Saturday, 4 July 2015

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 3rd 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 3rd 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.


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