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LOBOs - The next banking scandal?

First we had PPI. Then LIBOR. Then swaps miss - selling. Now Ladies and Gentleman I give you LOBOgate. Or How The Banks Ripped Off Local Authorities and Housing Associations From Someone Who Was There.

(I am open to guidelines for a better name)

Cast your minds back over a decade to the early 2000's. Life become excellent. Both the public and private sector in the UK had been doing pretty nicely. However as a treasurer for a nearby authority or housing association cash was nevertheless tight every now and then. It was nonetheless vital to borrow money.

You would have notion that a local authority ought to borrow cheaply, when you consider that in training if not legally they may be backed by the United Kingdom principal authorities. Indeed they can borrow from central government thru the PWLB at charges handiest slightly better than the governments very own debt issuance. But to a treasurer recommended to make their department behave like a earnings centre even these prices had been too high.

It would of route made really no sense for the nearby authority to technique a bank. Even inside the halcyon days of the early 2000's banks normally had worse credit score ratings than the nations that hosted them, and had to borrow money a touch extra expensively; and to make a earnings lend out at a bit more once more.So borrowing from the financial institution become glaringly going to be extra luxurious than borrowing from the PWLB.

It could have made no feel at all..... However that is exactly what the nearby government did. And they were capable of borrow greater affordably than from the PWLB. And the banks made big earnings, however now not as a great deal as a few people operating as money brokers did.

Welcome to the magic of the Local Authority Lender Option Borrowing Option - LOBO deal. Surprisingly what little fuss has been made approximately those deals has targeted on their tenuous connection to LIBOR-Gate. In truth this is a very exclusive scandal.

A little introductory economic alchemy

Lets say I provide to lend you ?40 and fee you three% hobby for 5 years. Some different man comes alongside and offers you the same deal; however the twist is he could have the choice to ask for his money again each time he likes.

You would not borrow cash from him because its clearly a worse deal.

(By the way if you don't think its a worse deal then I have some double glazing and PPI insurance to sell you; plus did I mention that I am distantly related to a member of the royal family and there is $40 million in escrow with my name on it, 10% of which is yours if you send me your bank details...)

Suppose he sticks to his weapons but as a concession he will lend you the cash at simplest 2.Nine% interest. Would you are taking that? What about 2.5%? 2%?

Essentially what I am asking you to do is to value the choice of the lender wanting their cash back. Why would the lender need their cash again? There may be all types of motives, however the maximum probable purpose would be that interest rates have risen to say four%; and they would instead lend the cash to a few different person than have your three% coming in.

Of course having to all at once repay your mortgage while hobby charges have risen to 4% is the worst feasible thing for you. I count on you haven't were given the cash to pay off it. Your rich aunt hasn't died has she? You do not have a spare kidney, or spare first born son you could promote? No? Then you're going to need to borrow the cash from someone else. At 4%. Ouch.

[To be pedantic LOBO deals allowed the lender the option to increase the interest rate. The borrower then had the option pay the new interest rate or repay the money.

If interest rates fall: The lender wouldn't increase the interest rate if it was already high. If rates fall to 2% and the borrower is paying 3% the lender will stick.

If interest rates rise: The lender could increases the rate in line with market levels eg up to 4%, and the borrower decides to continue paying.

The lender always has the option to increase it to 'silly' levels eg 10%, at which the borrower would have no choice but to repay the loan. To make things simpler I'll treat the loans as if the latter always happens when rates rise; but this is gives a conservative valuation of the lenders option]

There is nothing unethical or unusual about this (but don't worry, the unethical bit is coming....). If like me you have a fixed rate mortgage then you probably have an early repayment charge (ERC) on it. Again this is just the value of the option that I have to repay the mortgage early.

In the LOBO deals the lender has the proper to ask for the loan to be repaid early. So they will charge less hobby because they personal a valuable alternative. The question still stays, how does the borrower cost that option?

Enter the middleman

To cost the mortgage option or the repayable mortgage option you simply need a bermudan swaption pricer, the relevant volatility floor, some form of hobby fee version calibrated to the correct tactics and the full ahead and spot curve.

You probably don't have this sort of issue at home. I did not once I took out my loan; I didn't absolutely spend time pricing the various costs, upfront charges and ERC in opposition to every other; despite the fact that I may want to have executed if I will be bothered - ninety nine.Nine% of humans cannot try this. That is why a variety of human beings use loan agents to get the excellent deal.

(Actually I didn't use a loan dealer, however it sort of spoils the tale if I point out that. And I used a calculator, a pencil and the lower back of the nearest envelope to do the calculations.)

Who should pay the mortgage broker?  Around this question the UK regulator changed the entire way the financial system not so long ago. It is generally a good idea to align incentives. So when you sell a house you pay an estate agent to get the best price for you. Suppose that when you sold a house the estate agent rather than taking a commission from you, instead took one from the buyer. There would be a strong incentive for a dishonest agent to take the cheapest offer for the house, if its was coupled with a fatter commission for them personally.

(Okay this may nonetheless happen. Its not unusual apparently for property dealers to be offered bribes through determined or unscrupulous customers whilst the housing market is specially hot. But we shouldn't make it less complicated for people to act badly, should we?)

In the UK economic customer international till quite lately the incentives have been distorted. Customers did not want to pay large up front expenses for economic recommendation, so alternatively advisers have been paid through commission from the humans providing the economic products. If you do not know what occurred as a end result you could probable wager by using now.

It could be no wonder if I inform you that the LOBO offers had been now not achieved without delay by Local Authorities with Banks, however via middlemen acknowledged collectively as 'cash agents' (a as an alternative old skool time period, but I like the the Dickensian overtones, do not you?). Interestingly for my part the principle reason this was being performed was to defend the neighborhood government... Although as we shall see it had the alternative impact.

A quick records of neighborhood authority mismanagement

Why keep the banks faraway from Local Authorities? Well there has been a landmark prison case within the early 1990's whilst the borough of Hammersmith and Fulham had got themselves concerned with buying and selling hobby fee swaps (a sort of interest price by-product)... To reduce their investment prices (oh the irony!!!). It turned into decreed that they'd handed their criminal authority in signing these deals so consequently the deals had been null and void. Local government were no longer allowed to exchange those spinoff products.

They had been not allowed to alternate swaps and really no longer bermudan swaptions, a greater complicated shape of spinoff. A bermudan swaption is a proper to cancel a change... You may guess wherein this is going. Yes the kind of choice embedded in a LOBO deal is a bermudan swaption. So its ok to have a cancellable loan (or a cancellable constant rate loan) that embeds a complicated by-product however not to exchange them directly. Interesting standpoint, isn't it?

A now not so brief records of an instance exchange

Lets supply an instance of a alternate which may additionally or might not have befell which the writer of this put up may also or might not have had intimate knowledge of while working on a financial institution buying and selling desk inside the early 2000's.

(This is a 'composite' tale with factors of things which actually happened; oh permit's no longer be coy you can google me - at Barclays Capital; though they had been no manner the best bank doing this)

First the housing affiliation B asked the dealer to get them the satisfactory deal on a cancellable mortgage; say a forty yr mortgage first cancellable in 2 years and then each next 6 months. There are not many folks who can try this form of deal due to the fact the relevant derivatives marketplace isn't always very liquid (due to the fact loans over 30 years are pretty rare, even to the United Kingdom government). They likely rang spherical three or four UK primarily based banks and at the least one German bank.

The German bank cannot do this deal themselves so that they called up one of the British banks to get a price for hedging the risk. Interestingly this ended in a state of affairs when the applicable trading desk had requests for pricing an identical hedge from unique parts of the financial institution. The request made immediately would have made the financial institution extra money so the trader instructed the German sales man no longer to play around with letting the Germans try to undercut them and steal their commercial enterprise. Probably the Germans were given a quote excessive sufficient to prevent them from creating a competitive offer to the broking.

(Actually come to think of it this is probably bordering on cartel like behaviour but I am not a opposition attorney so I don't know.)

So the charges are available in from the banks. The broking chooses one. I do not know how he chooses the quote, I wasn't there (I by no means even met the fellow, all deals being done via financial institution sales humans). What I do understand is that the charges might have protected a negotiated fee for the dealer (do not forget the banks are paying him for arranging the loan). I recognize that the commissions at the offers that we won (and we regarded to win pretty a bit) have been often very high in comparison to commissions on different brokered products.

Would the broker have selected the exceptional deal for the nearby authority or the first-class for himself? It is probably tougher to make the proper selection if the fee became very massive...

So as an example most merchandise broked bank to financial institution had commissions of fractions of a basis point, or possibly one foundation point (1 basis point is 1/one hundred of a percent). Wheras on a few LOBO offers the commissions may be drawing close 1%. Although those deals are greater unusual and complex than many other products, that is still a completely large commission. In money phrases we are speakme ?20 - ?50 million dollar offers, so those six parent brokerage commissions had been no longer unusual.

On this unique deal the fee turned into so large in percentage terms that it surpassed inner limits. Even the most difficult nosed buyers at the trading table had been feeling pangs of.... Properly not guilt possibly however worry that this sort of thing would possibly sooner or later be written on a blog. But the broker agreed to take half of of the fee spread over subsequent deals, so that become k.

As a factor of reality the commission that the buyers themselves within the financial institution would have personally earned on that might have been lots lower than the agents however those offers even though no longer large inside the grand scheme of factors (billion dollar bond troubles are not uncommon, although with tons lower % profits) had been honestly a great contribution to the desks earnings.

(To be pedantic buyers don't commonly receives a commission a set fee of a deal however a percent of the earnings made by using the buying and selling desk over a whole yr; the proportion isn't always fixed of direction and depends on many other factors. So its an awful lot more difficult to pin down precisely what a financial institution employee might have crafted from an person deal like this)

How far does this move?

What I do not in my view recognise is the extent of this. It may want to simply be a few remoted trades with one UK financial institution that I for my part recognise approximately over more than one years. I actually have simply no evidence that that is a major hassle.

But I'd wager cash that it is going a lot further than this.

No laws damaged?

Of course none of this was illegal. That isn't a formal legal opinion and I may subsequently be proven wrong. But nobody comes out of this smelling particularly well. The money brokers for me are the worst offenders; their behaviour was downright immoral and they personally benefited the most. Its very easy to blame the bankers and they certainly should have behaved differently, but their incentives were to either pay the commissions or lose what was a very profitable business.

(What the bankers concerned need to have carried out become leave their jobs in disgust and cross and work somewhere else more moral. Then simply once they had the moral excessive ground recaptured they have to wreck all of it via going to work for a hedge fund. It worked for me).

But it is not just them. Just as naughty I think have been the people who placed stress at the treasurers to lessen their funding prices through a few fractions of a percentage, at any value. The treasurers themselves. The well that means folks who thru the regulation of unintended consequences prevented the neighborhood government from getting charges immediately from banks that could have stepped forward things a bit.

(This takes place all the time. For example the usage of economic advisors, funding and pension experts to guard buyers from being ripped off just provides layers of prices and in my opinion adds no value. But it truly is any other tale.)

It may be interesting to look how this tale develops...

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