Falling in the trap

Banks are providing loan contracts to public authorities called LOBOs that contain derivatives. LOBO loans are potentially illegal as Local Authorities were prohibited from taking out swaps contracts following the 1989 Hammersmith and Fulham vs Goldman Sachs case 1.

In the 1980’s 137 Councils including Hammersmith and Fulham had been encouraged by banks and brokers to enter into hundreds of interest rate swap agreements. Under these swap contracts the bank would pay the Councils if interest rates fell, and the Councils would pay the banks when rates increased.

Hammersmith Council was the largest player in the interest rate swaps market. It had signed hundreds of swaps contracts placing UK taxpayers on the hook for $6 billion in potential losses as interests rates moved against the council in favour of Goldman Sachs. UK Government as the “lender of last resort” to Councils took a keen interest in the case, as the debts snow-balled and Council defaults and Government bailouts to repay the bank lenders became a realistic proposition.

Ultimately, the matter was decided in the UK High Courts, where QC’s scouring over the fine print of the 1972 Local Government Act ruled that councils entering into stand-alone swaps and derivatives contracts was “ultra-vires”, or outside Council’s legal powers. The High Court ruled it was not Council’s role to be speculating upon interest rates, and taxpayers should not be held liable, much to the anger of bankers in Wall Street and the City of London. 2

But this has not stopped bankers from finding inventive ways of “engineering around” the legal restrictions by designing new forms of borrowing for the public sector which hide derivatives risk by embedding them within the loan contracts.

Since the 1989 ruling, the use of derivatives by UK councils has remained in a legal twilight zone. It is widely assumed that derivatives are illegal, and yet it appears derivatives are still in widespread usage across the public sector.

In this regard, Debt Resistance UK (DRUK) is exposing suspicious lending practices between the private sector and Local Government, in the form of Lender Option Borrower Option (LOBO) loans. DRUK’s research shows at least 230 UK councils have LOBO’s on their books.

Useful Links
  1. 2008 – Duncan Campbell Smith – Closing the Swap shop
  2. 1989 – The New York Times – British Court invalidates some financial swaps