The dark art of financial engineering
Italian 10-year bond yields are rising and the country cannot afford to lose credibility. Unfortunately, a can of worms is about to be opened
The word ‘derivatives’, along with a fair bit more of the financial lexicon, came to the attention of the man in the street at the beginning of the financial crisis in 2007. Derivatives, to most people, mean financial contracts which have been messed about with, and that is as accurate a definition as you are likely to get.
When the financial crisis began, Italy’s banks were thought to be in reasonable shape. The truth is that the banking sector was pleasingly outdated and whilst it had looked at these newfangled instruments it hadn’t really gone in for them.
Not so Italy as borrower. Whilst the financial crisis involved repackaging ‘sub-prime’ loans for investors, there is all manner of things the modern banking system can do for the indebted. Italians like these dark arts, this alchemy which can seemingly turn simple debt into something positively glistening and new. American and British bankers saw the potential and came here in droves.
First it was the local government: Regions (like Lombardy or Tuscany), Provinces (large regional cities) and even Communes were eager to restructure their debts. Clever financial engineers were able to devise instruments with a one-off payment to the borrower, paid for by higher interest rates over time. They are still looking for some of these one-off payments.
Now it is the turn of central government to come under scrutiny. In what appears to be a joint scoop between The Financial Times and La Repubblica, the left of centre broadsheet, it was announced on 26th June that a secret report by the Treasury, leaked to the two papers, concerned the revaluation in 2012 of existing derivatives contracts which could result in massive potential losses. Unnamed ‘experts’ consulted by the Financial Times suggest the losses could be as much as €8 billion. La Repubblica described it as “a time bomb in the public accounts”.
The following day Fabrizio Saccomanni, Minister for the Economy, moved to dampen speculation saying “This was a normal check by the Audit Office. There is no effect on the public finances”.
I don’t know if this statement will come back to haunt him like Harold Wilson’s infamous “It doesn’t affect the pound in your pocket” speech in 1967. A ‘mark to market’ unrealised loss may be as yet unrealised, but it should still count as a loss. And €8 billion is a sizeable sum: it is roughly what Italy needs (flowing in the opposite direction) to cover the abolition of the property tax and the postponement of the VAT increase due in July. Despite Mr Saccomanni’s words, this is serious.
The story doing the rounds is that in the late 1990s, when Italy was desperate to be accepted into the euro, the Treasury restructured billions of euros of debt to provide for lower outgoings. They received payments from the bank which offset the deficit, of course involving repayment some time in the future. The budget deficit went from more than 7 percent in the middle of the decade to less than 3 percent in 1998, the crucial year for acceptance. There was a suggestion at the time that ill-advised financial engineering may have caused this dramatic fall, that the books had been cooked, but nothing came of it.
Now Salvatore Nottola, head of the Corte dei Conti (audit commission) has referred the matter to the Guardia di Finanza (Financial Police). Nottola had said in his report on last year’s accounts: “the damage done to the state’s income constituted by negative outcomes of derivatives contracts is particularly critical and delicate”. But it is proving extremely difficult to get accurate information.
As Renato Brunetta, head of the centre right PdL in the House of Deputies said, “The state of Italy’s finances is like the formula for Coca-Cola: it is secret”. The Treasury has long been known for releasing as little information as possible.
One thing we do know, and we know it from filings to the American SEC, is that Morgan Stanley, the American investment bank, closed out on derivatives contracts last year, involving a payment from Italy to the bank of €2.57 billion. Morgan Stanley is thought to be the only counterparty which had a break clause of this nature. These other contracts have not been closed out yet. The €8 billion of potential losses are calculated on today’s market prices. Things could improve; or they could get worse.
One concern is the high percentage of losses. The €8 billion represents around 25 percent on notional values of €31.7 billion, which would suggest some fairly extreme restructuring contracts in the 1990s. However things might be even worse since the contracts were restructured again last year, when interest rates were particularly low. Following the Fed’s hints about the end of quantitative easing, and thus perhaps the end of cheap money, rates have been rising. Could Italy have lost money on both the first and the second restructuring? The inquiries already established by the Corte dei Conti will have to determine this.
Whatever the detail of the story, and the facts are bound to emerge eventually, the effects will be widespread. Mario Draghi, now head of the European Central Bank, was Director General of the Italian Treasury between 1991 and 2001. What did he know about this? Draghi recommended his old pal Vincenzo La Via for the job of Director General of the Treasury in 2012. La Via had worked with Draghi on managing the debt in the late 1990s.
And the European Union seems likely to be involved. It is reported that it knew the details of Italy’s derivatives at the time of its joining. Was the full extent known? Was Italy’s joining the euro nodded through by Helmut Kohl despite him knowing the figures were dodgy, as Der Spiegel suggested in its investigation last year?
And what else might be discovered when the can of worms is opened? Italian 10-year bond yields are already rising; the nation cannot afford to lose credibility now.
Tim Hedges had a career in corporate finance before moving to Rome where he works as a freelance writer, novelist, and farmer
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