Banks swap rewards for risk on public deals

April 9, 2014

By Dominic Elliott

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Investment bankers are wising up about reputational risk. Deutsche Bank and UBS are now loath to offer long-dated swaps to municipalities. New capital rules making it less attractive to enter into long-dated interest rate swaps partly explain why. But the legal tussles and bad publicity from dealing with public sector clients are a bigger factor.

Arranging swaps – simple derivatives that exchange the costs of fixed and floating interest rates – is less profitable than it used to be. Basel III requirements are hiking capital charges on long-dated derivatives. And new rules requiring swaps to be centrally cleared will probably hit margins.

But UBS’ decision to all but abandon long-dated swaps transactions for municipalities – and Deutsche’s call to limit the duration of its deals to three years – say more about the perils of dealing with public sector clients. Even if the bank has done a good job, the normal rules of caveat emptor don’t apply.

Take Detroit, which pledged future casino taxes as collateral for an interest rate swap that hedged against future pension risk. The city’s bankruptcy should have netted the two banks that took the other side – UBS and Bank of America Merrill Lynch – $286 million. But a local judge’s intervention means the two banks may not even receive a third of that amount.

Then there’s Italy. Some 525 Italian local authorities entered into interest rate swaps worth an estimated 35 billion euros between 2001 and 2008. High fees and a series of restructurings after an original 2005 transaction for Milan left the city nursing big losses, and the four banks involved – Depfa, Deutsche, JPMorgan and UBS – settled a civil suit with the municipal government in 2012. The banks were cleared of separate fraud charges on appeal last month.

Not all investment banks are fessing up to having changed their ways like UBS and Deutsche. But bankers with long memories will recall that swaps sold back in the 1980s to London’s Hammersmith and Fulham Council caused a similar stink. Those staying in the market 25 years on should be aware that derivatives and the public sector remain a toxic combination.

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