Investment management company Traderisks gives its view of the LOBO finance deals that are currently being offered to housing associations
LOBOs are the current hot topic in social housing finance and, for many housing associations, the only funding currently on offer. With 30 housing associations due to close on new LOBO transactions in the next month, how much do housing associations know about the pricing and refinancing risk implications of these opaque, but also ‘too good to be true’, financial arrangements?
What is a LOBO?
In the current environment, obtaining a new facility is extremely difficult. The only funding being pushed by some lenders is through LOBOs. LOBO funding typically comes in the form of a facility restructuring, involving a small amount of new funds. The new facility containing the LOBO then replaces the old facilities. Typically the new facility amount is only, say, 20 per cent larger than the original facility.
LOBO stands for Lender Option Borrower Option. The underlying loan facility is typically very long-term - for example 40 to 60 years - and the interest rate is fixed. However, in the LOBO facility the lender has the option to call on the facilities at pre-determined future dates, such as every 5 years.
On these call dates, the lender can propose or impose a new fixed rate for the remaining term of the facility and the borrower has the ‘option’ to either accept the new imposed fixed rate or repay the loan facility. The upshot of this is that on the option exercise date, the lender could propose an extreme fixed rate, say 40 per cent, which would effectively force the repayment of the underlying facility. The borrower’s so called ‘option’ is only the inalienable right to accept or refuse a new deal such as a fixed rate of 40 per cent.
How can they be priced?
The LOBO proposal is quite complex to value as it contains three elements: removing the borrower’s existing derivatives, changing the facility profile, and adding new derivatives. As a result, it is impossible to even estimate an approximate value without sophisticated pricing tools that the majority of housing associations will not have access to.
Housing associations are the fixed-rate payers and therefore their derivatives portfolios are largely ‘out-of-the-money’ (i.e. their market value is negative), as a result of the recent downward shifts in the swap curve.
Let’s assume that the new cost of debt for housing associations is around 200 basis points above LIBOR. Then the typical 30-year loan facilities obtained before 2008 have a very large positive value for the housing associations as these facilities will typically have margins ranging between 20 and 50bps.
So every year the borrower is saving more than 1.5 per cent on its margin relative to a new facility. When restructuring the facilities, the housing associations are giving away these very valuable long-term low-margin option-free facilities.
Most LOBO proposals involve replacing 20 to 50bps margin facilities with an all-in fixed rate facility with complex derivatives attached. They should be seen as 200bps margin facilities (valued at par by definition as 200bps is the cost of new debt), plus Bermudan cancellable swaps where the swaps’ fixed rates are 200bps below the LOBO fixed rates. The only assumption made here is that interest rate volatility is equal to the volatility of the interest rate plus credit spread.
As the maturity of the swaps is very long (between 40 and 60 years), the options have very high values, so the market value is very negative for the housing associations.
What do they cost?
Although what follows is an illustration, it is based on actual cases that we have seen. Let us assume a new £50 million LOBO which is intended to replace an old £35 million facility. The market value of the fixes within the old facility is -£2.1 million, and the market value of the margins of the old facility is +£4.8 million. Therefore the total (interest rate plus credit margin) market value is +£2.7 million.
The underlying Bermudan cancellable swap within the new LOBO facility has a market value of -£11.3 million. Therefore the total economic loss or cost for a borrower entering into this LOBO would be -£14.0 million (minus £11.3 million plus the £2.7 million loss of value on the old facility).
This cost is equivalent to a staggering 9 per cent interest rate increase on a 30-year amortising loan of £15 million. In other words, the LOBO proposal is equivalent to having a new £15 million facility with a margin of 1100bps. In addition, if the LOBO was prepaid say tomorrow, the housing association would be subject to a prepayment penalty of £11.3 million, representing the market value of the embedded derivatives. How many housing associations entering into LOBOs have evaluated the true cost of these arrangements?
We understand the difficulties faced by banks in this environment and that the cost of debt will never return to what it was. However, it is essential that the market finds a new level at which borrowers and lenders transact. Transparency is key for this level to be found. LOBOs do not provide this transparency and this is regrettable. Furthermore through these LOBOs, housing associations are replacing safe 30-year facilities with new facilities that could end in five years time, thus creating a significant refinancing risk in this very uncertain future.