‘LOBO’ Loans: Derivatives, Local Government Debt & Citizen Audits

AN Fischer (2008) Fundament. Mapping of world GDP and global derivatives trading volume for 2008. Birch and poplar.

I was recently asked to contribute to a piece on derivatives for an economics education website – with the brief being to explain why derivatives ‘matter in daily life’ for readers with no presumed or particular interest in finance. So far, I confess, I’ve not found it particularly easy. Derivatives are a funny kind of sociological object. We’ve almost all heard of them; many will have a sense that they (or some particular use of them) were implicated in the 2008 financial crisis; and it is reasonably likely that some of us will have come across one of the countless news items (or visualizations) that asks, along with sociologist Elena Esposito: “What is sold and bought in financial markets that move a mass of capital exceeding by 20 times the entire world GDP, which then clearly does not refer to the goods?” Such news items frequently earn the ire of derivatives enthusiasts, who are keen to point out that the ‘notional value’ of the world’s outstanding derivatives is not a proper measure of the market value of outstanding derivatives (see also here and here). The notional value, they would argue, refers to the ‘face value’ of the underlying asset from which the derivative ‘derives’ its value. But the amounts for which derivatives change hands can be fairly detached from the face value of the underlying asset*. And besides, as this article for Global Finance magazine points out, since “the parties to a derivative contract are seldom required to pay out the full value of the asset”, the notional amount outstanding does not reflect the “actual risk” that traders take.

If anything, this is likely to trouble the observer even further: How is it possible that derivatives derive their value from an underlying asset, but don’t have to pay the full value of that asset – or, in the case of most exchange-traded commodities futures, don’t have to deliver the underlying asset? As Mazen Labban points out in this brilliant Geoforum article, only 2-3% of the sweet crude futures traded on the New York Mercantile Exchange were settled for actual delivery in 2002. How can you enter into a contract to buy an asset at a set price on a given day (the value of the contract being derived from the value of the underlying asset), but not have to deliver that underlying asset when the contract matures? The simple answer is that exposure to derivatives trades are now frequently ‘netted out’ between the firms who trade them. But accounting for this state of affairs in historical and sociological terms is a little less straightforward.

For some of the earliest sociological and anthropological commentators on derivatives, Edward LiPuma and Benjamin Lee, the ascent of derivatives (especially currency derivatives) since the 1970s represents a shift in ‘the globalizing process’. And this shift involves a ‘decoupling’ of speculative finance from the ‘real’, productive economy.  Social scientists who emphasize the ‘circulatory’, ‘decoupled’ or ‘virtual’ nature of derivatives have been criticized by sociologists like Donald MacKenzie, but LiPuma and Lee don’t leave it there – and they do in fact point towards one very important way in which derivatives matter in our daily lives. For LiPuma and Lee, derivatives became important after the introduction of a regime of floating currencies in the 1970s, because they allowed a new breed of multinational companies, headquartered in the USA but operating around the world, to manage the risk of doing business in different currencies. It would not do to enter into a contract to supply goods manufactured in one country, in exchange for a set amount of local currency in another country, if foreign exchange fluctuations could mean that on the day you were due to get paid, you would effectively be making a loss. For LiPuma and Lee, while specific derivatives could help companies ‘hedge’ against these risks, the growth of currency derivatives markets (where, as we saw above, the ‘delivery’ of the underlying asset was increasingly not the point) meant that the currency derivative developed a “bipolar personality”. As they write in their 2004 book:

Swaps are thus financial instruments that attempt to price the risks of connectivity itself…Anything from currencies and interest rates to broadband and electricity can serve as underliers so long as they are volatile, produce risk, and can be given a price. The argument that underpins our analysis and differentiates it from others is that the concatenation of these basic derivatives does not simply produce more complex and quantitatively different financial instruments, but engenders and represents a qualitative transformation in the way that speculative capital conceptualizes and globalizes types of risk.

In a powerful paper co-authored with Thomas Koelble, LiPuma shows that when risks become tradable at any moment at the right price (something that the derivative enables), and when derivatives markets get large enough, they can in fact set social policy. Thus, after the first post-apartheid elections in South Africa,

the currency markets assigned South Africa an abstract risk premium based on its quest for social justice and its racial complexion. Accordingly, the forward currency contracts predicted a continuing decline in the value of the rand… In a self-fulfilling prophecy, the repercussions from the rand’s devaluation – based on the market’s assessment of risk (the risks caused by failure to privatize, the counter-party risk posed by a Black African government on a continent where government failure is endemic, the risk that the HIV/AIDS epidemic would drain government funds) – began to cause the economy to stumble.

More recently, Dick Bryan and Michael Rafferty have also examined the derivative as a form of enacting social policy (although they are rather critical of the tendency for authors like LiPuma and Lee to treat derivatives as ‘speculative’ and disconnected from the ‘real’ economy). Writing in Sociology in 2014, they argue that the salient point about derivatives is that they price risk in order to allow the trade in price variability (i.e., the variability in the price of foreign exchange). Increasingly though, ‘non-price derivatives’ – like weather derivatives, or health insurance derivatives – require a process of “decomposing things once thought whole into a spectrum of constituent attributes.” In other words, you, the individual patient or student, will be decomposed into a set of metrics – based on ethnicity, age, education, social class – that allow your student or consumer debt, or your health premiums, to be packaged up, securitized, and used as the ‘underlying’ for a range of new derivatives. Thus,

increasingly, in a financialized world, people live in tranches…profiled not as objects of state policy, but as differing financial risks, manifesting in the tranches…into which people’s student debt and electricity bill payments will be classified.

And it is precisely the link between derivatives and state policy that this blog is concerned with. In particular, I’m interested in an affair that is slowly gaining attention in the UK, thanks in large part to the efforts of Debt Resistance UK (DRUK): the unfolding LOBO loans scandal. The story is told in far greater detail by DRUK, and journalist Nick Dunbar, but at the heart of the LOBO (or ‘Lender Option Borrower Option’) scandal is the fact that many of London’s local councils are paying around 40% – and in the case of Newham, close to 80% – of their council tax income servicing their debt (see this DRUK chart). The LOBO works by giving the lender the option to renegotiate the interest rate agreed on multi-million pound, very long-term (50-70 year) loans at fixed intervals, at which point the borrower may exercise their ‘option’ to either accept the new rate, or repay the outstanding sum in full. These are hardly symmetrical options. Councils have got themselves into trouble by accepting loans at ‘teaser’ rates  which appear more attractive than the rates offered by the Public Works Loan Board. But these teaser rates are then jacked up at the first lender option exercise period. An additional concern is raised by the apparently close relationship between LOBO loan brokers who seemed to be going directly to issuers with whom they had a company relationship, rather than ‘going out to market’ and looking for the best rate they could get for the councils. But perhaps more worringly, many councils took on ‘treasury management advisers’ who despite ostensibly working for the councils, seemed to cultivate overly close relationships with both the brokers and the loan issuers. The Financial Services Authority have not investigated these treasury management advisers, despite being directed to by a Parliamentary committee in 2009-10. In fact, just yesterday another controversy began to unfold after treasurers expressed hostility towards a proposed new code of conduct for treasury management agents, that was drawn up as an explicit response to the LOBO scandal.

And what does this have to do with derivatives? Well, the LOBO aspect of the loan is a kind of ‘embedded swaption’ or interest-rate swap, and this could prove even more controversial. In 1991, the House of Lords ruled that local authorities were not permitted to participate in swaps. This was after a long tussle, initiated when Anthony Hazell of the (now defunct) Audit Commission sent a memo regarding his concerns over derivatives trading by Hammersmith and Fulham’s local council (their swaps exposure at the time came close to making up 25% of the world’s sterling-denominated derivatives). As Adam Tickell documents in his 1998 paper for Political Geography, the positions taken by the council and the Audit Commission were neither consistent nor clear during the Hammersmith and Fulham case, but it was

one of the first high-profile cases to demonstrate that derivative products could be used to catastrophic effect if their formal risk management function was exchange for speculative purposes.

One former auditor, reflecting last year on the LOBO affair, recalls that when these loans were entered into around a decade ago, questions were not being asked about whether they had “unlawfully sneaked” swaptions into local authority loans. “The more basic issue was whether directors of finance understood fully at the time what they were getting into.” But it hardly makes sense to separate these issues out. In the Hammersmith and Fulham case, it was precisely the lack of understanding that rendered the council’s use of derivatives recklessly ‘speculative’. As Tickell recounts, when the crisis unfolded in 1989,

Treasurers sought to reassure that the potential exposure (which they feared at the time could be as high as £2.5 billion) was notional rather than real money. The clear impression given to elected representatives was that the authority had played the markets and won. The problem, they believed, was that the government had never given proper guidance on the ways in which local authorities could use the money markets.

The questions thrown up about treasury management agents’ conflicts of interest and ethical conduct only compounds the concerns today. And, of course, there is no more Audit Commission such as that which Anthony Hazell, who raised the alarm at Hammersmith and Fulham, worked for. The Local Audit and Accountability Act 2014 put paid to that. But it did introduce a ‘common inspection period’ – falling this year between the 1^st and 14^th July – when any local citizens may inspect council accounts and raise objections (subject to a ‘commercial confidentiality’ clause). As John Gaventa and Rosie McGee have observed, the use of ‘citizen audits’ as tools for resolving the ‘democratic deficit’ in  various contexts around the world is often hamstrung by their application “within an efficiency paradigm, with scant attention to underlying issues of power and politics”. But, when citizens are able to process newly available data, and the audits are linked to protest, litigation, or electoral pressure, they often lead to real and lasting change. Which makes the Debt Resistance UK’s campaign to skill-up citizen auditors in time for the July inspection period all the more significant, and all the more worthy of our attention.

If anything can make the heady world of derivatives seem relevant to ‘daily life’ during austerity, it is surely a situation in which upwards of 40% of council tax receipts are spent on servicing a loan containing embedded derivatives. Especially when those embedded derivatives allow lenders to renegotiate interest rates upwards – leaving borrowers either obliged to take the higher rate or take on more debt to repay the principal immediately – and where the relationships between treasury management agents, brokers and issuers seem far from savoury. Never mind that the whole situation is eerily reminiscent of the Hammersmith and Fulham affair, the first to show precisely how derivatives could be used “to catastrophic effect”.

*In the case of an interest rate swap (where one party agrees to pay a fixed interest rate, and the other pays a ‘floating’ rate), as you approach the date on which the swap is to take place you’d probably be less and less likely to find someone willing to pay a huge amount for the right to pay that day’s interest rate