Tuesday, March 23, 2010

Alabama and Milan make bankers nervous

Original published in the Financial Times by Gillian Tett:

Are the urbane, excitable citizens of Milan “sophisticated”? What about those of Alabama, USA? That is a question that could – and should – soon be provoking a welter of debate.

For while Alabama and Milan are rarely mentioned in the same breath, both locations now share something: they are making bankers nervous.

The reason is derivatives. Earlier this week, the city of Milan announced that it is suing Deutsche, UBS, JPMorgan and Depfa, for allegedly misleading the city on swaps that adjusted interest payments on some €1.7bn ($2.3bn) of deals. The banks deny the allegations relating to the case. The trial is scheduled to start in May.

Meanwhile, on the other side of the Atlantic – if not cultural spectrum – another battle has recently played out in relation to bonds and swaps arranged by JPMorgan for the city of Birmingham in Jefferson County, Alabama. Late last year, JPMorgan agreed to pay a $25m civil fine, make a $50m payment to Jefferson County and forfeit $647m in termination fees linked to swaps deals. This came after the Securities and Exchange Commission accused JPMorgan of malpractice (a claim that the bank neither admitted nor denied on settlement).

Now, I have no idea whether an Alabama-style settlement will emerge in Milan too: the legal systems differ, as do the details of the contested trades. However, the really interesting issue is whether this could be about to spark a wider trend.

After all – and as the Financial Times reported recently – the Milan deals are just the tip of an iceberg of complex financial deals that have been cut in recent years with Italian entities (including even religious orders). Moreover, those Italian deals are just one fragment of a vast global web of transactions that investment banks have sold to public, and quasi-public entities.

I daresay most of those deals have been arranged in transparent circumstances. Probably many have also left the clients happy. But some have not, particularly in the aftermath of the credit crisis. Thus, the scenario that now worries some senior bankers is that other western municipalities will look at the tale of Birmingham – or Milan – and lodge their own lawsuits.

The pain might not stop there. Many local government entities are saddled with public debt that they will struggle to repay. They also know that it is currently fashionable for politicians of all stripes to bash the banks. It is thus easy to imagine a scenario where some local government entities are soon tempted to seek haircuts on derivatives deals in all manner of ways (including legal suits).

And what makes that scenario doubly alarming for banks is that public sector entities do not usually post collateral when they cut derivatives deals; nor do banks usually price them to take account of future potential legal costs. The net result, in other words, is that some senior bankers are now quietly wondering if it is time for them to rethink how they assess and price municipal or local government risk.

Whether they will actually do that, remains to be seen. But as the anxiety swirls there is another issue where there is now an even more tangible need for a rethink – the question of what constitutes a “sophisticated” investor.

After all, a key reason why the banks have been able to stuff so many controversial deals into local authorities in recent years is that most bankers and regulators have assumed the world could be divided into two categories. In one box sat retail investors who were safeguarded by consumer protection laws; in the other, sat non-retail – such as Milan – who were considered to be “sophisticated”, and thus fair game for the banks’ sales teams. Caveat emptor. But the story of Italy (or Alabama) shows that this two-tier distinction is nuts. Some non-retail investors, such as hedge funds, are “sophisticated”, but many pension funds, or public sector entities are not. (In Italy, for example, some government officials purchasing the deals could not even read the English-language contracts).

If nothing else, this suggests that regulators badly need to rethink the two-tiered distinction (perhaps by creating a third, middle category of investors who are neither retail, nor fair game for banks.) In the coming months, Mary Schapiro, head of the SEC, is likely to do precisely that, by calling for a new definition of “sophisticated” investors. European regulators may do the same.

However, the banks need to act too, by voluntarily rethinking their definition of “sophisticated” clients. Doing that will not necessarily stave off lawsuits linked to past deals. But it might let them get ahead of the political curve, and even save costs in the long run. After all, legal disputes are costly for everyone (except lawyers) – not just in Milan, but Alabama too, not to mention all the other jurisdictions where more drama could yet emerge.

Comment letter from Adrian Jack:

Sir, Gillian Tett (“Transatlantic losses spark a sophisticated financial debate”, Insight March 19) overlooks a key factor in the litigation between local governments and the banks over derivatives and swaps. In a hedging contract, typically one party will accept a short-term loss for a chance of long-term gain while the other will take a short-term gain against the long-term risk. Entities controlled by politicians, such as cities and municipalities, will invariably prefer the latter position. The politicos get the kudos of the up-front money. But when the bets go sour, they will have moved on, or (even better!) the opposition party will be in power and will have to suffer the opprobrium and clean up the mess. Banks arranging the deals are aiding and abetting this conflict of interest on the part of the politicians. This is at the heart of the litigation.

Adrian Jack,
Barrister and Rechtsanwalt,
Enterprise Chambers,
London WC2, UK

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