Many local authorities and housing associations have taken out “LOBO” (Lender Option Borrower Option) loans over the past 15 years. They were particularly popular before 2008 in the “boom” time but are for periods of up 60 or 70 years and so they have potentially long term ramifications. Following an examination of these products and their implications by Channel 4’s Dispatches, the Local Government and Communities Select Committee heard evidence about them from experts and others with concerns about how they have been sold and used.

LOBOs are indeed responsible in some cases for councils spending much more on individual loan repayments than would be expected over a period when interest rates have persistently remained at unprecedented low levels. However, some argue that in current market conditions they are benign and can be useful in reducing funding costs so that many local authority LOBO borrowers have paid less for their borrowing than they would have at the Public Works Loan Board rate for the period from drawdown to date. Others consider that LOBOs have no place at all on any local authority or housing association balance sheet because of the complex risks involved.

There are undoubtedly many potential problems and pitfalls with LOBOs and experts point to local authorities who have ended up paying well over the market rate for their borrowing through LOBOs over the past 10 years.

What is a LOBO?

The acronym "LOBO" stands for Lender Option Borrower Option. This is a type of loan, supposedly giving both parties "options" as the title of the product suggests, but in reality the "options" are in favour of the lender, because it is only the lender who has the benefit of “options” with an economic value.

In its simplest form, a LOBO loan involves the bank lending the local authority a sum of say, £10 million at a rate of 3.75% for 60 years. However, unlike a straightforward fixed rate loan, on specified dates during the life of the loan the bank has the benefit of an option enabling it to impose an interest rate increase. When the bank gives such a notice, the borrower is then given its “option”– it can either accept the new rate offered by the bank and carry on paying, or it can repay the loan in full without any penalty. So the effect is that if market interest rates for the remaining term of the lending fall below the deal agreed between the bank and the borrower, the borrower still has to pay the agreed higher rate, but if market rates increase the bank can take the benefit of the increase by serving a notice requiring the borrower to pay a higher rate. There a LOBO is on the face of it a “win/win” position for the bank.

The bank will usually only serve a notice to increase the LOBO rate if rates in general for new loans for the remaining term of the LOBO have increased above the original rate on an “option date” so that the borrower is unlikely to obtain the same lending cheaper elsewhere. Otherwise the borrower would simply refinance elsewhere at a cheaper rate if the bank sought to increase the rate.

The bank’s “option dates” to increase the interest rate are typically the borrower’s only opportunities to make early repayment without penalty, and it can usually only do so if the bank has given notice it intends to increase the rate. If the bank never serves a notice to increase the rate, then typically the borrower is “locked in” and obliged to keep paying the rate originally agreed for the whole term of the loan. Therefore, once the initial period leading up to the Bank’s first option date expires, the borrower has no protection if interest rates rise and no opportunity to benefit if rates fall.

In order to repay the loan and refinance (in the absence of a notice from the bank to increase the rate), the borrower must pay a very hefty breakage cost equivalent to the market value of the remaining portion of the LOBO loan which, given the length of the arrangement and the valuable options which put the lender in a “win/win” situation, can be very substantial in a low interest rate environment. This breakage cost could exceed the amount of the outstanding loan itself.

Therefore, if market rates for equivalent lending remain low (and lower than the rate to be paid under the LOBO) the borrower is effectively locked in for the full term – it has no option to exit the arrangement and seek cheaper borrowing elsewhere – it must live with the rate agreed at the time the LOBO was entered into.  So from the borrower’s perspective, these loans are a very long term commitment to pay the rate agreed at the outset for a term, or higher. So, on the face of it, the borrower is in a “lose/lose” position.

The Rationale

The obvious question then is why would a local authority or housing association enter into such a one sided arrangement?

The borrower is in fact selling options to the bank (the options to impose rate increases or ask for repayment) and these options have a value. This value is traded by the borrower for a discounted lower interest rate on the loan. The more options that are included (i.e the more dates on which the bank can increase the rate or demand repayment) the more valuable the package of options is overall to the bank and the lower the loan rate should be.

So in theory the loans can allow the borrower to access funds at well below market rate, and well below the Public Works Loan Board rate (for Local Authorities) for at least the period between drawdown of the loan and the first “call date” on which the bank can exercise an option to increase the rate. After that, what happens depends on the interest rate market at that time – the borrower may continue to pay the LOBO rate agreed at the outset, or be forced to pay a higher rate imposed by the bank with the alternative of repaying the loan and refinancing elsewhere (which will also be at a higher rate if market rates prevailing at that time are higher at that point).

The Pitfalls

However, in many cases due to the pricing and structure of the LOBOs entered into around 2005-2008 the borrower is in fact worse off now in cash flow terms than it would be if it had entered into a fixed rate loan for a term equivalent to that first period up to the call date, or had stayed on the floating rate. In either case, even if the early cash flow benefit has worked well the borrower also has a large contingent liability to account for. If the borrower’s finances were to become stressed for any reason to the point where it was unable to make payments on the LOBO, or went into insolvency, then the breakage cost usually has to be paid and so must be accounted for when considering the assets and liabilities of the borrower. This can affect access to other sources of finance as other lenders will take that into account in deciding whether to lend and the scale of the contingent liabilities could potentially put borrowers in breach of covenants in other banking facilities.

Variety of Structures and outcomes

The impact of LOBOs depends on the exact structure and pricing in any individual case. In some cases it appears LOBOs have terms that mean a borrower has paid less since they were drawn down that it would have if it had taken out the other loan products available on the market (or from the Public Works Loan Board) at the relevant time. In other cases LOBOs are currently requiring much higher payments than would have been required under alternative structures.

From the legal perspective, a review of a selection of LOBO loan agreements and associated paperwork revealed following Freedom of Information Act requests to Local Authorities (the only LOBO agreements available publicly) reveals a very complex picture with a huge variety of loan terms, rates and structures entered into by local authorities between 2005 and 2009. Some have a rate which (subject to the bank’s options to increase/demand repayment) remains constant for the term at between 3.5 and 4.5%. Others have “stepped rates” with a lower rate (typically 3% to 4%) for an initial period of about 2-5 years and then a higher rate of 4.5% to 5% for the remaining term to 2060.

Some use a much more complex formula to calculate the rates. For example one London Borough of Brent loan for £10,000,000 taken out with RBS on 11 April 2009 has a rate of 0.25% above LIBOR for 1 year, 2% for the next 2 years and then “8.7% minus the GBP-ISDA-Swap rate” meaning “the swap rate for Sterling swap transactions with a maturity of 10 years, expressed as a percentage which appears on Reuters Screen ISDAFIX4 Page as at 11.00am in London time on the first date of each Interest Period” to 2015, when the bank’s annual option to impose a new rate takes effect,  and then this formula continues for the remainder of the term if no notice is served notifying a new rate. This arrangement, known as a “reverse floater” is particularly unfortunate for cash flow in recent years because it means that the lower market rates go, the more interest the local authority must pay RBS. It appears payments have been at c.6.% or more for the last 3 years. However, there is no obvious reason why a Council’s cash flow would be able to absorb this sort of fluctuation, particularly when interest rates in general are low.

There are some loans with option dates every 5 years, some every 3 years, some annually and some even more frequently than that. (Generally the more options, the more value generated by the borrower selling options to the bank, and so the bigger the discount on the interest rate should be).

The assistance of experts in structuring and valuing derivatives would be required in order to establish whether in each case the borrower got a good deal or a bad deal on the pricing of the LOBO. The more profit taken by the bank and intermediaries at the outset, the less likely it is that the LOBO will work out in the borrower’s favour because more of the borrowers “reward” for selling the bank the options (i.e. the value of the options which should be converted to a discount on the interest rate) has been diverted elsewhere and so whole structure is tilted further in the bank’s favour. This will also result in larger breakage costs and therefore contingent liabilities to be accounted for when assessing the borrower’s worth, and more potential impact on other sources of funding.

It is important in each case to consider the borrower’s alternatives and what its loss has been compared to the alternative the borrower would (and could) have taken instead.

CIPRA Guidelines

The Chartered Institute of Public Finance and Accountancy in its Treasury Risk Management Toolkit warns that LOBOs are inherently risky as a result of their “embedded optionality” and suggests caution and risk management policies such as spreading LOBOs so that they do not have option dates all occurring at the same time, not entering into LOBOs with very frequent “option dates” and accounting for LOBOs when considering the maximum amount of debt repayable in any one year as if they were all called in that year.

Crucially, CIPRA also reminds local authority finance departments of the golden rule – “Know your Product” and advises them that they should “gain a good understanding of the product in discussion with advisors brokers or banks” and warns them “If you are not sure, do not do it”.

This appears to be the crux of the issue. Did local authorities and housing associations understand sufficiently the products they were entering into and the risks of doing so? Were they suitable for their objectives? And was the pricing fair and transparent to them? And if not do borrowers have a right to recover damages from any of the parties involved?

Potential Claims

As well as the Banks selling the loans, many authorities engaged treasury management advisors or brokers (or both) who involved in the loan arrangements and were paid either fees by the authorities or commissions by the Bank.

LOBOs are assets of very substantial value because of their typically high value and long term nature. A straightforward interest only loan for £10 million for 60 years at a rate of 4% per annum is an instrument with a revenue stream of £24 million. LOBOs are essentially fixed rate loans with values of that order that have been tweaked, typically so as to reduce interest costs (in cash flow terms) to the borrower in the early stages of the loan by stacking the deck in favour of the bank at the back end of the loan.  This makes the pricing and risk analysis more complex for the parties involved – the more complex the structure the more reliant the borrower becomes on specialist advisors and brokers to obtain a suitable product at a fair price.

Taking all this into account, have the local authorities saved money compared to the other options they had available to them at the time they entered into their LOBOs? Or have they entered into an arrangement that was to their disadvantage if rates fell.  Was that a risk they consented to or were they misled in any way during the sales process?  Were the products inherently unsuitable or is any damage caused merely a result of unforeseeable extremes?

What about the relationships between the advisors and the brokers? Some of the advisors being paid by the authorities to provide independent specialist advice on these loans were subsidiaries or sister companies of the brokers who arranged the execution of the deals with the Banks and were paid commission for doing so. Did the taxpayer get the best deal in those circumstances?

Did the advisors who were paid by the borrowers to provide advice do so with reasonable skill and care? Did they comply with their contractual obligations?

Some of the loans use LIBOR and ISDAfix as benchmarks, which are now known to have been manipulated by the Banks involved in setting the rates. Has this caused the borrower a loss?

There are a number of potential causes of action for borrowers including:

  1. misrepresentation (negligent and possibly fraudulent depending on the facts e.g. regarding LIBOR) by any of the parties involved in inducing the borrower to enter into the loan;
  2. breach of contractual obligations to advise regarding suitable products, or to provide “best execution” or to manage conflicts of interest;
  3. negligence/negligent misstatement regarding the suitability or risks of the products;  
  4. conspiracy (e.g. re benchmark manipulation)

The potential claims in each case will depend on the structure and terms of the loan, the wording of any relevant contractual agreements with brokers and advisors, what disclaimers/limitations on liability of the various parties have been agreed and what impact the particular LOBO has had on the borrower’s financial position to date.

The issues surrounding LOBOs are complex and each loan and its financial effects, and the circumstances surrounding the transaction, needs to be examined individually to assess whether the borrower has a claim against the bank or any of its advisors or brokers.