Today, a pledge was announced at the Labour Party conference that PFI contracts would be reviewed and if necessary, brought back in-house. This is reported here:
It is apparent that private investors who have put money into PFI schemes will need to be compensated. This is acknowledged by a spokesman saying “a future Labour government would compensate shareholders in PFI companies by swapping their shares for government bonds.” That might well be acceptable, though equity holders may not be at all happy about being placed in a different part of the capital structure with a completely different risk/reward structure and also having their exposure changed to a different entity. This however will be acceptable providing they are given enough government bonds. I am not sure how popular a “stuff their mouths with gold” policy to ensure silence (and no lawsuits) will be but we will see. The real problem however lies elsewhere.
The way PFI works is that the government or an NHS trust signs a contract with a private sector entity, often a consortium the members of which will include prominently construction and financial firms. The contract, very basically, will say “you agree that we will have a usable hospital between three and thirty years from now” and “we agree to pay you cash amounts for the same period.” This removes risk from the government because it no longer has to build the hospital — which incidentally it probably cannot afford to do in any case — and any other interruptions to service during the lifetime of the contract. This by the way is why it is not an objection to PFI that it costs more: it should cost more because the government has avoided a great deal of risk. We know how prone government expenditure is to going over-budget: with PFI that risk is passed to the private sector.
The private sector consortium now has a good chance of receiving government cashflows for 30 years, providing it can build the hospital without problems. These cashflows are excellent for backing bonds: or in the jargon, they are good candidates for securitisation. Because they are such good candidates, almost all of them will have been. One reason why they are so good is that there is very strong demand for such long bonds — from everywhere in these low rate times — but especially from pension funds. Naturally they want long bonds because they have long liabilities.
Here’s the problem. These investors are very focused on Repayment Risk. This is the risk that you give them their money back before they were expecting it. This sounds like good news for the investors, but it isn’t because the pension fund was hoping to get paid interest for 30 years at a rate fixed today and now you have given them their money back they won’t get that. This is especially painful for them if rates have declined in the meantime. The current ultra-low rates environment just underlines this. Imagine 10 years ago you bought a bond paying you 6% a year for 30 years and now they give it you back and say “go ahead and find another bond that pays you that much…”
Because investors hate this so much, they insist on what is known as a Spens clause. This basically says that if you repay early, you have to roll up the remaining excess interest payments for the remaining life of the bond and hand that over now. This will be unimaginably expensive because the excess interest will be calculated primarily from the original rate paid by the bonds and the general rate available. That difference will be huge in a lot of cases because rates generally are so low. So you will have to roll up a huge difference for maybe 20 years.
Conceivably the government could legislate to take out the Spens clauses. But that would mean government had intervened radically in contracts agreed between consenting experts in full possession of their faculties…and would destroy the reputation of the City as a secure global marketplace. We don’t need that ahead of Brexit. In any case, it would also kill most of the pension funds. Many of those are foreign, so even if the government were able to lean on the local ones, they would still pick up some fearsome litigation.
I spent almost a decade on the fixed income trading floor of various investment banks. I concluded that psychological factors were extremely important in driving market events. I am just about to publish a book on this topic. You can learn more at the link below.