The Lobo with Dresdner was taken out on 3/12/2004 for a period of 50 years. The terms were as follows,
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1 Sector Treasury Services Introduction This paper outlines the current Lobo loan held by Worcester City Council (the Council) and considers the options that are available in terms of reducing the current interest costs associated with this loan and removing/reducing refinancing risk from the Councils debt portfolio. Basic Terms of Lobo The Lobo with Dresdner was taken out on 3/12/2004 for a period of 50 years. The terms were as follows, Initial rate = 3.45% for the period 3/12/2004 to 02/12/2009 Secondary rate = 4.50% for the period 3/12/2009 to 02/12/2054 six monthly calls within the secondary period. The loan is a Lobo structure which is a Lenders Option, Borrowers Option loan. This means that the loan is fixed for the first five years at a rate of 3.45% and reverts to a rate of 4.50% on 3/12/2009. From that point on the lender has the option to change the rate every six month s, if this option is exercised then the Council has the option to repay the loan at no cost or take the new rate offered. Interest Rates at time of borrowing At the time the loan was taken 30yr + rates were 4.65% and the Sector forecast was as set out in Table 1 in the Appendix. The Lobo had an Effective Interest Rate of 4.52% which compared favourably with the equivalent long term PWLB rate both at the time of borrowing and the forecast rates going forward. Our records indicate that this Lobo was taken out as part of a rescheduling exercise where 4million of debt was repaid (at an average rate of 9.78%). Current market conditions Current long term PWLB rates are 4.35% for a 45 year loan so the new rate that will apply on the Lobo with effect from 3/12/2009, this still looks an attractive deal when compared to the current long term interest rate forecasts where both Sector and UBS expect long term rates to rise over the next months with Capital Economics of the view that rates will fall.
2 In terms of where rates are currently placed the following graph highlights (with the exception on February/March 2006) that we are at a low point of the interest rate cycle, giving further support to the view that rates will in fact rise Jul-03 Nov-03 Mar-04 Jul-04 Nov-04 Mar-05 Jul-05 Nov-05 Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Average PWLB 25-30yr In terms of whether the Lobo will be called (the point in time at which the Lender will attempt to put up rates) at the first opportunity (June 2010) this will depend on the value that the lender considers exists in the cash flows contained within the loan structure. The mechanics of a Lobo are hard to understand as each bank will have different ways of calculating value but in simple terms the bank has an instrument where it will receive fixed rate interest for the next 40 years if it does not wish to change the terms. The bank can then undertake a serious in interest rate swap transactions with other counterparties to pay variable rate interest (which are currently below the 4.50% due from the Lobo) and until such time as this becomes uneconomic to the bank holding the debt instrument then the chances of it being called remain slim. In simple terms short term rates would have to rise above 4.50% in the near term before the Lobo was called. The following graph illustrates this. 8.00% 7.50% 7.00% Forward Interest Rate Historic Interest Rate Poly. (Boundary Rate) 6.50% 6.00% 5.50% 5.00% 4.50% 4.00% 3.50% 3.00% Jun-99 Nov-04 May-10 Nov-15 May-21 Oct-26 Apr-32 Oct-37 Mar-43 Here the Boundary Rate (top line on graph) is the rate that the bank has calculated where interest rates must reach before they need to change
3 the terms of the Lobo. In this example the Forward Interest Rate (bottom line on graph) is the markets view of where variable rates will go and as they are not predicted to breach the Boundary Rate the chances of the Lobo being called are minimal. The bank that hold the Councils Lobo will have similar models to calculate the Boundary Rate and this will influence their decision making process. Options/Refinancing options As with any loan instrument the borrower has the right to ask the lender if they can repay the loan early. In the case of PWLB debt the cost of early repayment can be calculated on a daily basis as the method used to calculate premium/discount is available in the public domain. This is not the case in respect of a Lobo as each bank has its own pricing structures which it will not normally disclose. The Council could approach the lender to request for a quote for the early termination. If the loan was a PWLB loan the cost of repayment today would be 765,000, it is expected that it would most certainly be more expensive to repay a Lobo. The options currently available to the Council can be summarised as follows, Option Potential Benefit Risks Associated Request costs of early repayment and replace with PWLB loans at lower rates that the secondary rate contained within the Lobo Existing Lobo loan can be replaced with lower cost PWLB debt and costs of repayment can be amortised over life of existing loan (45 years). Debt at a rate of below 3.76% would need to be taken to generate a saving over the 45 year period (taking the estimated 765,000 Cost of early repayment could be higher than estimated using the PWLB method. The Period of refinancing via cheaper PWLB will introduce re-financing risk that could be greater than staying in the Lobo structure. Request a change to the structure of the Lobo Anticipate early repayment being available at next call date and take replacement borrowing now Take no action and reconsider refinancing if the lender exercise their option to increase the rate Use the volatility that exists within the Councils debt portfolio as a result of the Lobo structure as an opportunity to rebalance the Councils debt maturity structure. premium write down into consideration). Refinancing risk removed for the time being, no early repayment costs incurred Existing Lobo loan can be replaced with lower cost PWLB debt (10 year at 3.70% or 45 year at 4.24%). No early repayment costs will be incurred Lobo stays at 4.50% for next 45 years. The Council uses current cash balances to repay if the rate is changed The Councils Capital Programme contains a borrowing requirement and this flexibility could be used to take on short term borrowing at lower interest rates to either fund capital spend or to cover the repayment of the Lobo. New rate is in excess of current rate and term of Lobo could be extended. Accounting issues could arise Cost of Carry will exist between now and repayment of Lobo (that is to say interest costs on PWLB debt taken in advance will outweigh interest received on investing this money). Lobo may not be called and early repayment of PWLB debt may prove costly Lobo is called at a point of time when all other refinancing opportunities are more expensive than current levels Timing of the Lobo call and capital spend result in additional borrowing being required at a time when interest rates are more expensive than current rates.
4 Recommendations Lobo loans will always provide savings during the initial period when compared to equivalent long term PWLB structures but they also introduce an element of volatility into a Councils debt portfolio once the secondary period is reached. Whilst Sector would not recommend early repayment or modification of the Lobo the Council should contact the existing lender to obtain an indication of the costs of early repayment of the loan and to establish if the lender would be willing to change the structure of the loan, this would ensure that all options have been considered during this process. Taking replacement PWLB borrowing now will ensure that any re-financing risk is removed and the new cost of borrowing will be known in advance and be lower than that of the secondary rate of the Lobo. The maturity period of the replacement borrowing will be determined by the amount of revenue savings that need to be achieved, but additional refinancing risk could be introduced if the balance struck between rate and maturity is not considered carefully. Which ever course of action is taken the Council should keep a close eye on current long term interest rates and interest rate forecasts as even if no action is taken now the fact that the Lobo will soon enter its variable period potential decisions will need to be considered on a six monthly basis, therefore a sensible strategy in the current environment would be to take on some additional short term debt at current low interest rates in anticipation of the Lobo being called at some point in the near term, if this does not occur the borrowing can be used to finance the Councils current Capital Programme. M Swallow Sector Treasury Services 21 st October 2009
5 Appendix Table 1:
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