In the world of a 10yr old, EPIC (TheEconomist)

This will likely be a seminal event in this period of global capital, currency and confidence chaos.  I am of the opinion that the CDS/CDO, leverage, lack of transparency, compromised trust and growth for the sake of growth are the core of the current problems.  This process might allow us to see a little more inside the real world of these goings on.  Adding to those works by many that have been given their perspective.  We know of pockets of this continent's municipal challenges, and are they possibly at risk from exposure to similar circumstances?  This case will provides its perspective.

Municipalities and derivatives

Cities in the casino

A derivatives farce makes its way to court in Milan. Others are sure to follow

Mar 18th 2010 | BERLIN | From The Economist print edition

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.

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