Monday, 1 May 2017

Royal Bank of Scotland; LOBOs

Sir Howard Davies
Royal Bank of Scotland

Dear Sir Howard,

I am a Cornwall Councillor and I currently shadow the Finance Portfolio. My background is I am a retired partner from one of the largest London law firms. So, I am reasonably familiar with complex financial products. I am not standing in the local elections on 4th May but I will brief and assist my successor on this important matter.

It came to my attention that the former Cornwall County Council (now Cornwall Council) had entered into a very large number of so called Lender Option Borrower Option ('LOBO') debts up to 2009. Serious questions have been raised as to whether these debts represented value for money for the Council and whether members of the County Council understood their terms and the risks undertaken.

For example, there was a Channel 4 Dispatches programme on this. ('How Councils Blow Your Millions').  Further, apart from the programme and the concerns that I have expressed from my own investigations, objections have now been made to the Council's accounts. The objector alleges that the LOBOs are such poor value for money, they are 'irrational' and possibly illegal.

According to the response to a Freedom of Information request the only advice the Council received on these transactions was from the in house Treasury team.  I have to say that in all my dealings with the members of the Council it seems clear to me that they do not understand that the Council generally secured a small reduction in its introductory interest rate (the so called 'teaser rate') for these loans (as against Public Works Loan Board fixed rates- then around 4% ) but in turn exposed the Council to the risk of paying up to (in the case of the loans from RBS) about 8% for up to 60 years. If officers understood this, there is no evidence that knowledge was shared with members.

The two 'inverse floater' LOBOs entered in to with RBS give rise to particular concerns around understanding by councillors and value for money.  Overall, the Council was betting that interest rates would climb quickly and steeply and stay high.  Then it would benefit from a low interest rate as the interest rate on the loan goes down as market rates rise.  However, if this produced an unattractive rate for RBS then it was only exposed until the next option date (generally every five years) when it could reset the interest rate.

On the other hand, if rates stayed lower for longer then RBS would not call for a rate reset. In that case, the Council could be exposed for a period of up to the duration of these loans (60 years).

So, the financially sophisticated bank took a 5 year risk horizon and perhaps hedged out its exposure but the Council took a 60 year risk horizon and did not (and possibly could not except at a huge cost).  I note that the liability under these loans is currently valued by the Council at £164m (as opposed to their face value of £85m).

I have not been told the precise interest rate currently payable on the RBS inverse floaters but I understand that it is around 6.2%. The difference of over £1m between that and the Council's average long term borrowing cost from the Public Works Loan Board would, for example, pay for the maintenance of all public toilets in Cornwall every year. The Council says it cannot afford to maintain these and is trying to transfer them to others or close them.

This matter is now being examined by the Council's auditors, Grant Thornton, in conjunction with the National Audit Office in an investigation that is likely to take a year.

I understand from the Council that Barclays, who had a similar size of portfolios of LOBOs with Cornwall Council (but not 'inverse floaters') has recently volunteered to 'detoxify' their loans.

I noticed in the press recently that the mis-selling of mortgage backed securities by RBS is still an ongoing issue. In that context, £85m of loans to Cornwall Council is a relatively small matter to RBS but it is a huge issue to Cornwall.

May I urge you please to include us (on a without prejudice basis) in your 'detoxification' exercise so that the proud Royal Bank of Scotland may have a fresh start and we can fund our vital public services.

Yours Sincerely,

Fiona Ferguson
Cornwall Councillor

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