Warren Buffett once referred to derivatives as "financial weapons of mass destruction" created by "madmen." Real WMD have rarely been used. However, derivatives are used quite a lot, a $600 trillion per year market dominated by a narrow oligopoly of mega-banks. It appears that Italy got hit by the derivatives WMD in January.
Last week, it was belatedly disclosed that the government of Italy paid Morgan Stanley $3.4 billion to terminate derivatives contracts that had been in place since the 1990s. For Italy, facing precarious finances and painful austerity, this is a damaging loss of cash. Italy has raised sales taxes by $7 billion for this year as part of a plan to put its house in order, so half will go to Morgan Stanley. Bloomberg reminded us that this is only part of the story. Italy is reported to owe over $31 billion in connection with derivatives overall. For perspective, Italy is struggling to implement an $80 billion austerity plan that cuts its $1 trillion budget and raises taxes.
This is nothing new. The Hellenic Republic of Greece entered into a similar € 2.8 billion swap with Goldman Sachs in 2001 that came back to haunt them as they faced down default. Local governments in the United Kingdom, Italy and Germany have all been burned by derivatives, some successfully claiming after the fact that the prior governments had no authority to enter into the obligation to avoid payments.
And, in the United States, derivatives fiascos abound, having driven Orange County, California, and Jefferson County, Alabama, into bankruptcy, just to name two of the local governments that have been hard hit. While regulations under the Dodd-Frank Act have been disappointingly weak in their disclosure requirements on banks dealing with US local governments, the regulators may still use enforcement actions in the future to curb the most extreme examples. History demonstrates that they should be forceful in this area.
Italy entered into these swaps and options to acquire swaps in response to its mushrooming debt in the 1990s that caused the interest rates on its bonds to hit 10%, an unsustainable rate. Bloomberg reports that the derivatives reduced current interest payments, spreading them out over periods as long as 30 years.
It is critical that the use of derivatives to reach this result does not camouflage what happened. Derivatives always involve extension of credit in complex and obscure ways, and can easily be structured to loan money up front. The details of the Italian derivatives contracts are not known, but that really does not matter to the substance of the deal. The reports make clear that Italy borrowed money from Morgan Stanley to pay current interest costs and agreed to repay it over a period up to 30 years. Comments in the press that the government was simply trying to reduce debt service costs are completely misleading by suggesting benign prudency. The fine points of the financial engineering simply do not matter to the underlying substance. They only obscure it. These transactions were meant to borrow money in an incredibly risky way, hiding the substance of the transaction from the public and sometimes skirting regulations.
Can we assume that Morgan Stanley provided Italy with a fairly priced deal, with fulsome disclosure? That may not be a fair assumption. After all, recent academic work catalogues evidence that even the "quants" of Wall Street do not understand the actual value of the derivatives they peddle to clients. It is entirely possible that Italian taxpayers paid far more than they should have because the government never understood the amount being charged or because Morgan Stanley miscalculated the actual value of the transaction and over-charged unwittingly.
Giving Morgan Stanley the benefit of the doubt, the fundamental question is whether the mega-banks should be doing these types of transactions with governments even if they are fairly priced and disclosures are made. This is not a question whether Morgan Stanley or any other bank violated a law or even intentionally misled the governmental customer (though to think that banks uniformly resist the temptation to rip off government customers by slight manipulation of valuation assumptions or other methods is really naïve beyond imagination). The answer to that question must await further disclosures.
At the threshold, it is a question of morality and fundamental fairness. First of all, it is abundantly clear that very few governments are able to comprehend the complex risks of derivatives. Furthermore, outside advisors to governments, who are after all financial markets participants, are often only marginally better qualified to evaluate the transactions than their clients. And they almost always have significant interest in currying the favor of the mega-banks that they are hired to evaluate.
But most important, these transactions are often designed to drive a wedge between decision-makers, who are constantly concerned with elections and short-term results, and the interests of the publics that they serve. Governments are not business corporations. Elected officials live and die by cash budgets, not returns on investment in plant and equipment. Cash today has a present value to a corporation based on the value of the productive use of that cash. For a politician, the present value may be infinite in terms of electoral results. In our societies, drug users face consequences that often include criminal sanctions. But pushers face far greater sanctions. In judging the morality and fairness of banks offering structured derivatives to governments, the analogy is apt.
An example that I am personally familiar with might provide a good example to today's banks. When Orange County, California, was looking to do a huge interest rate swap deal in the late 80s, one firm decided not to participate in the lucrative opportunity: the pre-Greg Smith era Goldman Sachs. By 1994, the county had lost $1.5 billion on the derivatives deal and declared bankruptcy, dragging most of Wall Street into protracted litigation. The co-head of Goldman's fixed income division, Marc Winkelman, retrieved the letter he had sent turning down the deal and hung a framed copy in his office.
There just may be executives at Morgan Stanley that wish they had such a letter hanging on the wall.