Risky Finance 22 November 2006

A rash of derivatives scandals a decade ago led to the tightening up of accounting rules for companies. But sadly not the same has been true of government accounting rules, at least in continental Europe.

Both central governments and local authorities alike have become heavy derivatives users. This generates enormous revenues for the investment banks that sell the instruments. Perhaps there are benefits to taxpayers too, but it is hard to understand what they are because, unlike the corporate sector, there is no requirement to disclose derivatives positions at fair value.

As a result, information about derivatives use by European governments tends to emerge in haphazard fashion via the trade press. For example, why did Life & Pensions magazine learn that the Italian debt management office had sold some €10 billion of interest rate options to Citigroup in January? Because insurance giant Munich Re wanted to explain why a similar amount of options it had bought from Morgan Stanley for hedging purposes had declined in value.

Investment bankers like to say that the lack of disclosure is besides the point. Italy exploited corporate activity in the options market to reduce its debt funding costs, saving taxpayers millions of euros. By introducing governments to such tricks, banks are making available strategies that were once the preserve of hedge funds.

But should governments act like hedge funds? Italy will only succeed in locking in the saving for taxpayers if it buys back the options it has sold at a reduced price. Otherwise Italian taxpayers could face unlimited options exposure as interest rates rise. As hedge fund aficionados know, market timing is everything in such strategies.

In the absence of full disclosure, there are more plausible explanations for Italy’s derivatives activity. Rather than a sign of growing hedge fund-like sophistication at the national debt office, could the options trade – put on in the dying days of the Berlusconi government—be a sign of desperation? With its debt level at well over 100% of GDP, and the deficit/GDP ratio at around 4.5%, Italy may have been trying to gamble its way out of trouble, secure in the knowledge that derivatives don’t have to be recorded on its balance sheet at fair value.

For an example of where this leads, look to Greece. In 2001, under its then socialist government, Greece was in a similar financial position to Italy today. Like Italy, Greece turned to derivatives, entering into a notorious series of swap deals with Goldman Sachs. These deals were ostensibly a humdrum exercise to re-jig the foreign currency mix of Greek debt, in line with perfectly permissible practice in the corporate sector.

In reality the deals were a ruse to conceal billions of debt—permissible within toothless Brussels accounting rules—using credit default swaps to transfer exposure to third parties. Because of the specialised nature of the transaction, the costs to Greek taxpayers far outweighed the benefits.

It took a change of government for this to be acknowledged. Addressing parliament in December 2005, Greece’s new finance minister George Alogoskoufis said, “our efforts to restore fiscal transparency have revealed concealed deficits, hidden debts, understating of public spending, overstating of revenues”. Indeed, the conservative administration of Kostas Karamanlis has become a torch bearer for government transparency in the EU.

This transparency, Alogoskoufis said, “revealed the detrimental swap agreements of 2001, which under a complicated structure of 12 different contracts led to the vanishing of E2.8 billion of debt. These swap agreements had a direct cost of E500 million in transaction fees and an indirect cost of E1 billion. They will cost the budget E400 million annually until 2019”.

Of course, some would say that the Karamanlis government has an incentive to denigrate the previous administration. Goldman, for its part, has said that the fees cited in Alogoskoufis’ speech are an overstatement.

None of this necessarily implies that Italy similarly fiddled its finances using derivatives. But it is hard to defend a culture of secrecy in government finance. The unequivocal message of the Greek disclosures is that secrecy combined with derivatives is a toxic cocktail.

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