Although definitely before my time, the case of ‘Hammersmith and Fulham interest rate swaps’ has loomed large over my local government treasury management career. Taking place in the late 1980s and early 1990s, it still acts as the epitome of excessive local authority risk taking. The ramifications of it still impact on how local authorities manage their money to this day. In this article I will describe what happened, but also explain how things have now moved on from this once landmark case.
An interest rate swap is a contract where you agree to pay someone a variable rate of interest on a notional amount of money, and they agree to pay you a fixed rate of interest back on the same notional amount of money. They are a type of derivative. Although commonplace now, in the 1980s these were a relatively new product. Interest rate swaps can be used to reduce risk if purchased to hedge existing debt positions. However they can also be used to speculate on market interest rates.
In the 1980s a large number of local authorities had begun to use these products. In the majority of cases purchases had been modest and done to reduce risk. The exception to this was Hammersmith and Fulham Council, who had been progressively purchasing enormous quantities of swaps that made a one-way bet that interest rates would fall. The Council’s finance department did this without the knowledge of their elected members, their Chief Executive, their auditors or the Audit Commission (the Audit Commission was at the time main regulator of local authority finance). The accounting treatment of the swaps was such that an upfront premium could be recognised as income, with costs only needing to be recognised later. The purchase of swaps was thus regarded as a handy income stream for the ever cash strapped authority.
The Audit Commission only got wind of what was happening because a newly arrived American working at the Goldman Sachs swap desk was so concerned about the Council’s position that she rang the Controller of the Audit Commission to warn him about it. This London borough with annual expenditure of £85.7m1 was single handedly 0.5% of the entire global derivatives market and 10% of the sterling derivatives market. By August 1988 the notional sum that the Council’s interest rate swap contracts were based on was £4.2 billion. All of this was a one way bet that interest rates would fall. Rather than stop these derivative purchases once they were under investigation from the Audit Commission, the Council further ramped up this activity: closing deals on underlying amount of £6.2 billion between 1987 and 1989.2
Then interest rates didn’t fall - they rose. Bank Rate was 9.9% in 1987 when the Council significantly expanded derivatives trading, and 14.9% by the date of the first court hearing in October 1989. It is estimated that the cost to the Council of closing deals would have been around £300m: 3.5 times their entire annual expenditure or around £4,000 to every rate payer.
At this time no local authorities had the ‘general power of competence’. This meant that a local authority was not allowed to do something unless there was a specific law saying they could do it. The Audit Commission issued advice that local authorities did not have the legal power to enter into derivates contacts. Banks, facing large losses if this was the case, took the Audit Commission to court.
The ‘Hazell v Hammersmith LBC’ legal case considered whether all swap purchases by councils were illegal or whether only speculative swap purchases were illegal. It also considered whether, if initial swap purchases are entered into and it later becomes apparent they may be illegal, it is legal to undertake later swap purchases to try to mitigate the situation (as Hammersmith and Fulham had done for some swaps).
The first court verdict ruled that local authorities did not have the legal right to purchase any swap contract. Such a contract was, to use the legal term, ‘ultra vires’ and therefore null and void. The banks sent the case to the Court of Appeal. In contradiction to the first ruling this court ruled that whist purely speculative swap contracts were illegal, those for risk management purposes or to mitigate the risks of previous voided contracts, were allowed. This was then appealed to the House of Lords, at that time the highest court in the UK. This third and final judgement then contradicted the Court of Appeal and went back to the decision the first court had made: that all swaps entered into by local authorities were ultra vires.
The upshot of this final decision was that Hammersmith and Fulham Council, and central government which may have ultimately had to bail them out, was off the hook. Banks had to bear the loss of the illegal contracts they had entered into: these are thought to have amounted to around £600m overall. The case meant that banks stopped selling any derivate contracts to local authorities.
It was fully acknowledged at the time by the Audit Commission, and no doubt others that were aware of the situation, that the court ruling created an unfair outcome. It saved one council that had made astonishingly poor decisions, at the expense of every other local authority that had or might want to use derivatives moderately to reduce their risk. The practical implications is that many authorities ever since have had higher costs, or experienced greater risks, or both due to being unable to access these financial products.
Fortunately we believe that there was a game changer in 2011 in England, 2014 in Northern Ireland and 2021 in Wales when local authorities got the general power of competence. Unfortunately Scotland still misses out here, and Police and Fire and Rescue Authorities across the UK remain a grey area. Having the general power of competence means local authorities are now allowed to do anything unless there is a specific law that says they can’t. So just as you and I can purchase an interest rate swap, so can they. Crucially, we still believe that it is only allowed for local authorities to purchase swaps or other derivates in order to reduce risk: not to speculate on financial markets, which would be in contravention of the Prudential and Treasury Management Codes.
Assisted by Arlingclose in October 2020 Plymouth City Council entered into an interest rate swap transaction with Santander, in the first of its kind since the Hammersmith and Fulham ruling. The transaction enabled the authority to have certainty of long term interest rates and make significant savings.
For more information on interest rate swaps please contact the Arlingclose team at info@arlingclose.com or on 08448 808 200.
1 https://eprints.lse.ac.uk/87352/9/Braithwaite_thirty_years_law.pdf
2 ‘Follow the Money: the Audit Commission, Public Money and the Management of Public Services 1983-2008’ by Duncan Campbell-Smith
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