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Problems Unwinding PFI


PFI is politically unpopular. For that reason, politicians often announce that they will roll it back. Plenty of projects like hospital construction would be impossible without PFI. Many of the arguments against it fail since they do things like add up 30 years of interest and say that that is the cost of the project. There will moreover be significant problems unwinding PFI due to the bonds issued. I will outline that below.

Who Wants to Unwind PFI?

It was at one point Labour Party policy to unwind PFI. PFI contracts would be reviewed and if necessary, brought back in-house.  The report of that is here:

Private investors who have put money into PFI schemes will need compensation.  A spokesman said “a future Labour government would compensate shareholders in PFI companies by swapping their shares for government bonds.” 

That might be acceptable, though equity holders may not be at all happy about being placed in a different part of the capital structure. They would have a completely different risk/reward structure and also have exposure changed to a different entity. 

It would work if they got 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.

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How Does PFI Work?

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 that government projects go over-budget all the time. With PFI that risk passes to the private sector. Most critics do not price risk correctly.

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.

What are the Problems Unwinding PFI?

Here’s the problem.  These investors focus 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. The pension fund wants interest for 30 years at a rate fixed today. 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.

Conclusions: Problems Unwinding PFI Mean You Shouldn’t Do It

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. Problems unwinding PFI are such to make it a bad idea even if PFI was a mistake, which it isn’t.

See Also:

The Psychology of Successful Trading: see clip below of me explaining my new book!

Cognitive Biases And How They Affect Stock Markets

Jacob Rees Mogg Is Wrong To Say That Loss of Passporting Will Not Be A Problem For The City

UK Government Spending: Where It Needs To Be Cut And Why

By Tim Short

I am a former investment banking and securitisation specialist, having spent nearly a decade on the trading floor of several international investment banks. Throughout my career, I worked closely with syndicate/traders in order to establish the types of paper which would trade well and gained significant and broad experience in financial markets.
Many people have trading experience similar to the above. What marks me out is what I did next. I decided to pursue my interest in philosophy at Doctoral level, specialising in the psychology of how we predict and explain the behaviour of others, and in particular, the errors or biases we are prone to in that process. I have used my experience to write The Psychology of Successful Trading. In this book, I combine the above experience and knowledge to show how biases can lead to inaccurate predictions of the behaviour of other market participants, and how remedying those biases can lead to better predictions and major profits. Learn more on the About Me page.

4 replies on “Problems Unwinding PFI”

I do think you have missed an angle here though, which you only touched on in the second paragraph. If you listened carefully, Labour admitted they would not take all PFI contracts back; presumably some contracts would be cheaper than others to buy back, and I guess it will be those ones that end up getting bought.

The bigger picture is the risk, and as you say, PFI enabled the government to get rid of some risk. One of the first questions to ask prior to making an investment is “what is the correct level of risk for me?” All other decisions are mostly about execution to hit that target.

Politically, I think it is fine for people to say the government should take more risk, and de-risking should not have been the motivation for PFI. More Vs. less government risk has hitherto been the main left Vs. right political argument. By pledging to reverse PFI, Labour are signalling to the electorate that government risk is back on the table.

Buying back a handful of high-profile PFI contracts may not be the best investment in terms of execution, but it may be close to optimal for signalling to both the market and the electorate that risk is back. In that sense it could be good value to Labour.

It sounds as though it has to be right that they would be buying back only the cheapest ones. However, I presume the policy objective would be more closely related to “we want to bring the onerous contracts back in house” rather than “we want to bring the cheapest contracts back in-house.” This problem will be exacerbated by the fact that the most onerous contracts will be the ones which are most expensive to bring back in house. That will not be due to the Spens clause problem I mention above, but because if the contract payments are large, then so will the compensation be for termination.

I agree with the second point. On Twitter today a lot of points were being made that failed to see this. No one claims PFI is risk-free, but if you negotiate correctly, you get a fair risk transfer for a fair price.

Well, you might want to do some derisking if your recent public procurement projects included NHS database or Berlin Airport. I am not sure that more vs less risk has been the left/right debate. The right is taking the vast and terrible risk of Brexit and the left has been looking like it wants to flirt with tanking the UK credit rating. Both of those are very bad. I would normally, as you know, say that the latter is the worst but that was before I saw that Brexit costs 3% of GDP.

I think that this is “risk-on” policy is quite high risk for Labour.

I don’t think there is a policy objective much beyond exciting the base. That’s sub-optimal, but is unfortunately how politics has been conducted for quite a while; Ed Miliband would be a much more reasonable PM than any of the current offerings, but you get nowhere in politics these days by being reasonable.

I would say that optimal might even have been to do PFI but then take additional risk in other areas to make up for the risk you weren’t taking in hospital finance. My preference would be research and education, but I would say that, wouldn’t I. One reason why the PFI contracts look onerous is precisely because the risk-aversion of our times caused interest rates to crater for an extended period. People who criticise PFI are misdiagnosing the mistake, which was not PFI, but failing to compensate by taking other risks instead. Presumably there would also be some scope to use PFI counter-cyclically, i.e. use PFI at the business peak (which would be the Blair years), but do things in-house during recession (post 2010).

You should explain the Spens clause because clearly if the contract says 6% for the next 15 years and you have to pay it all now then you have to apply some discount for the opportunity cost. The government may claim that since they are going to be investing heavily, interest rates will be going up, so 6% five years from now may not be that great. You’d need an agreed upon model of where interest rates are going, and we probably don’t have that.

Exciting the base it might do, but nothing much beyond. And it’s even a very narrow base. Blairites would have been part of it at one time.

That’s an interesting set of ideas in para 2. Obviously it would be great to take some huge risks in R&D and see if some of them come off. The problem with only using PFI some of the time is that when HMG is borrowing constrained, as it presumably always will be, you can’t do that stuff on balance sheet.

The Spens clause is onerous because it is not intended to reflect anything much beyond the investors extreme reluctance to get repaid early. The clause is in fact never or rarely enacted; it is more there in the way of issuers saying to investors “we will never prepay you and to prove that we will give you this clause.” So no discounts. It is striking that even in gangbusters times when there is a lot of “cov-lite” lending going on, long investors — who are perhaps a little more sober than the short end guys — have still insisted on this. Basically if Standard Life spends a year deciding to buy a hospital bond, they want to get what they were promised — 6% a year for 30 years — under all circumstances. That now looks very expensive because of what rates have done in the meantime, but they could equally well be 18% and Standard Life would look dumb. Or maybe not equally well but it is possible…

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