Wednesday, April 29, 2009

Milan Officials Seize Assets Of Firm Linked To Indy's Derivative Meltdown

Indianapolis Water Company officials are paying a penalty of at least $85 million as a consequence of its decision to issue a form of derivatives, interest rate swap notes, in lieu of long-term fixed rate bonds. The Indianapolis Bond Bank obtained insurance from Depfa Bank as part of those transactions. In Milan, government officials have seized $620 million in assets belonging to several major banks, including Depfa Bank, amid a probe into alleged fraud linked to the sale of derivatives. Bloomberg News reports:

The police froze the banks’ stakes in Italian companies, real estate assets and accounts, the financial police said in a statement today. The assets seized yesterday also include those of an ex-municipality official and a consultant, the police said.

The City of Milan is suing the four banks after it lost money on derivatives it bought from the lenders in 2005. The securities swapped a fixed rate of interest on 1.7 billion euros of bonds for a variable rate that was losing the city 298 million euros as of June. Milan is among about 600 Italian municipalities that took out 1,000 derivatives contracts worth 35.5 billion euros in all, the Treasury said.

“Milan is an important case because it can be used as an example by others,” said Alfonso Scarano, who is heading a study into the trades by AIAF, a group representing Italian financial analysts. “This is a unique time for borrowers to shed light on their potential losses and renegotiate contracts” to take advantage of interest rates that have fallen to record lows. AIAF will next week testify before the Italian Senate’s inquiry into the cities’ use of derivatives contracts.

Officials at all four banks declined to comment. In January, JPMorgan filed a lawsuit against the city in London. The bank is seeking to have dispute heard in the U.K., according to two people familiar with the claims . . .

The banks reaped about 100 million euros in fees from the transactions, Milan’s financial police said today. Public officials, seeking to cut the cost of their debt and help fund their budgets, turned to the banks to refinance borrowings from the state-owned lender Cassa Depositi e Prestiti.

The 30-year bond carried annual interest of 4.019 percent. With the derivatives, the city swapped the fixed interest rate for a floating rate set at 12-month Euribor. Milan also agreed to repay the principal by annual payments instead of at maturity, according to the city’s report . . .

The banks misled municipal officials on the advantages of buying the derivatives, including the impact of the fees they charged on the contracts, the financial police have said. The banks made three times more money from the cap than Milan did from the floor, according to the city’s report.

Local governments often entered into derivative contracts without soliciting bids from competing buyers. In 2007, Milan also sold a credit-default swap, exposing itself to the risk that the Republic of Italy might default, the document shows.

The Milan case is among lawsuits filed by local governments from Germany to the U.S. amid allegations of mis-selling and fraud. Italy’s Senate is leading a review of the use of derivatives among local administrations.

Anyone planning any investigations here? Or will we just make taxpayers foot the bill as usual?


varangianguard said...

These are not the low-down, dirty polecats you're looking for.

Move along.

Anonymous said...

Failed derivitive swaps are the reason that we can pump $45 billion dollars into a bank who then shows less then a $2 billion dollar profit - and even then the profit is only because the government agreed to change accounting standards, allowing banks to remove their most toxic assets from their spreadsheets.

The derivative swaps are nothing more than a ponzi scheme, designed to profit those banks who got in on the early action. Now that the pyramd is collapsing, we have trillions of dollars in "speculative" profits that are simply disappearing as their values spiral out of control. So... when the Fed indebts us to trillions of dollars in bailouts, what's happening is that the money is simply going "poof" and disappearing into thin air. It's nothing more than a buffer to keep banks from going so far into the red that they aren't even viable enough for nationalization. Those on the profit end of the banking system remain solvent while the rest of us pick up the tab.

With regards to Indianapolis, the impact of derivative failures isn't new on the radar:

Here's more on the topic:

Unigov said...

There ought to be a law (!) about utilities engaging in risky ventures, like this one, or like Citizens Gas buying gas futures.

CG bought futures last year at the peak, and the result was Indy heating bills were double what they would have been had CG simply bought gas at spot prices.

Somebody makes a ton of fees in these deals, and I wonder if someone else's pocket is being lined. Just sayin'.

Jason said...

There isn't anything wrong with derivatives as long as they're used to hedge instead of speculate. The gas company should be creating a true hedge. We may have paid more than had they bought at the spot price, but there should be an offsetting gain via lower fees some time. Citizen's is in the gas business, so the derivative hedge makes sense. You're giving up potential gains via lower spot prices for certain expense caps.

The Water company is a different. I believe the interest rate swaps were more speculative in nature.

fulpy said...

Here's how the swap transaction would work. City enters into a swap with a counterparty agreeing to pay a fixed rate and in return receiving a variable rate based off of either Libor or the SIFMA (tax-exempt index). City then issues variable rate bonds. The model is that the rate on the variable rate bonds should roughly equal the rate received on the swap, offsetting each other, making the interest rate cost being the fixed payment to the counterparty.

However, where things can and did go wrong is the type of bonds that are issued, the liquditiy provider, collateral requirements, and the swap counterparty. I don't know if the water company issued auction rate bonds, but that market went to hell in a handbasket, and the rates on those types of bonds were well above what issuers were receiving on their swaps. There is another kind of variable rate bond that isn't an auction rate, but requires a liquidity provider. Think of liquidity like a co-signer agreeing to pay off the bonds if they fail to sell at the next sale (these bonds are sold at an interval (say weekly), and each successive sale pays off the prior bondholders). However, in a bondholders mind the risk of the bonds is now on the liqudity providers health, not the issuers. So if a liquidity provider has issues, the rate on the bonds will spike because bondholders don't want to own the bonds because they aren't sure they'll be able to sell them if they needed to. So when firms like Depfa, and Dexia started to run into issues, municipalities across the country were screwed as they watched the rates on their bonds spike to in some cases double digits.

The last concern is 2 pronged and that is the risk of the swap counterparty with the issuer. If you issue fixed rate bonds, the issuer has no credit exposure to outside parties, and the bondholders only have exposure of the bond issuer. But a swap transaction exposes the issuer to the credit risk of the swap counterparty (with dire consequences for those issuers with swaps with Bear Stearns and Lehman). In addition, because swaps are marked-to-market, both parties may be required to post collateral if the mark on the swap exceeds a threshold. Think of it this way, you'll loan your brother a $100 unsecured, but if he asks for $1000, you want $900 in collateral in return. That's what's happening all across the country because interest rates are so low, the mark on the swaps is giving the banks large exposures to municipalities across the country.

I will say one more thing. I know a lot has been made of the water company paying to break the swaps and go fixed rate. The main reason for them doing this is because liquidity has gotten extremely scarce and if you can get it, extremely expensive.

A deal this big should have had a financial advisor on it as well as possibly a seperate swap advisor. It would be interesting to see if one was used in this case. I wonder if CDR Financial was involved. Google them to see what they're up to (one of the firms in the Bill Richardson investigation in NM).

Gary R. Welsh said...

Umbaugh acted as financial advisor to the IWC on the original derivative issues. Bear Stearns & City Securities were co-parties to the swap agreement.