Tuesday, 7 July 2015

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.


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