Cities in the casino
Mar 18th 2010 | BERLIN
From The Economist print edition
A derivatives farce makes its way to court in Milan. Others are sure to follow
ONE of the great advantages of financial innovation, it was often said, was that risk would end up going to those best qualified to hold it. In fact, much of it seems to have ended up in the hands of those least able to understand it. How some of it got there may soon be revealed in an Italian court. On March 17th four big banks, 11 bankers and two former city officials were charged with fraud in connection with the sale of interest-rate derivatives to the city of Milan. The trial is due to start in May.
The prosecution relates to a huge bet on interest rates that the four banks—UBS, JPMorgan Chase, Deutsche Bank and Hypo Real Estate’s DEPFA unit—helped the city authorities to take in 2005. The banks helped arrange the sale of €1.7 billion ($2.3 billion) of bonds for the city and then also helped it swap the fixed interest rate it was paying on the bonds for a lower, floating rate. Part of the contract is thought to have involved a “collar”, a way of limiting the range of outcomes on a bet, which protected Milan from rising rates but which also meant it would have to pay out if they fell.
The city claims that it was originally promised interest savings of about €60m on the deal but has now made big losses because interest rates have fallen, triggering payments to the banks. Bankers with knowledge of the transaction claim that, in fact, the city has benefited from offsetting gains as the interest rate it pays on the underlying debt has fallen too. The prosecution also claims that the banks charged more than €100m in fees that were built into the price of the swaps and were not properly disclosed to city officials. The banks all deny any wrongdoing.
The outcome of the case will be closely watched elsewhere. In Italy alone, local municipalities had derivatives exposures with a face value of €25 billion last year, according to the Bank of Italy. Some academics reckon that losses on these may go as high as €8 billion. In many of these cases local authorities swapped fixed rates for floating ones, only for collars incorporated into the deals to leave them with losses as interest rates fell. In other cases, losses may only start to show when rates move the other way. Had their bets paid off, however, it seems unlikely that any cities would be crying foul.
Other egregious examples of financial incompetence can be found in nearby Germany, where scores of public authorities also signed contracts that they seem not to have understood. In Leipzig the courts have been asked to rule in a dispute between the city and UBS. That case relates to a complex sale-and-leaseback agreement that the city signed for its local waterworks. Part of the deal reportedly entailed the city agreeing to insure a portfolio of loans against default through a collateralised-debt obligation (CDO). Making good on those loans may bankrupt the city.
In all, about 100 German local authorities are thought to have entered into sale-and-leaseback agreements with American investors over the past decade in a bid to take advantage of loopholes in tax laws. In many of these deals local municipalities unwittingly agreed to take on credit risks for various counterparties, exposing them to demands for collateral as the ratings of institutions such as AIG, an American insurer, fell.
Municipalities in America are also grappling with derivative contracts they barely understand. The city of Los Angeles is pressing Bank of New York Mellon to soften the terms of an interest-rate swap on $443m of bonds that is costing the city money because rates fell. And Jefferson County in Alabama is teetering on the edge of bankruptcy after it entered into swaps that were worth more than $5.4 billion at their peak.
Sorting out this mass of claims and counterclaims will keep lawyers busy for decades. In the meantime, cities can expect to have less room for financial manoeuvre. On March 11th Italy’s Senate Finance Committee endorsed proposals that will restrict the use of derivatives by municipalities. It will, for instance, force them to get an opinion on a proposed deal from the Economy Ministry and require them to prove that a transaction would leave them better off than simply repaying their current debt. To keep dancing, high finance and low-level bureaucrats may need a chaperone.
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