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Atrociously Bad Interest Rate Decisions (#ABIRD)

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Imagine you took out a twenty-year term loan for £100,000 – interest only. Four years on, your lender calls you and says - sorry - we have made some mistakes in how we set up the loan. Your debt is not £100,000 but £70,000. How would you feel?

Now, imagine that you rang up the bank, and asked the same question. Now, the bank says – because of the way you set up the loan, you now owe us £130,000. How would you feel? What if it was £160,000? Or over £200,000?

This is the unfortunate position facing virtually all of the UK’s local authorities today. From the largest, with debts of hundred of millions, to the tiniest, who have borrowed less than the amount of a home loan, they are getting that same bad news over the phone. And it could get worse……

What has happened? In essence, all of these councils have taken a bet. Then, they covered up the bet with impressive words. They talk of “hedging their interest rate risk”, “technical risk analysis”, and looking at experts’ forecasts. Many of them didn’t actually realise they were taking bets. However, the bad news is published annually by their lender, the Government. The losses for each council are shown clearly. As at 31 March 2018, NO council made a profit on their bets. ALL made losses, except those who didn’t bet – they, of course, ended up around even.

There are just over 1,500 councils in the UK - England, Scotland and Wales. The lender (Public Works Loan Board) divides England into major and minor councils. So we have four sets of data.

How much has the debt gone up, on average, for each group, in excess of what they borrowed?

Starting with the worse ones:

Wales 61%

Scotland 55%

England (Major) 44%

England (Minor) 27%

This is fascinating. Why should Wales do so badly? The image of canny Scots is dealt a hammer blow. And size does not seem to help – England’s major counties are lagging behind the minor ones – the biggest gap (17%) of the lot. It would seem that the more money you’re managing, the worse decisions you make! Why should this be?

First, there is controversy as to whether it is safer to borrow at fixed or floating interest rates. If you borrow at fixed rates, you are exposed to capital risk – your debt can go up or down (to put it another way, your loan has a sort of negative equity in it, which can go up or down). With floating rate loans, the capital stays the same, but the interest you pay, and hence your cash flow, can vary.

The most senior players in this debate are the Bank of England, and HM Treasury. The Bank believes that floating rates are best, and tries to help run the economy on this basis. HM Treasury think everyone should “hedge their interest risk”, and borrow at, or convert to, fixed rates.

Fixed rate loans are valued using an interest rate “forward curve”, details of which are issued daily by the Bank of England. If that curve falls, the negative equity in fixed loans gets worse. It has been falling continuously since around 2009, with a big hit immediately after the Brexit vote. I publish regular comments regarding the changes in the curve on Twitter as @SchemeActuary .

Apart from the issue of fixed or floating rates, there is the length of the loans. These seem to vary widely by council, without necessarily any regard to size. At this point, I lay down a few principles, which are open to discussion:

1) RISK Borrowing is always risky – for both borrower and lender. Clearly, the lender can lose interest and/or capital if the borrower gets into trouble. Lenders impose covenants – restrictive requirements on borrowers, and, if these get broken, they can then impose unwelcome sanctions. Restrictive control from an outsider is always unwelcome. Accordingly, loans should be minimized in size, and paid off as soon as possible.

2) PROACTIVITY Contrary to 1) it is sometimes desirable, or necessary, to borrow in order to achieve longer term financial or social aims, eg, developing a library/adult education facility. In these cases, different principles apply. You need access to funds, in order to create a wealth generating or otherwise beneficial structure.

3) REALISM To reconcile 1) and 2), a degree of pragmatism is necessary. For example, most projects overrun on both time and budget. Accordingly, borrowing more, and for longer, makes sense. Within reason. Crossrail is an enormously involved project, involving digging large tunnels under highly developed real estate – yet it’s taken about only 12 years.* * Approved 2007 – Full delivery 2019?

Why does a semi rural council borrow money up to 2065 in order to, say, just build (or even buy!) a shopping centre? (Which, we may see, will rest unused, like a Liverpool PFI school, if shoppers keep swinging towards web based shopping?)

4) AWARENESS The too often given reason for borrowing longer is “because it’s cheaper” Well, yes it is. However, it’s cheaper for a reason – lower demand for longer-term borrowing. The market expects longer rates to fall (pessimism), and therefore lower rates are needed to tempt borrowers longer. The important thing to realize is that you’re not doing any thing clever by borrowing longer.

5) DEMOCRACY Councils are reelected (or not) every four years – is it right to lock in successive administrations to the effects of borrowing decisions that extend up to ten times that period?

6) NATIONAL COMPARISONS Central Government (Gilt, or Gilt edged security) borrowing is virtually all fixed rate – and a mixture of short and long term. However, for historical reasons, the HM Treasury is restricted in how it borrows. Moreover, national governments can raise taxes if the cash flow from their borrowing becomes uncomfortable. The same governments can cap or pressurize down council tax – councils are therefore weaker in their ability to support their own debt risk.

7) “IT DOESN’T MATTER, ITS ONLY CAPITAL – THE LOSS WILL BE ZERO AT THE END OF THE LOAN TERM”. This is a common fallacy. Credit rating agencies will mark you down for bad debt decisions. The gilt “Treasury 4 ¼% 2036 “ rose in value from about 100 in 2006 to 150 just after the Brexit vote – a 50% rise in value. To effect quantitative easing, the Bank of England had to pay the THEN CURRENT price. If a government can’t fiddle the amount it has to pay, then neither can a council.

I produced a graph mapping size of loan against “unnecessary debt” factor – This factor was on average about plus 10% - 20% for smaller loans (most by number) – but as the size picks up, so does this ratio – and we are looking at plus about 50% for the largest band (with a few “total turkeys” standing out).

There are some startling results – but before looking at the extremes, I have compared two I spotted which had almost identical borrowing. LB Wandsworth had £120 million borrowed as at 31 March 2018 – and LB Hounslow had £121.5 million. Almost identical.

Not now, though – Wandsworth owes £124 million – up 3% - but Hounslow owes £157 million – up 27% Why? It’s the same lender!

Before I even look, I’ll suggest the following:

1 Wandsworth’s debt is closer to maturity and/or

2 Wandsworth borrowed more at floating rate (this doesn’t change value) and/or

3 Wandsworth borrowed later – earlier fixed rate loans typically have higher interest rates.

Most interestingly, if Wandsworth had borrowed at floating rates, 1 and 3 wouldn’t have mattered - all loans would have changed by 0% - ie, not at all.

Two questions, then, for Hounslow council taxpayers to ask:

a) How hard did you consider the advantages of floating, as opposed to fixed, loans when you borrowed the money? and

b) Bearing in mind your performance compared to Wandsworth is pretty poor, will you now review future borrowing practices, especially floating rate loan opportunities?

However, at only 29% loss, Hounslow can actually pat themselves on the back, as this is a lot better than the average – especially the average for larger councils!

The worse 1% group comprises 15 councils/bodies. The best raised its debt by 88% - the worst by 211%. The latter was a bit of a one-off – the next worst was a rise of 132%. Of the 15, the largest is a council name with a historical reputation for overspending – as far back as the 1980s. However, those historic spends went to support council taxpayers, not on financial speculation. Their current loss is £380 million. To make the point clear, that is £388 million of “dead money”. They borrowed £408 million but now owe £788 million. They are part of a group comprising nine larger English authorities, four Scottish ones, and two Welsh ones.

Of the 1,546 councils, about 870 (about 56%) have borrowings under £200,000 – around the size of the average new domestic mortgage today. However, current domestic mortgage borrowers do not lock into 25-year fixed rates. From current statistics available, the average fix is under three years. It does however, seem that regulators are trying to push borrowers into longer term fixed – FCA’s mortgage rules since 2014 require a stress test using the Bank of England forward curve if the fix is less than five years. However, experience to date is that this would have been bad advice (see diagram below).

The upshot of this is that most Council and Authority treasurers would have done better to have copied their non-financial council officials, and their decisions on their own mortgages! This seems to be an area where the amateurs do much better than the professionals!

The treasurers would argue, no doubt, that interest rates would have gone up, and variable rates would have cost more. However, the bank lending forward curve has been falling almost continuously since the end of 2008, with some big discrete drops. This drives a reduction in base rate, as the Bank of England needs to acknowledge lower confidence in the economy.

Variable rates are carefully managed by the Bank of England, for the benefit of both borrowers and the economy as a whole, which reviews national inflation and growth, every month.

Fixed rates, on the other hand, are at the mercy of the $300 trillion swaps market, which dwarfs both the UK and US treasury bill /gilts markets (around $3 trillion and $30 trillion respectively). These are actively traded by very bright and dedicated traders, who are staring at screens all day to make their bank profits – and bonuses. As a Local Authority official, you have to ask – is your treasurer really likely to beat these guys – even with the occasional help of Capita?

To avoid this risk, all you need to do is to stick to variable rates, or short-term fixes. (a 2 1/2 year fix is obviously just 10% of a 25 year mortgage).

So how did this all come about? As an example, I have provided a link to an article in “Treasury Today” (which sounds like a reputable journal). This was the second item listed on Google when I searched “Treasury Interest Rate Hedging”. Dated May 2001, it underlines the thinking used by most treasury managers over the past 18-odd years, at least.

Entitled “The use of swaps to manage interest rate risk”, it can be found here:

http://treasurytoday.com/2001/05/the-use-of-swaps to- manage-interest-rate-risk

Trouble is, it is clearly weighted towards pushing bor rowers towards fixed interest rates:

To quote an extract geared to answering the question

“How to manage interest rate risk”.

“ · Fix the interest rate.”

Loans can be taken out at a fixed rather than a floating rate, thus protecting the company from the effects of any changes in interest rates. Similarly, interest rate swaps can be used to convert a floating to a fixed interest rate.”

Note, fixing the interest rate is given as an example of “managing” risk. When an honest bank lends money for more than, say, two years, it will usually do so at floating rates, as this is likely to minimise the risk associated with the loan. Unless the company is contracyclical, fixed rates render the loan riskier, for reasons mentioned above.

Accordingly, that honest bank would not want you to effect the swap, as illustrated in the diagram. It would see this as an up risking of the loan, and might want to increase your loan risk loading to take account of it. Bang goes your clever profit. From the banks point of view, you are now speculating in derivatives.

Second, no-where in the article is stated the capital significance of the swap. While the possibility of adverse rate changes is cited, the fact that the swap contains its own equivalent of negative equity, which can work against you, is totally ignored. The combination of the subtle push and the exclusion of the capital risk lead me to the inevitable conclusion that the writer is actually a salesman, or employed by a selling organisation.

Unfortunately, the apparent “safety” of making fixed rate payments, and the strategic exclusion of any mention of capital gives the reader the impression that he or she is in some ways getting a “free ride”. However, many corporate loan covenants include a minimum capital requirement. Even if these are not explicit in the loan documentation, no lender is going to be happy if the borrower suddenly acquires an uncontrollable debt, which may increase substantially, and suddenly.

I also confirmed with the Government lender – the Public Works Loan Board – that they do not “push” either variable or fixed rate borrowing – it is up to the council or body to make their own decision.

Finally, I look at some of the borrowers who have the best records.

“Silver Award” councils, which have switched their more recent borrowing to variable rate, comprise the following:

• Lancashire County Council

• South Derbyshire District Council

• West Yorkshire Police and Crime Commissioner

• North Lanarkshire Council

These councils had switched to variable rate borrowing as at 31 March 2018, as measured by their “latest” borrowing practices (just having a couple of variable rate loans on the books does not qualify). …

and the single “Gold Award” council which was 100% in variable rate loans was Beckley and Stowood Parish Council, whose debt exceeded their borrowing at 31 March 2018 by a miniscule ½% - which can reasonably regarded as admin fees!!

We will review the March 2019 positions (including the effects of “LOBOs”, and other bank provided lending) once these are obtained. Some councils are very shy about revealing full details of their borrowing! As borrowing at fixed rates is the equivalent on betting on a good Brexit, the results after 29 March 2019 should be very interesting!

by Mr Peter Crowley Actuarial consultant - FIA MEWI BSc Windsor Actuarial is an independent firm of actuarial consultants with considerable expertise in corporate pensions. Established by Peter Crowley in 2005, their excellent actuarial and pensions consultancy is complemented by cutting-edge software and technical support.

Windsor Actuarial Consultants Ltd Suite 46, Albert Buildings 49 Queen Victoria Street, London, EC4N 4SA

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