For the 33,000 residents of Cassino, the Italian town’s attempt to cut its borrowing costs using derivatives was a losing bet the moment it was struck. The Wall Street bank that created the deal reaped an instant profit.
Cassino, flattened during World War II, signed a contract with Bear Stearns Cos. (BSC:US) in 2003 to swap the fixed rates it was paying on 22.5 million euros ($29.5 million) of debt for a variable rate, according to documents obtained by Bloomberg News last month under a court ruling. After the cost of the swap spiraled, the town sued JPMorgan Chase & Co. (JPM:US), which bought Bear Stearns in 2008, and the bank paid to end the contract, leaving Cassino with a 577,000-euro loss, more than half of what it pays each year to provide free nursery care.
The documents give the most detailed account of how opaque derivatives fashioned by securities firms are costing Italian taxpayers more than $1.2 billion, according to estimates by the country’s central bank. Firms such as JPMorgan and Deutsche Bank AG (DBK) sold swaps to governments from Greece to Jefferson County, Alabama, that offered the promise of cost savings while being stacked in banks’ favor. Cassino is now cutting nursery-care funding and has raised charges for garbage collection.
“The deal wasn’t likely to make Cassino better off,” said Satyajit Das, author of “Extreme Money: The Masters of the Universe and the Cult of Risk” and a former Citigroup Inc. (C:US) banker who reviewed details of the swap’s terms. “The city took on a complex cocktail of risks.”
The contract generated an initial profit for the bank of about 800,000 euros, according to a review of transaction documents by Bloomberg LP’s BVAL derivatives-valuation unit. In a separate analysis, Cambridge Systems Associates Ltd., a financial consulting firm based in Cambridge, U.K., estimated the profit at 690,000 euros.
The reviews were based on documents provided by Cassino as a record of the final contract with Bear Stearns in compliance with a ruling by a regional administrative court in Latina, Italy, that the papers be made available to the public under freedom of information laws.
The interest rate Cassino paid never dropped below 4.95 percent, even when market rates fell to less than that, according to the contract.
“We lost money, and if there are ways to recover the losses we will pursue them,” said Enzo Salera, Cassino’s finance director.
Cassino stopped payments on the swap in 2008 and sued the bank as Italy’s financial police began to probe the transaction. The following year, New York-based JPMorgan paid the city 386,000 euros in compensation, more than three times the town’s mark-to-market gain on the swap at the time, to end the contract and the legal fight, the documents show.
“JPMorgan Chase Bank’s involvement with this matter arose from its subsequent acquisition of Bear Stearns in March 2008,” a spokeswoman for the bank in Milan wrote in an e-mail. “Neither party had made any admission of liability and the underlying transaction has been terminated as part of the settlement. Both parties considered the outcome to be mutually advantageous.”
The settlement, details of which the city refused to disclose for more than two years citing a confidentiality agreement with the bank, may provide a template for other municipalities trying to recoup losses from bets on derivatives.
“The threat that the settlement arrangements by public entities may one day become public is a deterrent to bad practice and a further control of how public money is spent,” said Dario Loiacono, a Milan-based securities lawyer who has represented both banks and municipalities in swaps cases. “However, there is an equally important interest of favoring settlements by preserving the confidentiality of agreements and attorney-client privilege.”
Cities from Milan to Pforzheim in Germany also are seeking redress from banks that sold them derivatives that soured.
Bankers from Bear Stearns met with city officials in May 2003, the documents show. A month later, the bank’s Nicola Bonito Oliva and Alberto Guazzi wrote to Mayor Bruno Scittarelli detailing the proposed terms of the swap, according to the documents. The city didn’t seek competing bids from other firms, papers filed by the municipality show.
The contract agreed to swap Cassino’s fixed-rate payment on mortgages with Italy’s state-owned lender for a variable rate tied to the 12-month U.S.-dollar London interbank offered rate, or Libor (US0012M).
It was an “extremely risky” deal given that dollar Libor was at a record low, the police said in testimony to the Italian Senate in June 2009. Dollar Libor climbed to an almost six-year high of 5.76 percent in June 2006 from about 1.19 percent at the time the contract was signed. By the time the city settled, rates were still higher than when Cassino agreed to the swap.
The town also bet that the cost of borrowing against dollar rates would be lower than the cost of using euro rates as the benchmark. In the two years before the deal was signed, dollar Libor remained consistently lower than Euribor, a trend that reversed in 2004, when dollar Libor started rising over a flat Euribor, costing Cassino. Euribor, or the euro interbank offered rate, is the rate at which European banks say they see each other lending in euros.
Scittarelli resigned as mayor in July 2010, and the city was put under direct central government control until a replacement administration was elected last year. He declined to comment when reached by telephone, as did Bonito Oliva, the former Bear Stearns banker who now works at S2R Ltd., a London- based renewable-energy firm. Guazzi, who now works at Banca del Ceresio SA, a private bank in Lugano, Switzerland, didn’t return calls or respond to an e-mail.
Cassino, 80 miles southeast of Rome, gained in the first year of the swap, according to BVAL and Cambridge Systems. Then, as interest rates rose, Cassino started to owe the bank money, beginning with the half-yearly payment due in December 2004. The payments peaked at more than 500,000 euros in 2006. Over the life of the swap, the city paid about 960,000 euros to the bank, BVAL and Cambridge Systems said.
Even when rates fell in June 2008 amid the financial crisis and Cassino started making money on the derivative, its gains were limited by a clause that meant its interest rate never could fall below 4.95 percent.
Meanwhile, the mark-to-market loss for Cassino of as much as 800,000 euros the day the deal was struck would have translated into a gross profit for the bank. From that, the firm would have to meet the costs of hedging the transaction and set aside funds to cover counterparty credit risk, the possibility that Cassino might default on the agreement.
Bear Stearns also paid a fee to “third parties for their services” on the contract, the terms dated Aug. 5, 2003, show. The documents don’t identify the recipients.
As the contract drained Cassino’s coffers, town managers stopped payments in 2008 and sued the bank. Italy’s finance police estimated in 2009 that Cassino had paid as much as 2 million euros on the swap. An official at the federal auditor for the Lazio region said he couldn’t comment on the difference in the estimated losses because the probe is continuing.
Italy banned local governments from signing derivatives in mid-2008 as lawmakers reviewed existing rules. Concern that many municipalities misused swaps led legislators to hold a wider inquiry in 2009 into their use.
The Senate committee proposed barring towns that aren’t provincial capitals and have fewer than 100,000 residents from using derivatives. Banks that act as counterparties to swaps also would be prevented from advising towns on the suitability of transactions. The legislation is pending.
In September 2009, when JPMorgan agreed to cancel the deal, the bet was in Cassino’s favor by about 100,000 euros, BVAL data show. Cassino had sought 990,000 euros in compensation, according to the documents. As part of the settlement, the town dropped its claims in a Milan court for damages, and JPMorgan agreed to abandon a separate suit at London’s High Court seeking validation of the contracts.
Other cities also are seeking redress for derivatives. JPMorgan, UBS AG, Deutsche Bank (DBK) and Depfa Bank Plc (DEP) agreed last month to unwind interest-rate swaps with the city of Milan’s government in a 455 million-euro transaction. The banks, on trial for fraud, agreed to close the swaps at a gain for the city. In Germany, the city of Pforzheim is seeking compensation for losses of more than 56 million euros from JPMorgan.
Alabama’s Jefferson County filed for the biggest municipal bankruptcy in U.S. history in November after it defaulted on debt backed by sewer revenue. The financial crisis had pushed up the cost of its bonds, and swaps tied to the securities didn’t shield it from rising expenses. Greece’s losses on a 2001 swap with Goldman Sachs Group Inc. (GS:US) almost doubled to 5.1 billion euros by 2005. The country is now in the process of the biggest sovereign-debt restructuring in history.
“Transparency allows market forces to come in and act,” said Christopher “Kit” Taylor, a former executive director of the U.S. Municipal Securities Rulemaking Board. “Banks would come in and pitch a better deal if there’s poor pricing -- and it avoids the Greek problem. Had the Greek swap been known, it would have stopped other lenders giving it money.”
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