LOBO loans were the brokers and dealers who concocted the transactions in the first place).

Probably the most egregious behaviour in the local authority LOBO loan market thus far though has been that of Royal Bank of Scotland.

RBS shows up as the lender in only a handful of LOBO loan contracts prior to 2010 but then, in the same year that George Osborne announces that PWLB interest rates are being hiked up, enters the arena in a big way. According to analysis of the contracts seen by DRUK, nearly three quarters of the LOBO loan contracts signed by UK local authorities over the next three years were drawn up by RBS, who’d found a new way of hooking council finance officers.

The RBS bait n’ switch

Now that interest rates were low the banks needed to find new tactics to obtain local authority lending business. LOBO loans were still the favoured vehicle since the banks could immediately sell off the embedded option and book the profit up front. But now LOBO loans were being marketed to councils with very low interest rates for an initial period of 2 to 6 years (a ‘teaser rate’) and terms which could stretch to over 65 years.

The ability to cut interest payments for the next 5 years is probably very attractive for a council treasury officer who’s only thinking in terms of her own career. It’s probably not as attractive a proposition for the ratepayers whose grandchildren will still be paying the higher interest rates in 50 years.

RBS is also notable for basing LOBO loan interest rates on LIBOR – the interbank rate which it, along with Barclays, was subsequently fined for manipulating.

Holding the bag

The number of banks and other lenders who issued LOBO loans to local councils over the last few decades is much larger than the list of institutions who are currently holding LOBO debt – largely due to the financial crisis and the restructure/insolvency of some of the banks. In fact, over a third of local authority LOBO debt is thought to be held by ‘bad banks’ in France, Belgium and Germany.

These ‘bad banks’, along with RBS in the UK, are largely taxpayer owned. Which means that UK ratepayers, via their local authorities, are paying large sums in interest to other public bodies instead of funding essential services. But rather than being recirculated in the public sector, as payments to the PWLB would, these interest payments are instead swallowed up by an increasingly dysfunctional financial sector.

The absurdity of this situation makes clear that local authority borrowing via the PWLB is a far more sustainable, accountable and transparent method for funding council projects. It also demonstrates that private banks in general, and derivatives in particular, really have no place in local government finance.

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