The considerable press attention on Newham’s portfolio of toxic LOBO loans over the past few days (see here and here) has not only brought the issue in front of a wider public but has also forced the council to go ‘on the record’ in defence of it’s terrible financial management. What we see is a continued failure among the council’s executive to understand the deals that the London Borough has entered into.

I’d like to juxtapose two quotes. The first is from the 1995 Scorsese movie Casino. Robert De Niro’s character is describing how to run a successful gaming operation in Las Vegas:

In the casino, the cardinal rule is to keep them playing and to keep them coming back. The longer they play, the more they lose, and in the end, we get it all.
– Sam ‘Ace’ Rothstein

The second is from a December 2015 Financial Strategy meeting at Newham Council. Deputy Mayor and Cabinet Member for Finance Lester Hudson has just heard Councillors John Whitworth and John Gray raise concerns about the amount of money the council has borrowed in the form of LOBO loans. They asked whether legal action should be taken to remedy the situation. Here’s Cllr Hudson’s response:

John is talking about 20/20 hindsight. We fixed and we fixed based upon reasonable forecasts at that point in time. If I had a time machine and I could have anticipated the collapse of interest rates we would have made completely different decisions. But I do not have a time machine. It is the reasonable person test. If John can actually dig out economic forecasts, [made] at that time, that showed what interest rate forecasts were going to be, I will listen to his arguments. So, put up or shut up, John.
– Councillor Lester Hudson

Newham’s LOBO loans were one-way bets

Cllr Hudson clearly doesn’t understand the basics of how to manage interest rate risk. No one has a time machine. Forecasts are just that: forecasts. Predictions. Guesses.

Every time a local authority has to decide what form its borrowing should take – fixed rate or variable rate, from the PWLB or the markets – its officers should be considering a wide range of potential future scenarios.

It is clear from Hudson’s remarks that Newham saw only one potential future – the one that was forecast for them by the banks. (Journalist Nick Dunbar has already written about Newham’s finance officers boasting about their close relationships with the bankers.) Newham believed in this forecast wholeheartedly. Rather than packing a coat in case it rained over the next 50-70 years, Newham’s finance officers decided to listen the bankers who were telling them that it would be sunny every day.

From a quote in today’s FT article on LOBOs it’s clear that Newham still hasn’t learned its lesson.

The council says that it took out the loans in 2009 when yields were expected to rise, not fall. “This situation was not predicted by the best pundits,” it says. It admitted the inverse floater Lobos were “expensive” but said their rate should fall amid expectations of an interest rate rise.

In other words, nobody saw it coming so how can they be blamed? Because the point of prudential financial management is that you never know what’s coming. If you did, there wouldn’t be any need for prudential financial management in the first place. Your bets wouldn’t be bets and the bank wouldn’t make any money from taking them.

Newham’s LOBO loans weren’t part of a prudential financial management strategy. They were a one-way bet on interest rates. It was a bet the council lost, leaving the Borough’s residents footing the bill.

The psychology of the gambler

What’s even more extraordinary than the fact that Newham entered into gambles with taxpayer money (a constant refrain of Mayor Robin Wales is that Newham’s investment returns are the best in the country, seemingly oblivious to the fact that yields are very strongly correlated with risk) is the sheer scale on which they entered into the bets and the tendency to throw good money after bad.

Everyone’s familiar with the gambler trope of trying to win back what’s been lost by making more bets. The foolhardy gambler stays at the table until they’re back on top, no matter how far into debt they sink. Could the same psychology have been at work in Newham, with council finance officers throwing good money after bad, enabled by the bankers’ ever more exotic ‘sure things’?

See Newham’s LOBO loan details

It seems that the bankers played Newham’s finance officers beautifully, keeping them at the table, encouraging them to place ever more risky bets, while pretending to feed them the results of the games they were betting on. Finally RBS managed to get Newham to go ‘all in’ in 2009, and take out a whopping £150m in ‘inverse-floater’ LOBOs.

By now, Newham is long overdue a stint in rehab.

Posted in BlogTagged LOBO Loans, Newham