By Vernon Silver and Elisa Martinuzzi Aug. 27 (Bloomberg) –In June 2005, Milan’s city council voted to hire four banks to arrange Europe’s biggest-ever municipal bond sale at a fee of just 0.01 percent. That minuscule cost puzzled one councilman. “I had a hunch something was wrong,†says Basilio Rizzo, one of 14 politicians on the 60-member council who tried to change the deal after becoming suspicious of the banks’ motives. “Banks can’t do things for free.†Rizzo was onto something. Depfa Bank Plc, now a unit of Hypo Real Estate Holding AG; Deutsche Bank AG; JPMorgan Chase & Co. ; and UBS AG charged Milan 168,532 euros ($239,189) to find investors for 1.69 billion euros of bonds — the promised 0.01 percent. That wasn’t all. As part of the deal, the same four banks were hired by the city to advise it on how to use the new bonds to restructure its existing debt in a way that would cut costs. The banks had two pieces of advice for Milan: First, the city could save money by buying interest-rate swaps, which are derivatives designed to keep monthly payments low as rates change. Second, the institutions best prepared to sell them those swaps were none other than the banks themselves. The four banks thus play four roles — as underwriters, advisers, swap dealers and counterparties in the derivative contracts. Undisclosed Fees The group of banks wrote in a June 3, 2005, letter that the bond issue would save Milan about 55 million euros over the 30- year life of the bonds. The firms never said what their fees on the swaps would be, public records show. Today, Milan faces so-called mark-to-market losses of 231 million euros on its swaps, according to council member Davide Corritore. In all, the city’s losses include at least 101 million euros in hidden fees, according to Milan prosecutor Alfredo Robledo , who’s investigating the swap deals. The fees were buried because they were built into swap interest rates without any written explanation, the prosecutor says. That 101 million euro price tag for Milan’s dealings with the four banks was 599 times the original figure of 0.01 percent for selling bonds and providing advice. Without seeking competitive bids, the city agreed on June 16, 2005, to let the four banks sell them swap contracts. Neither the new swap rates nor the costs associated with them had been part of the original vote by the city council. Seeking Indictment Robledo said in July he would ask Milan judges to indict Depfa, Deutsche Bank, JPMorgan, UBS and 14 individuals, including two city officials, on fraud charges in connection with the swap deals. He said the banks were bound by U.K. securities rules because their London-based bankers managed the transaction, which was signed in London. The banks violated regulations by failing to inform Milan in writing that for the swap deal the city was no longer a customer, but a counterparty to the banks, Robledo said. Banks are required to shield customers from conflicts of interest and provide them with clear and fair information that isn’t misleading. The banks had agreed to abide by those rules. The soured Milan swap deals are part of a string of such transactions that have stung local authorities. The Italian Finance Ministry, through its Financial Police unit, is examining contracts worth 9.11 billion euros signed by 46 cities and regions, according to a June 10 report. Global Phenomenon The city of Turin, combined with the surrounding region of Piedmont, had a total of 2 billion euros of swap contracts outstanding. Turin and Piedmont had lost 214 million euros combined on their swaps, according to Italy’s state-owned RAI television network. Italy’s tales of swaps, losses and conflicts of interest are part of a global phenomenon in which local governments have signed contracts they had hoped would lower their debt payments. In many cases, taxpayers later discovered the swap deals held risks and expenses that their elected and appointed officials didn’t expect or understand and that banks hadn’t disclosed. In September 2008, JPMorgan closed its municipal derivatives unit in New York almost two years after the U.S. Justice Department began its largest-ever criminal investigation of public financing. Prosecutors sent letters to five JPMorgan bankers saying they were likely to be indicted. No charges have been filed, and JPMorgan declined to comment. Jefferson County, Alabama, the state’s most populous county, has been on the verge of bankruptcy for more than a year because $3 billion in swaps meant to lower its borrowing costs backfired and credit ratings for its bond insurers were lowered. More Losses Italian government bodies with swap contracts, from mountaintop towns to entire regions, have so far seen losses on paper of at least 1.93 billion euros, according to data from the Rome-based Bank of Italy. After suffering losses, some countries, including Poland and the U.K., have restricted municipalities from engaging in derivative transactions. In mid-2008, Italy temporarily banned public derivative contracts. “Municipalities and local governments around the world have target signs painted on them for bankers,†says Satyajit Das , a former derivative banker at Citigroup Inc. and Merrill Lynch & Co. and author of “Traders, Guns & Money†(FT Press, 2006). “They’re generally not financially sophisticated, and they’re under pressure to raise money,†Das says. “And nobody in the derivative business is willing to actually be truthful.†Low Odds Cities and regions worldwide that have entered swap deals were bound to lose from the start, says Marcello Minenna. The head of quantitative analysis at Consob, Italy’s financial market regulator, Minenna holds a master’s degree in financial mathematics from New York’s Columbia University and a doctorate in applied math from Universita degli Studi di Brescia. He analyzed a typical municipal interest-rate-swap contract with terms that were representative of those issued around Italy in the past few years. He found the odds of a locality’s benefiting from such a deal on the day the contract was signed were 0.16 percent. Minenna, 37, showed how these likely day-one outcomes allow banks to build hidden fees into swap contracts and said banks could easily disclose them to clients. Banks included such hidden or implicit costs in swap contracts that Milan and other cities signed to switch fixed interest rates on loans to floating ones, Das says. Concealed Fees Banks that drafted the contracts were able to conceal the fees by calculating them into the new, variable yield . They also set limits on how high or low the rate could go, known as the cap and the floor. Interest-rate swaps require a municipality and bank to exchange payments as frequently as every month. Each participant in a swap contract is called a counterparty. Banks tell governments that swaps are intended to save the public money. The amounts that change hands are based on various global lending rates. Bankers set swap terms to their advantage without telling clients by using computer programs that project likely future rates that signal what the odds are of profiting from any combination of yields, floors and caps, Minenna says. “Even when interest rates change, the government entities don’t benefit from lower rates because of limits built into the contracts,†Minenna said at a June 12 presentation in Rome to Italian municipal administrators who’d gathered for a conference on derivatives. ‘Just Gets Worse’ “The local government’s position, in terms of the costs and the ability to renegotiate, just gets worse,†he said. To exit an unfavorable swap deal, a city has to pay its current liability from the contract to the bank. If a municipality sticks with the deal, it keeps paying predetermined rates that may be to its disadvantage. That’s the fix the Umbrian city of Polino, population 290, finds itself in. In 2005, it swapped an average fixed rate of 4.65 percent on its 547,367 euro loans for a variable rate that could go no lower than 4.3 percent and no higher than 7.16 percent. From the moment the hilltop town’s officials signed the contract, Polino was out 11,000 euros in an upfront fee that wasn’t disclosed in the agreement, according to data compiled by Bloomberg. When prevailing interest rates later decreased, the contract’s floor prevented the city from benefiting. The city has lost as much as 27,000 euros on the deal, which is the amount it would have to pay to cancel the contract. Stopped Payments For a city that size, that amount covers the cost of fixing and cleaning streets for a year. So the city decided not to pay the bank anything and await the outcome of the Milan dispute. Polino Mayor Ortenzio Matteucci says he agreed to the deal because other, bigger cities had entered into swap contracts. “I thought, ‘Can the Province of Terni and all the other municipalities bigger than us, such as Milan, all be wrong?’†says Matteucci, 59, a retired steelworker. The Milan case has led to a public swap showdown with hundreds of millions of euros at stake. The city sued the four banks in January, alleging they hid profits on the sales. And the Financial Police, acting on prosecutor Robledo’s behalf, seized 345 million euros in assets from the banks’ Italian accounts on April 27, pending resolution of the cases. Negotiated Return The banks have since negotiated the return of some of the assets after agreeing to a cash guarantee for an amount equal to each bank’s share of the 101 million euros in allegedly hidden profits from the swaps. Frankfurt-based Deutsche Bank and Zurich-based UBS argued in civil court in Milan that the city was aware of fees charged on contracts for derivatives. “The city of Milan was a sophisticated counterparty which fully understood the nature of its transactions with JPMorgan,†bank spokesman David Wells says. “We are vigorously defending the legal proceedings brought by the city and are confident that the strength of our legal position will ultimately be demonstrated through the judicial process,†he says. “JPMorgan further considers that the JPMorgan employees involved in the transactions acted with the highest degree of professionalism and entirely appropriately.†Deutsche Bank says it did nothing wrong. “We believe that our case is compelling and will prevail,†the bank says. “We are also confident that our employees involved in the transactions acted with integrity.†Market Rate The fact that Milan already had derivatives meant the city was sophisticated in such transactions, a lawyer representing UBS says. Milan officials understood the four banks’ potential conflicts of interest, and the banks gave the city a market rate for the swaps, the lawyer says. Officials at Munich-based Hypo Real Estate and officials for the city of Milan declined to comment. Milan’s recent journey through the opaque world of interest-rate swaps began in January 2005, when bankers from JPMorgan sent letters to the city suggesting ways to refinance Milan’s debt. At the time, Milan owed about 1.2 billion euros in variable-rate mortgages at an average cost of six-month Euribor plus 0.26 percent. It also held 524 million euros of fixed-rate mortgages at an average cost of 5.16 percent, according to transcripts of council meetings. Some of those mortgages were accompanied by swaps the city had entered into three years earlier with another bank, Milan- based UniCredit SpA , Italy’s biggest lender. Closing Swaps In letters to Giorgio Porta , Milan’s director general, JPMorgan bankers Antonia Creanza and Antonio Polverino argued the town could save money by selling new debt. JPMorgan said that would pay off the liability while taking into account the need to close previous swaps, court documents show. Robledo has said he’s also seeking to indict Porta for fraud and collusion for his role in helping to oversee the debt restructuring. A lawyer for Porta declined to comment. Robledo said in his asset seizure request that it’s significant that the banks’ early pitches discussed the process of unwinding old derivatives. Later correspondence, after Milan selected the four banks, didn’t discuss those costs — an omission the prosecutor says was part of the alleged fraud. As the banks’ proposals made their way from Porta to other members of the city’s governing council, or giunta, the elected officials chose to take advantage of the chance to save on their debt by pushing out payments over a longer time period. Re-Election The city was about 100 million euros short of its budget target that year after plans to sell a stake in Milan airport company SEA SpA had been blocked by a court. Giunta members were coming up for re-election the following year, and cutting expenses wasn’t a viable option, according to a January deposition by Porta. The city opted instead to refinance. On May 3, 2005, members of the giunta voted to hold a competitive tender to select banks for the refinancing. Citing the potential for savings from eliminating payments on existing debt, the giunta vowed to replace existing mortgages provided “the entire transaction is financially advantageous,†according to a deliberation cited by the prosecutor. The city gave banks a week to pitch for the role, city documents show. Milan judged the contenders based on experience in managing other municipal bond sales, as well as their fees for selling both 20- and 30-year debt. Didn’t Ask While the city also sought the banks’ derivatives credentials, it didn’t ask how much the swap contracts would cost the taxpayer. On May 20, bankers gathered at Milan’s Palazzo della Ragioneria, a municipal building across the road from La Scala Opera House, to hear the announcement of the winning bids, says council member Rizzo. Milan selected Depfa, Deutsche Bank, JPMorgan and UBS. All four agreed to charge the lowest fee that had been proposed, the 0.01 percent Depfa had bid, public records show. The next day, council member Rizzo, 62, a bespectacled, graying nuclear physicist who has served on the Milan council since 1983, started raising objections to the process. He told the council that the winning offer, with the 0.01 percent commission, was essentially free, so the process must be flawed. “I’d like to point out that in the coming three-year period, the benefit would be 174.1 million euros,†the late Mario Talamona, who was then Milan’s budget commissioner, told the city council, according to a transcript of the June 13, 2005, council meeting. ‘Who Will Run It?’ Rizzo remained skeptical, meeting records show. The following day, at a June 14 council session, he asked: “Will there be a tender for the swap? Who will run it? How will our counterparties be chosen? Wouldn’t it have been more useful to have a tender on that?†Rizzo now says, “There needs to be a separation between those that are advising the city’s administration and those who act as counterparties in derivative transactions.†The tiny commission should have raised a danger alert, says Piero Burragato, a former derivatives banker at Dresdner Kleinwort Benson and Nomura Holdings Inc. who hasn’t been involved in the Milan transactions. “An underwriting fee of 0.01 percent looks unreasonably low indeed, particularly so in relation to the underwriting risk of a fixed-rate, 30-year bond,†says Milan-based Burragato, who now advises companies on restructuring. Comparative Fees Similar deals in Italy in the same period have carried fees of 0.3 and 0.45 percent of the face value of the bonds. Without derivatives, the transaction couldn’t have been done. The 30-year bonds themselves needed swaps because Italian laws, intended to keep municipalities solvent, prohibit a city from pushing off its obligations so far into the future. What’s more, if Milan replaced its mortgages with a bond, the city would need to dispose of its existing swaps. When the banks gave Milan officials their overview of the deal’s financial benefit to the city, they didn’t mention the swaps, according to court records. The banks sold the bonds on June 24, 2005. That day, during a meeting at Deutsche Bank’s London office, Milan finance director Angela Casiraghi first learned the financial details of the swaps; the banks had never addressed potential losses, she says now. “They always said that the city, at the end of the 30 years, would have saved,†Casiraghi said in a Jan. 19, 2009, deposition in prosecutor Robledo’s investigation. ‘Never Showed’ “They never showed the potential problem of a negative mark-to-market,†meaning that based on current interest rates, Milan could lose money under the contract, forcing the city to pay the banks if they ever needed to exit the deal. Three days after the bond sale, Milan and the four banks signed the swap contracts related to the bonds. Three months later, as Milan used the bond proceeds to pay off its old mortgages, the four banks oversaw the second derivative deal: the unwinding of the swaps related to those old loans. At the time, those swaps had a value of 96 million euros in favor of the bank, UBI, a unit of UniCredit. To get out of the swaps, Milan would have to compensate UBI by that amount. The prosecutor hasn’t accused UniCredit of any wrongdoing. The city did it in parts: Milan paid UBI 20 million euros. The group of four banks absorbed 48 million euros, using extra, hidden fees it had taken from Milan in the bond-related swap contracts, prosecutor Robledo says. Hidden Cost And Milan paid off the final 28 million euros by rolling that debt over into another derivative contract with UBI, which charged the city 2 million euros, or 7.14 percent, in a new implicit fee, Robledo found. Robledo learned the amount of that hidden cost because he has access to the financial records of the Italian bank, which booked the implicit fee as revenue. In mid-2007, Robledo began his probe of the four banks, the bankers and some city employees. The prosecutor had been steeped in high-profile investigations before. He assisted former U.S. Federal Reserve Chairman Paul Volcker in probing kickbacks in the United Nations oil-for-food scandal. And he has pursued a case against Italian Prime Minister Silvio Berlusconi for false accounting and embezzlement. The three-time premier has fought off the charges, which have been temporarily suspended, partly because allies in parliament passed an immunity law in 2008 shielding him from prosecution. Bellwether As Robledo prepares to bring the banks to trial, local government officials around Italy are watching the case as a potential bellwether, saying they hope it might lead to improved terms for their derivative deals. Magenta , a town of 25,000 residents just outside Milan, is one of many municipalities that have lost money on swap deals — and now is looking to its larger neighbor for help. In 2001, Magenta bought interest-rate swaps from Caboto Holding SIM SpA, which is now a unit of Milan-based Intesa Sanpaolo SpA , on 4.6 million euros in fixed-rate loans. Magenta then restructured the deal in 2005 and 2006, signing similar contracts with the same bank. “The problem is that there’s never been an adviser, and our contact at the bank essentially took on the role as our consultant,†says Diana Naverio, director general of the city of Magenta. “This is the conflict of interest that’s talked about. There was never an objective third party.†Crimp Plans Magenta has a mark-to-market loss of about 120,000 euros, according to Naverio, down from about 900,000 euros a year ago. The possibility of future losses may crimp the city’s ability to plan, says Luca Del Gobbo, Magenta’s mayor. In the past year, Magenta has sought to round up 19 municipalities from three northern provinces and consulted with a lawyer in efforts to force banks to renegotiate the current deals. “One town against the bank probably can’t get anything better,†Del Gobbo says. “But we’re banding together under the slogan we’ve adopted: ‘He who with harmful derivatives flourishes, with collective legal action perishes.’†What happens next — in Magenta or hundreds of other Italian cities — depends on Milan. Das, the former derivatives trader, says the four banks are likely to settle with Milan prosecutors. That agreement may leave swap practices worldwide unchanged. So, he says, he expects municipal officials will continue to hand over money to banks in deals they don’t understand. “Cities still think they can get money for nothing,†he says. “The bankers are laughing.†To contact the reporters on this story: Vernon Silver in Rome at vtsilver@bloomberg.net ; Elisa Martinuzzi in Milan at emartinuzzi@bloomberg.net
