Bloomberg News

JPMorgan’s Swaps Occupying Cassino Prove Curse Like World War II

January 04, 2012

Dec. 28 (Bloomberg) -- World War II’s Battle for Cassino leveled the Italian town and its hilltop abbey. Now, the 33,000 residents are digging out from the rubble left by Wall Street.

Six decades after U.S.-led forces ousted the Nazis from Cassino, a new generation is grappling with the fallout from the debts of postwar rebuilding -- borrowings that grew because of a derivative that backfired. Soaring costs forced Cassino, 80 miles southeast of Rome, to settle an interest-rate swap with JPMorgan Chase & Co. in 2009, leaving the town unable to pay for daycare for 60 infants and services for the poor.

For Iris Volante, who chairs Cassino’s assembly finance committee, the bankers who share responsibility for peddling the derivatives should pay with their jobs. She, like Occupy Wall Street protesters around the world, is demanding an overhaul of the financial system to stop history from repeating itself.

“Heads rolling is the least we would expect,” Volante, a 57-year-old gynecologist who also has worked for the city for more than a decade, said in an interview in a Cassino cafe earlier this month. “When people’s attitude is to cheat others, new rules are needed to prevent it happening again.”

Cassino, whose government office overlooks a U.S. tank and other war relics in the town’s central square, plans to cut funding for its daycare center and may ask families to pay several hundred euros a month per child after running out of other cost-cutting measures, said Volante. The town already has reduced staff to about 250 employees from about 450 by not replacing those who left or retired, she said.

Milan Trial

While the New York-based bank led by Chief Executive Officer Jamie Dimon has no retail branches in Italy, it didn’t hesitate to sell complex swaps to municipalities over the past decade. In Milan, JPMorgan and its employees are on trial, along with Frankfurt-based Deutsche Bank AG, Germany’s Depfa Bank Plc and Switzerland’s UBS AG, for allegedly tricking the city into buying the contracts in 2005. The banks deny any wrongdoing.

Across Italy, cities faced with shrinking income and rising expenses bought swaps from JPMorgan, the largest U.S. bank by assets, and other lenders to cut short-term interest costs, putting them at risk of paying more in the long run. Cassino purchased a 22 million-euro ($28.7 million) contract from New York-based Bear Stearns Cos., acquired by JPMorgan in 2008, which switched interest payments on the town’s debt from a fixed rate to a variable one. The rate, a record low at the time the contract was signed in 2003, soared over subsequent years.

About 300 municipalities, from the toe of Italy’s boot to the Alps, were losing a total of 912 million euros on such derivatives as of March, Bank of Italy data show.

Brian Marchiony, a spokesman for JPMorgan in London, declined to comment.

Jefferson County

Local governments and regulators in Germany and the U.S. also have brought cases against banks, including JPMorgan, over derivatives contracts.

The German city of Pforzheim sued JPMorgan a year ago over 56 million euros of losses on interest-rate swaps. A hearing at the Frankfurt Regional Court is scheduled for Jan. 16. Marchiony declined to comment on the case.

In the U.S., JPMorgan was investigated by the Justice Department, the Securities and Exchange Commission and attorneys general in 25 states for its role in rigging the bids of investment contracts. The bank agreed to a $228 million settlement this year on charges that it conspired to overcharge cities at taxpayer expense, acknowledging responsibility for illegal, anticompetitive conduct by former employees.

In 2009, JPMorgan entered a $722 million accord with the SEC to end an investigation into its role in selling derivatives that helped push Jefferson County, Alabama, to declare the biggest municipal bankruptcy in U.S. history. The bank paid $75 million in fines and restitution and wrote off $647 million it was owed by the county.

Interest-Rate Swaps

The sales happened before Dimon took over as CEO in 2006. In September 2008, the bank said it would stop marketing interest-rate swaps to municipalities.

Banks globally sold $707.6 trillion of over-the-counter derivatives as of June 30, about 18 percent more than the $601 trillion at the end of 2010, according to data published by the Bank for International Settlements last month. Counterparties would have to pay $19.5 trillion to replace the contracts at market rates, the data show.

Interest-rate swaps account for more than three-quarters of the total, BIS data show. The Basel, Switzerland-based group doesn’t break out what percentage is bought by municipalities.

JPMorgan was the largest global dealer of interest-rate derivatives among U.S. banks in the third quarter, according to data from the Office of the Comptroller of the Currency. The bank had $75.4 trillion in notional derivatives within its JPMorgan Chase Bank NA subsidiary, of which 77 percent, or about $58.1 trillion, were interest-rate contracts, the data show.

‘Without Thinking’

Dimon, 55, led the charge in the U.S. against new banking regulation, criticizing Federal Reserve Chairman Ben S. Bernanke in June for saddling lenders with too many proposed rules. The rules, to be overseen by the Fed, are meant to avert future financial crises and banking abuses.

“Banks pitched deals without thinking about the well-being of others and created lots of financial problems for many towns,” said Carmelo Palombo, a former Cassino official who helped negotiate the settlement with JPMorgan. The agreement stopped the city from losing even more money, said Palombo, without providing details.

Secret Settlement

A 2001 Italian law said local authorities could buy swaps only if the transactions would improve municipal finances. Italy banned governments from signing new derivatives contracts in mid-2008, and the Senate finance committee approved recommendations in March 2010 that would prevent towns that aren’t provincial capitals and have fewer than 100,000 residents from using derivatives. Those rules are still pending.

Cassino sought to keep the settlement terms secret, citing a confidentiality clause in its agreement with JPMorgan. An administrative court in Latina, Italy, in September backed a case brought by Bloomberg News under Italian freedom of information law asking the town to make the swaps contract and settlement public.

The city plans to comply with the court order, said Enzo Salera, Cassino’s finance chief.

In Milan, Dimon’s bankers say they played by the book, adhering to rules that allow swaps dealers to withhold details, including how much they’re charging their customers. Hidden charges on derivatives contracts are what Milan prosecutor Alfredo Robledo says made them fraudulent.

Robledo says banks charged 101 million euros in fees in selling the derivatives that adjusted payments on the city’s 1.7 billion-euro bond offering in 2005 and in later restructurings.

Gross Margin

“Every time I sold a derivative to a public administration, even before getting to the details, the first question was always, ‘How does the bank make money?’” Antonia Creanza, an executive director at JPMorgan in London said in court Sept. 21 under questioning by her lawyer. “I would explain that we would retain a margin. Never has a legal adviser told me, ‘Look you need to detail the gross margin.’”

Banks seek to earn a gross margin when they agree to a swap with a client by skewing the terms to their advantage, Creanza, 42, a member of the bank’s interest-rate team at the time of the Milan deal, testified on Sept. 28.

The gross margin is “photographed” when the deal is struck, Creanza said. That value is then managed by a trader over the life of the contract, its magnitude varying as the derivative agreement changes in value, she said. The final profit for the bank can’t be known until maturity, said Creanza, who declined to elaborate further.

‘Asymmetry of Information’

The bank didn’t tell the city of Milan how much it was charging, and the municipality could have sought competing bids from other banks or independent advice, she said.

Creanza said she earned a bonus that year, a payment JPMorgan had guaranteed irrespective of her performance when the firm lured her from a competitor in December 2004. She didn’t say what the bonus was.

The city of Milan is seeking damages as part of the criminal trial.

“There’s an asymmetry of information between banks and local governments, which have stringent limits, not least in their spending,” Letizia Moratti, 62, Milan’s mayor from 2006 through May of this year, said in court last month. “There was a clear conflict that the banks didn’t highlight.”

Watershed Events

In Cassino, which lies on an ancient road connecting Naples and Rome, residents curse two watershed events: the five-month battle in 1944 that claimed more than 70,000 casualties and turned the town into a moonscape, and the day in 2003 that the government entered a seven-year swap with Bear Stearns.

The contract, which adjusted payments on about 22 million euros of debt, switched the city’s 4.7 percent fixed interest rate for a variable one, according to a June 2009 report by Italy’s financial police. The floating rate was based on the U.S.-dollar London interbank offered rate, or Libor, an “extremely risky” bet given that it was at a record low, police said in testimony to the Italian Senate that month.

Three-month U.S. dollar-Libor was at 1 percent in June 2003 and by January 2006 had surpassed 4.7 percent, according to data compiled by the British Bankers’ Association. The measure climbed as high as 5.7 percent in September 2007 as credit markets began to seize up, before declining to a record low of 0.25 percent by December 2009 after policy makers cut rates.

Depleted Funds

Cassino started losing money on the swap with the third half-yearly payment, paying about 2 million euros after Libor soared, according to police testimony. That depleted funds intended for sanitation and road works that the city raises from parking tickets and federal grants.

The transaction was presented as advantageous to the municipality at the time, said Volante, who worked as a city culture chief when Bear Stearns pitched the deal.

For Cassino, whose rundown postwar architecture bears little of the ancient charm of neighboring towns, the challenge now is to cut services without damaging the most vulnerable residents, said Danilo Grossi, the city’s education chief.

A new administration, which took over after May elections, will boost charges for the city-run nursery starting next year to help pay the 900,000 euros it costs to operate annually, said Grossi. Talks with the families have begun, he said. The town is still grappling with a shortfall that in 2010 forced out the previous administration and led the federal government to take financial control of the municipality.

Helping the Poor

Cassino’s pain has increased as Italy’s economy contracted in the third quarter, signaling that the country may have entered its fifth recession since 2001. Facing soaring borrowing costs amid investor concern that the nation may struggle to repay its debt, Prime Minister Mario Monti’s government is adopting austerity measures that may further weigh on growth.

While Cassino eventually extracted itself from the swap, the damage may be lasting, according to Giuseppe Lauro, a retired manager for Italy’s largest power company, Enel SpA, who now volunteers for church-sponsored charity Caritas Italiana. The shrinking local economy and cuts in city spending are creating a growing class of poor, he said.

On a foggy December morning, as local politicians were busy hosting Italy’s Chamber Speaker Gianfranco Fini to mark the 150th anniversary of the nation’s unification with songs in the town’s Teatro Manzoni, Lauro was looking after the poor, picking up the pieces of the city’s financial wreckage.

About half of those who sought assistance from Caritas in Cassino for the first time in 2009 were of working age, seeking help with paying bills and food and clothes, a 2009 study by the charity showed. More than half of those who relied on Caritas were below 40.

“We need more city funds,” Lauro, 66, said in an interview at the charity’s shelter, a few hundred yards from town hall. “The city’s demise means there are new poor and they’re younger. They need jobs.”

--With assistance from Lorenzo Totaro in Rome, Karin Matussek in Berlin, William Selway in Washington and Martin Braun and Michael J. Moore in New York. Editors: Robert Friedman, Frank Connelly

To contact the reporters on this story: Elisa Martinuzzi in Milan at emartinuzzi@bloomberg.net; Vernon Silver in Rome at vtsilver@bloomberg.net

To contact the editors responsible for this story: Melissa Pozsgay at mpozsgay@bloomberg.net; Edward Evans at eevans3@bloomberg.net


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