Councils are set to rid themselves of the majority of their Lender Option Borrower Option (LOBO) loans within 18 months, according to a leading treasury adviser.
Last month, Birmingham City Council borrowed £81.75m from the Public Works Loan Board (PWLB), using the cash to pay off a major chunk of its £200m LOBO portfolio.
David Blake, strategic director at treasury adviser Arlinglose, said more and more councils are reaping the benefits of reduced exit fees on offer from at least three banks which are now eager to offload the instruments.
He said: “LOBOs are an increasingly awkward and costly instrument for a bank to hold.
“Lenders want to see their capital working hard for them, earning a decent margin, rather than committed to local authorities in the form of somewhat controversial, loss-making loans over the next 50 years,” he added.
Blake said that banks have already booked the profit made on LOBO options by selling them to third party banks, losing control of the deals.
In addition, some banks are making losses on LOBO books because their net hedged funding costs are higher than the interest they receive on the loans.
The pace at which some banks are looking to exit LOBOS is being accelerated by regulatory deadlines.
As well as being required to set aside additional capital to cover potential losses on long-dated debt, leverage ratios will be tightened when the Basel III accord on banking regulation is fully implemented in 2019.
Meanwhile, volatile valuations may create losses for the banks due to the introduction of new rules under the IFRS9 accounting standard.
Banks could rid themselves of £4bn of LOBOs within 18 months, Blake estimated, which is in addition to the estimated £5bn – £8bn of LOBO loans converted into fixed rate borrowing by Barclays in 2016.
The total value of LOBO loans taken out by local authorities has been estimated at £15bn by debt campaigners who claim that taxpayers are being ripped off because councils didn’t fully understand the loans when they were taken out.
Blake said: “There is a certain irony that the banks are taking the biggest hit, not that many will mourn their loss.
“Local authorities that can negotiate good prepayment terms on ‘vanilla’ LOBOs will have done quite well from a certain perspective – they will have had a loan that has run at sub-PWLB rates, no trigger of the lenders option, plus a subsequent restructuring that generates further savings and eliminates all remaining lender’s options.”
Councils should take advantage of the deals on offer, as banks are also exploring the sale of LOBO books to institutional investors, he added.
Talking about his authority’s recent deal, Martin Easton, head of capital and treasury at Birmingham City Council, told Room151: “It is a significant chunk of our LOBO portfolio in a deal that works financially for us, reduces the rate we were paying on these loans and removes the risk from a call on the options.
“Where it gave a rate below PWLB and our view of option risk meant it was worthwhile, we were happy to do a small proportion of our book as LOBOs.
“That has been a significant success – we have not had any option calls and the LOBOS continued at a rate below that we would have been paying had we taken out PWLB borrowing at the time we took them.”
A spokesperson for Northamptonshire County Council said it was looking at options relating to refinancing its LOBO borrowing.
Conrad Hall, chief finance officer at London Borough of Brent, said his authority is keeping an eye on the situation, but thought deals on offer could get even better.
He said: “At the moment we are sitting tight. I don’t think that the situation is going to get any better from the point of view of banks. We are not in position of having a LOBO portfolio that is significantly more expensive than our PWLB portfolio.”
It is doubtful that other investors would be interested in taking over LOBO portfolios that banks did not want on their books any more, he said.
Hall added that the interest rate the authority is paying on its “inverse” floating LOBOs has gone down following the Bank of England’s decision to increase the base rate by quarter of a per cent at the start of August.
He said: “The rate on these loans has gone down – that is exactly what they were supposed to do.”
Unwinding reverse LOBO arrangements was more difficult, due to their more complicated structure, according to Blake.
In addition, some banks are happy with their LOBO books, having secured funding and facing lower accounting pressures, meaning some councils may remain stuck with LOBOs for some time to come.
At the end of August, auditors resolved an accounting issue relating to inverse LOBO loans which had delayed the signing off of accounts at several councils.
In July, A group of 14 local authorities announced they were taking action against banking giant Barclays, claiming that manipulation of Libor rates cost them millions in repayments on their LOBO loans.
