Smart Bankers + Dumb Politicians = Unhappy Taxpayer

I stole the title from a Globe & Mail reader, Marvin Android, in regards to a story speculating on potential losses by Italian governments from derivatives contracts:

In a test case, a judge in Milan will decide in coming weeks whether to try 13 people and four banks – UBS, Deutsche Bank, Germany's Depfa and JPMorgan Chase & Co – on aggravated fraud charges. The case stems from a derivatives swap over a €1.68-billion 30-year bond, the biggest issued by an Italian city.

Milan, Italy's financial capital, is facing a €100-million loss on the deal, city officials say. Milan is also suing the banks for €239-million in overall liabilities.

In the southern region of Puglia, prosecutors are seeking to bar Merrill Lynch, a unit of Bank of America Corp, from government contracts for two years. The move stems from derivatives losses from €870-million in regional bonds.

JPMorgan, UBS and Deutsche have denied wrongdoing, and Depfa has declined comment. Merrill has not commented.

Almost 500 small and large Italian cities are facing mark-to-market losses of €2.5-billion on the contracts, according to the Bank of Italy. Analysts say that figure will balloon when interest rates go up.

Most of the contracts involved switching fixed rates on loans to variable ones with banks.

Generally, these situations are ignored when the government (or whomever else) is making money off the derivatives contracts. But when the contract turns against the government (or other) entities, it turns into a crisis. It's still not clear what the final losses will be, or if there may even be gains, but, so far, it doesn't appear to be very good for those Italian government entities.
Part of the problem is that accountants, auditors, financial experts and other officials working for the government either don't care about their employer (the government) or are simply incompetent in their duties. In some cases, I suspect some of these working on behalf of the government probably think they can outsmart the bankers or whoever is on the opposite side of these contracts; yet, as businessmen and investors know all too well, don't mess with the bankers when it comes to money. Sure, the banks or others involved in the derivative business may be wrong at times, but the successful ones will be far better in understanding finance and risk than these governments.
Of course, as is often the case—Italy but elsewhere too—the government and its employees who cut these derivative deals atempt to back out of their contracts by suing the bankers or whoever else they signed the contract with. This may make it more palatable to the public and provide some short-term benefit but it is very detrimental in the long-run. If someone can't have faith in the financial contracts, well, we might as well rip up everything and go back to the stone age. Even worse, charging the bankers with "aggrevated fraud"—I assume this is a somewhat serious charge—is simply going to drive investors away.
I personally think the banks aren't doing themselves any favour in the long run. If the banks end up being correct, it ends up looking like they are taking candy from a baby—often to the tune of hundreads of millions of dollars. After all, is the public or a neutral observer more likely to be sympathetic to the government, whose expertise isn't finance, or to the bankers, who are specialists in finance and appear to be concocting opaque and difficult-to-understand instruments? Don't the shareholders of these financial institutions realize that they are destroying their other businesses in good standing (like retail banking) by dabbling so much in the high risk derivatives arena?
When it comes to America, one good thing is that American municipalities got burned badly in the 90's with derivative contracts* and hence haven't used them much in the last decade—at least that's my impression (I am not too knowledgeable about this market and may be wrong though.)
If there is any positive from any of this, it's the fact that derivatives are a zero-sum game (although a country may show a loss while the profits may accrue to foreign companies and citizens.) So it isn't really a net loss per se. In contrast, the collapse of real estate can be a net loss and would be far worse.
Foot Note:
* The most famous, and the largest municipal bankruptcy in American history, is the fall of Orange County, California, in 1994. Orange County ended up with a $1.7 billion loss due to derivatives. Reading The Globe & Mail article I linked above, I get the feeling that the Italian cities, as a whole, may post losses possibly higher than Orange County (there are many more towns and cities here and some like Milan are far larger than Orange County.) Ultimately it comes down to the nature of the derivatives contract and the actual outcome.


  1. The main issue with these contracts seems to be the incentives involved. Most of the Italian municipalities took up¨front payments in exchange for contracts that they knew were moneylosers longer term. The politicians signing of on the deals did not care that their municipality would lose a fortune as they expected to be long gone by the time the shit would hit the fan. Meanwhile, the upfront payments allowed them to buy nice stuff for their voters. So much nicer to bury your corruption in arcane contracts nobody really understands. (compare Greece burying debt in swap contracts that would lose a pile of money long term bur produced upfront payments)

    The bankers may not have counted on becoming generally hated though... It certainly looks as if a lot of politicians are seeing a great opportunity to get out of these contracts. (not that they will give back the upfront payments mind you)


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