Streetwise Professor

March 18, 2010

How Do You Say “Swaps are not free options” in Italian?

Filed under: Derivatives,Economics,Politics — The Professor @ 3:48 pm

A prosecutor in Milan, Italy has filed charges against four banks, alleging fraud in dealing swaps in the Italian city.  There are numerous other allegations of fraudulent marketing of swaps to municipalities, in Italy primarily, but also in the United States (e.g., Jefferson County, AL).

So far, the reporting is a bit sketchy, and in the Milan episode specifically, is driven by the prosecutor’s charges, and the flat (but uninformative) denials of the accused.  This article from FT goes into more detail about the issue generally.

Here’s my initial take.

According to the FT article, many of the municipalities borrowed at a fixed rate with the banks, and then swapped into a floating rate (by entering a receive fixed, pay floating swap).  This was all great and stuff when interest rates were low.  When interest rates rose, not so good.

But that’s a risk you take when you effectively borrow at a floating rate.  To the extent that losses resulting from rising interest rates are the basis for grievances–or legal action–against the banks that offered the swaps, I say tough luck.  You take a risk, and you shouldn’t be able to walk when that risk doesn’t pay off.   You can walk away from an option–but you have to pay money for that privilege.  (Once upon a time, in fact, options were called “privileges.”)  You entered into a swap, which costs nothing up front, and have to take the downside with the upside.

Other aspects of the deals are somewhat cloudier.  Because of options, in fact.  Some of the deals included collar structures (caps and floors).  These are embedded options.  A zero cost collar should have cap and floor strikes such that the values of the cap and the floor offset.  The banks are likely to be better informed about option values, especially given the very long terms on some of these transactions.  Thus, it is plausible, though not proven, that the options were mispriced in favor of the banks.

I am more sympathetic to such a claim, but not oodles more.  It would have been straightforward for a big entity like Milan, and many of the other affected governments, to hire a qualified, independent academic to vet the valuations.  Off the top of my head, I can think of a half-dozen very capable Italian finance academics that would have been overqualified to perform this rather routine exercise.  By spending a couple of thousand Euro in consulting fees, those now complaining could have saved themselves the millions of Euros they’re claiming they lost.  (A hundred million Euros, in the case of Milan.)  You’d think Italians would be able to understand the concept of caveat emptor.  (I don’t know how to say “due diligence” in either Latin or Italian, but the concept is the same in any language.)

There’s also an element of greed involved–and not just by the banks.  (Politicians and bureaucrats can be greedy?  Who knew?)  Many entities apparently renegotiated the deals frequently, and the new deals were priced off-market, but resulted in a cash payment to the municipalities at the front end.  This allowed the politicians to defer uncomfortable spending and tax choices.

But there’s no such thing as free money.  You get more money now, you have to pay more later.  Funny the way that works.  Again, the effective interest rate in the off-market swap vs. up-front cash payment might have been too high.  But again–that’s a fairly straightforward calculation to make, so hire somebody competent to do it.

The most likely explanation here is that nobody covered themselves in glory.  No doubt the banks saw suckers coming.  No doubt the municipalities were short sighted, greedy, and careless.  Funny how those two types seem to find one another, isn’t it?

The situation in Jefferson County, Alabama is somewhat different.  The county borrowed at floating rates through auction rate securities, then swapped that into a fixed rate.  That worked fine until the ARS market blew up, and the yields (and hence the county’s borrowing costs) spiked, and importantly, spiked relative to the floating rate in the swap.  This is a painful lesson in the risks of hedging.  You exchange flat price risk for basis risk.  In this instance, the basis blew out, and the hedger took a beating.

I haven’t followed the ARS debacle that closely (only so many hours in the day), but it seems that the implosion was an unexpected consequence of the unanticipated financial crisis.  It’s quite possible that both the banks and the county didn’t fully appreciate this basis risk.

To sum up, I’d say be very suspicious about sob stories and morality tales from municipalities that have lost money in derivatives deals.  In some cases, they took a risk, and they lost.  In other cases, it is possible that they were in fact overpaying to the banks on the other sides of the deals.  In still other cases, it’s likely that both things were true.  But from what I’ve read these deals weren’t so devilishly complicated that a qualified academic or independent consultant couldn’t have provided an analysis that would have prevented a municipality from entering into bad deals.  The municipalities should have some obligation to undertake due diligence, and letting them off the hook for failing to do so will only raise the costs of legitimate uses of such transactions.

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1 Comment »

  1. You are too polite to say it loud, Professor, so I will.

    This situation happens because in the municipal public sector, paying for a consultant means absorbing a few $$ of pain now. Not paying for one allows you to imagine you’ve deferred any pain indefinitely. Well, till after you’ve retired (same thing, right?).

    It’s like my mother says about lazy people. Being hard-working may pay off, but only in the future. But being lazy definitely pays off, right now.

    She also points out that lazy people are never happy people. Enough from my mother.

    A fool and his money are so easily parted that one wonders, pace [url=]Gordon Gekko[/url]*, how they ever got together in the first place.

    In this instance, of course, it was relatively straightforward because the fool simply got together with somebody else’s money.

    *apologies if that link doesn’t work. I cannot tell if your blog’s software likes these brackets: [ or these: <

    Comment by Martin — March 19, 2010 @ 6:03 am

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