Local councils are set to lose the property game
A carry trade in real estate is a dangerous way to cover budget holes. There is no such thing as free money. The residents of Orange County, California, discovered this in 1994, when the county declared bankruptcy. The county had invested municipal funds in derivatives trades that went wrong when interest rates rose. Nor was there free money for Detroit, Michigan, where the effects of depopulation were exacerbated by its use of complicated financing arrangements, including rate swaps. These went wrong when rates fell. The city went bankrupt in 2013.
Britain’s local councils can only have been listening to the song of free money when they parked £800m of funds in high-interest accounts in Icelandic banks. Those banks failed in the financial crisis. Only legal action allowed most of the money to be recouped.
The councils are still listening. As this newspaper has detailed, many councils have borrowed from the Public Works Loan Board, an arm of the Treasury designed to fund local capital projects at long-term rates of about 2.5 per cent, and invested the money in real estate projects at yields of about 5-6 per cent or more. Such investments totalled £1.2bn last year alone.
The return from this manoeuvre is very welcome at the councils. Government spending cuts have made it desperately difficult to fund local services, from social care to libraries to child care. Naturally, the return is not locked in. That would be free money. Yes, the loans are long term, but the yields on the investments — office parks, residential developments, and so on — are not guaranteed. Prices fall. Rents go unpaid or are negotiated downward. Accentuating the risk, councils’ finances are already leveraged, through tax receipts, to the local economy. When the loan-to-value ratios of the loans are 100 per cent, as some are, the leverage is amplified further. It would not, in short, require a big correction in the real estate market to turn these investments from a source of funding into an absorber of it.
Councils have now build a credit bubble. Fuelled by cheap state loans, local authorities are trying to plug the funding gap with property investments
In some cases, the real estate investments dominate the council’s balance sheets. Spelthorne council’s £380m in borrowing to fund the purchase of the BP campus in Sunbury-on-Thames is four times the size of all its other assets combined.
Nor is this arbitrage exercise costless for the central government. The local councils are in effect borrowing the central government’s credit rating. If things go terribly wrong after the PWLB lending inflates a credit bubble, the central government will, one way or another, be left to clean up.
Not all government-backed lending is dangerous. There are reasons, not all of them economic, for local projects to be backed by central government financial muscle. But such loans are not meant to become a source of local budget funding by way of a carry trade. Nor are local councils set up to function as investment managers.
The PWLB, for its part, is not a bank. It is not equipped to reduce the risks by tightening up its credit policies. Instead, it should simply refrain from lending for anything other than local capital projects. Equally, the government itself needs to have a hard look at the local council credit expansion and recognise that it is a symptom of budgets driven to the breaking point. Speculation cannot solve the crisis in social care. But if the government ties its own hands on revenue increases, local councils, left with few other options, will give speculation a try.
Local governments have long played the part of the “dumb money” in complex and ultimately doomed financial schemes. This familiar drama need not be replayed. The Treasury should put a stop to the local council credit bubble before it grows even larger.