RESHAPING WALL STREET

RESHAPING WALL STREET
It is the first big test of US President Barack Obamas plans to rein in the excesses of a seemingly unrepentant Wall Street.And the most sweeping overhaul of financial regulation since the Great Depression may not clear its first hurdle in the Senate on Monday,as Republicans held out for a bipartisan deal.Obama and the Democrats need at least one Republican to side with them in a procedural vote in order to begin debate in the Senate.

Game-Changing PROPOSALS



PREVENTING MORE BAILOUTS


Squash the idea that some financial firms are too big to fail.Prevent future bailouts like AIGs.Seek middle ground between bailout and bankruptcy through orderly liquidation process.

PROTECTING CONSUMERS


Stop abusive home mortgages,credit cards.Senate bill creates Financial Consumer Protection Bureau inside Federal Reserve.

VOLCKER RULE


Ban risky proprietary trading,unrelated to customers' needs,at banks with cost-of-capital advantage gained from taxpayer-funded bailout.

OVER-THE-COUNTER DERIVATIVES


Police $450-trillion OTC derivatives market.A hothouse for risk during boom years,it amplified the financial crisis.Obama wants OTC trading through exchanges to boost transparency,risk comprehension and price competition.

SYSTEMIC RISK


Create new entity to spot and head off next crisis.Senate bill sets up nine-member council of regulators,chaired by the Treasury Secretary.

POLICING BANKS


Rationalise bank supervision system to stop problems from festering in the cracks.Fed to keep oversight of bank holding companies with assets over $50 billion.But Fed would lose power over state banks with less than $50 billion in assets.

REGULATING HEDGE FUNDS


Hedge funds must register with government,opening their books to more scrutiny,but Senate bill exempts venture capital funds and PE funds.

FIXING SECURITISATION


Make securitisation market more transparent and accountable.Bill forces securitisers to keep baseline 5% of credit risk on securitised assets.

EXECUTIVE PAY & SHAREHOLDER RIGHTS


Give shareholders more say on executive pay and more clout in electing directors.

CRACKDOWN ON RATING AGENCIES


Boost SEC's power over credit rating agencies.Senate bill also seeks to curb use of unneeded ratings,and exposes raters to more legal risk.

Come clean on OTC deals

IF BANKERS FEEL THERES no fun left in Manhattan,they will move to London or Singapore.A slew of stifling regulations may only fatten other financial centres.As long as there is no limit on the money that central banks can create,financial markets will move from one bubble to another.Capping salaries of bankers may be the easiest to achieve,but will serve very little.Separating safer businesses like deposit taking from riskier ones like derivatives would question the very existence of modern banks that depend on low-cost deposits to cut aggressive deals.What can help,but only a little,is to make banks and hedge funds report their over-thecounter derivative deals and spell out how much of these are collateralised.That could be a rough and ready way to figure out the degree of risk.

How I caused credit crunch - Goldman CDO man

The writer of a book entitled "How I caused the credit crunch" worked for the unit of Goldman Sachs that sold the financial product at the heart of U.S. fraud allegations against the bank.

Tetsuya Ishikawa's name appears on the preliminary term sheet for the Abacus 2007-AC1 deal, a collateralized debt obligation (CDO) the U.S. Securities and Exchange Commission accuses the bank of using to commit fraud.

"Tets" Ishikawa, who is Japanese by birth but grew up in London, was educated at the elite British school of Eton and at Oxford University, according to a short biography in his 2009 novel. He left Goldman in 2007 and then worked for Morgan Stanley, structuring, syndicating and selling credit derivatives to investors.

His name and London phone number are on the Abacus term sheet as one of six people in the "Global Syndicate" group, part of a wider contact list that also includes Fabrice Tourre, the 31-year old Frenchman who has been charged with fraud by the SEC.

Goldman is vigorously defending itself against the U.S. accusations, contesting the idea that it was selling the CDO in the knowledge it would collapse so as to allow hedge fund manager John Paulson to bet against it.

Ishikawa's novel, about a fictitious Oxford graduate, "tells how a novice to the mysteries of hedge funds, subprime mortgages and CDOs can fix complex deals worth billions in the exclusive bars, brothels and trading floors of London, New York, Frankfurt and Tokyo," a blurb on the back of the book says.

The idea for the novel was born when Ishikawa was telling his friends "about the cliched high life I had been living while creating and selling billions upon billions of these securitization and credit derivative products, now better known as 'toxic assets'," the preface of his book says.

Ishikawa was made redundant by Morgan Stanley in May 2008. He now works for fixed income house Amias Berman & Co in London. He could not be reached for comment through his current employer. A spokeswoman for his publisher, Icon Book Ltd., said he did not talk to the press.

The book -- which contains a financial glossary -- uses no real names and says "any resemblance to actual firms of persons in this book is entirely and genuinely coincidental."


Based on an article that appeared in http://thewallstreetchallenger.com the use of Synthetic CDOs after 2005 would have been very risky. Since home prices grew at a high rate till almost the end of 2007 and peaking in 2005, CDOs backed by MSS were an ideal high return investment till approximately November 2005.

Using home prices forecast it is hard to believe that the financial institutions and credit rating agencies involved in the CDO business had sophisticated risk analysis simulations, but did not forecast price movements of the underlying collateral.

CDOs played a notable role in the financial markets. Did the CDO cause the financial crisis or was it blindness, greed and the need for riskier assets? The constructors of the CDOs may not bear direct responsibility. Rather their reckless use, misunderstanding and ignorance of key warning signs likely contributed to the magnitude of the financial crisis. You can observe the financial landscape today and recognize from the survivors, walking wounded and the absentees those who knew and those who had not understood the use of these tools.

Another disaster by Swaps......

Water and electric customers in the Seattle area, most of whom pay U.S. taxes, will pay an additional $14 million to get out of an agreement with American International Group Inc., the insurance company rescued from insolvency in 2008 by American taxpayers.

The fee from the Snohomish County Public Utility District, serving Boeing Co. and 320,000 other electricity buyers, will settle a nine-month-old dispute with AIG, according to a copy of the accord obtained under state public records law. The municipal power company and AIG sued each other over a contract created in 1994 to help Snohomish reduce its borrowing costs by $2.9 million -- an early version of a financial derivative known as an interest-rate swap.

Snohomish is among at least 1,900 public institutions from Puget Sound to the Aegean Sea that sought to lessen interest expenses using similar agreements with potentially hazardous results. Harvard University in Cambridge, Massachusetts, paid more than $900 million to get out of swaps that backfired when interest rates unexpectedly plummeted, increasing its costs.

Borrowers have paid as much as $5 billion to Wall Street to exit swaps since 2008, according to Peter Shapiro, the managing director of Swap Financial Group LLC, an adviser in South Orange, New Jersey.

“There’s a lot of so-called sophisticated stuff ginned up by the finance industry,” said William Kittredge, a former utility director in Oregon who is now director of the nonprofit Center for the Study of Capital Markets and Democracy in Arlington, Virginia. “When you’re talking about public money, it’s not the way to go.”

Exchanging Payments

In an interest-rate swap, parties exchange interest payments on a set amount of debt, often with the goal of locking in a fixed rate on a related set of variable-rate bonds. During the 2008 credit crisis, interest owed by local governments on floating-rate bonds exceeded payments they received under swap agreements.

Such “synthetic fixed-rate” deals pushed Jefferson County, Alabama, close to bankruptcy two years ago. It had refinanced $3 billion of debt with variable-rate bonds and purchased swaps to guard against borrowing costs rising. Its expenses soared when insurers guaranteeing the bonds lost their top credit grades, and the rate the county received fell.

‘Reckless Traders’

The Snohomish utility, which faced increased swap-related payments of about $5 million a year, resisted paying to exit its contract for almost two years. In its suit against AIG, Snohomish alleged that a “now-infamous unit of reckless traders” had “drawn a bead” on the utility. In the end, Snohomish opted to pay the termination fee and sell 15-year bonds to replace all its floating-rate debt, said Jim Herrling, senior manager of risk management and supply for the utility. Those bonds sold yesterday at 3.18 percent.

Snohomish projects it will save $14,179,907.63 in budgeted interest costs over the life of the new debt, Herrling said. All but $133,782 of that will go to AIG in the termination payment.

That fee is enough to buy a new energy-efficient refrigerator for 11,864 homes, based on estimates from the U.S. government’s Energy Star program. It amounts to about $43.75 for each Snohomish electric customer.

“The ratepayers I don’t think are going to be paying any more in the long run,” Herrling said. “They’re just making this payment up front and we’re reducing our future debt service payments between now and 2025.”

“We’re pleased that we have settled this matter,” said Mark Herr, a spokesman for New York-based AIG, which is 80 percent owned by the U.S. government after a 2008 bailout. Neither party made any admission of liability in the settlement.

Battled Enron

The Snohomish utility, located in Everett, Washington, 30 miles north of Seattle, unearthed audiotapes of Enron Corp. traders discussing manipulating California power prices in 2004. Enron, the bankrupt energy-trading company, had sued Snohomish over canceled power contracts. The utility paid $18 million, 10 cents on the dollar, to settle the suit in 2007.

In 1994, Snohomish needed money to build transmission lines, replace electrical poles and add street lighting.

Jerry Bobo, a banker at the time for New York-based Smith Barney Inc., recommended borrowing $58.3 million for 30 years at floating rates, using a swap agreement to lock in a fixed rate lower than Snohomish could obtain by issuing conventional bonds. The savings might total $2.9 million, according to a Smith Barney presentation obtained by Bloomberg through state public records law. In 1998, Smith Barney became a unit of Citigroup Inc., the bank rescued by taxpayers in 2008.

Reset Weekly

Rates on the debt, known as variable-rate demand bonds, would reset weekly. AIG agreed to accept a fixed 6.2 percent payment from Snohomish and pay the floating rate. A traditional fixed-rate bond at the time might cost the utility 6.95 percent, according to the bank’s presentation.

Through today, that spread saved the utility more than $4 million, according to Anne Spangler, the general counsel for Snohomish.

The power company gave up something more valuable: the right to refinance the bonds without penalty if interest rates changed, said Andrew Kalotay, a former Salomon Brothers bond analyst who is now a consultant in New York. That created significant risk for the borrower over the contract’s 30-year term, he said.

Kalotay compared it to a homeowner accepting a mortgage that would require extra charges in advance for refinancing. Private borrowers typically use swaps only to cover short-term rate movements of six months or less, he said.

Smith Barney’s presentation to the Snohomish utility portrayed the longer term of the accord as a way to save money.

‘No Significant Risks’

“The economics of a swap are such that the financial benefits of the transaction increase as the swap term increases,” one slide said. Another mentioned that credit raters would view the structure as fixed-rate debt.

“The result: True Synthetic Fixed Rate Debt,” the slide said. “No significant risks.”

“They could have done the same thing much more cheaply by using plain-vanilla, fixed-coupon bonds,” Kalotay said. “The swaps are a way for the banks to make a lot of money. Every 10 swaps municipalities enter into, nine of them turn out to be completely inappropriate.”

The floating-rate debt stood to make Smith Barney more in fees. Bobo acted as salesman and adviser as the utility debated the transaction. Then, his bank served as both underwriter and “remarketing agent,” responsible for setting weekly interest rates once the floating-rate debt was sold.

Additional Fee

That last duty earned a fee: 0.1 percent a year, or $1.7 million over the life of the bonds, according to documents presented to Snohomish officials. Those terms helped the bank earn more than double what it would have underwriting a traditional fixed-rate bond, the documents show.

Bobo, who has an office in Seattle, didn’t return telephone calls seeking comment. Citigroup spokesman Alex Samuelson declined to comment.

Floating rates on the utility’s bonds fell to as little as 1 percent to 2 percent from 2002 to 2004, while the utility was paying AIG 6.2 percent. Until mid-2008, Snohomish paid AIG a net $25.7 million, court filings show.

Demand for the bonds dried up during the 2008 credit crisis. The lack of liquidity was so severe it was likely to trigger a provision of the contract that, AIG said, would limit its own payments to the utility to an amount based on international bank rates. The power company would have to pay the higher floating rates, resulting in $5 million of additional annual costs.

Buying Back

Utility bond counsel William Doyle told Snohomish commissioners at a board meeting in September 2008 that they should buy back the bonds and put them into a trust. That would force AIG, then in the midst of a government bailout that totaled $182.3 billion, to pay the floating rate.

AIG’s lawyers questioned whether the arrangement was permissible under the bond agreements during a conference call. Doyle, of the firm of Orrick, Herrington & Sutcliffe LLP in San Francisco, “cut off the question,” according to AIG’s court filings. He declined to comment. The trust purchased the bonds in October 2008.

In July, AIG sued the utility in New York state court, saying the refinancing breached the swap agreement because the 58-page document required “written consent” from AIG for any purchase of the bonds. Snohomish then filed its suit against AIG in federal court, and the cases were consolidated in Seattle. The settlement disposes of it.

Citigroup was the senior underwriter of this week’s debt sale. The utility also added a co-manager, Barclays Plc, said Herrling, Snohomish’s financing manager.

“When you have two desks working your deal, you’re making sure you’ve got some checks and balances there,” he said.

The case is Public Utility District No. 1 of Snohomish County, Washington, v. AIG Financial Products Corp., U.S. District Court for the Western District of Washington (Seattle).

Melinda French Gates: Raising the Bar on College Completion

April 20, 2010
Prepared remarks by Melinda French Gates, Co-chair and Trustee

Thank you for your kind introduction, Dr. Spilde. And thank you all for a very warm welcome.

It is a special honor to speak to this association. Bill and I started learning about community colleges in earnest a few years ago, and it was immediately obvious that you don’t get the credit you deserve. One of the best-kept secrets in American public life is that you teach almost half of all college students—and you do it on a shoestring. For millions of young adults, you provide the only realistic opportunity for a better life.

I am here today to thank you on behalf of the Gates Foundation. Since we got involved in postsecondary education, we have been fortunate to have the benefit of your experience.

Now, we are embarking on a strategy to help twice as many students earn a postsecondary degree, and we need your help again. If you take the lead, we are very optimistic about what we can accomplish together.

Our mission at the Gates Foundation is to help all people have the opportunity to live a healthy and productive life. In the United States, we started by working on an issue that is still a passion for Bill and me: college readiness. In 2006, Warren Buffett’s amazing gift gave us the ability to effectively double our giving, and we began to ask, What else? What could we do to extend opportunity to more people?

We spent a year considering dozens of possible investments, and our research painted a stark picture. The pathway to opportunity now runs from high school graduation, through college enrollment, and finally to college completion.

Our college readiness investments were explicitly targeting high school graduation and college enrollment, but not college completion. So we decided to build on them with investments in postsecondary education.

We didn’t start with community colleges, but it’s where we ended up.

My favorite part of this work is meeting community college students. Bill and I are always moved by how much they value education. They encounter countless barriers and obstacles, but they keep struggling to overcome them, because they understand how important a college degree is for a successful future.

Last year, we met a young man named Cornell at Central Piedmont Community College in Charlotte, North Carolina. We asked him to describe his typical day. He clocks into work at 11 p.m. When he gets off at 7 the next morning, he sleeps for an hour. In his car. Then he goes to class until 2 o’clock. “After that,” Cornell said, “I just crash.”

One of his classmates, a single mom named Paris, joked that her one-year-old son thinks her chemistry book is a toy. And no matter how many times she explains it to him, he simply won’t respect the sanctity of homework time. But Cornell and Paris keep working toward their degrees—they cope with the sleeplessness and the guilt and the unrelenting pressure—because they are focused on improving their lives.

Central Piedmont is about an hour away from Greensboro, North Carolina. Fifty years ago, four African-American students at a segregated college in Greensboro started a movement by sitting down at the Woolworth’s lunch counter. The stools were for white customers only. Black customers were allowed to eat, but they had to stand up. Three days after the first sit-in, 300 students protested in front of Woolworth’s. Those heroes were demanding much more than just the right to sit and eat; they were demanding equal access to the American Dream.

Now, more than 200,000 African-American students attend 58 community colleges in North Carolina. They are pursuing the same dream their grandparents sat in for.

Community colleges in every state in the union have written their own stories of equal access—not just for African Americans, but for all Americans who have been denied the opportunity they have a right to.

There are now more than 1,000 community colleges, which is one of the main reasons why the United States has some of the highest college enrollment rates in the world.

But the American Dream is more than access to college. It is also the better future that is supposed to come with access. A reliable income. A rewarding career. A nice home, in a safe neighborhood, where parents can raise a happy family.

The evidence is clear on this point. Students need to earn a certificate or a degree to achieve these goals. According to every conceivable measure—employment rates, wage premiums, job market forecasts, you name it—the line between the haves and the have-nots runs right through your institutions. Students who go on to earn a degree will be able to seize a set of opportunities that will remain out of reach for students who don’t.

The problem is that the latter group, the have-nots, is larger than the former group. Completion rates at community colleges are somewhere around 25 percent. I know the exact figure is controversial. Community colleges are unusually complex, and it is hard to collect solid data. But we should be able to agree that the 25 percent figure is in the right ballpark. The reality is: More than half of community college students never earn a degree.

There are many good reasons for low completion rates. A few students never plan to graduate in the first place. Many more drop out because they’re not prepared for college-level work. Others have to drop out because life intervenes: Sometimes, it proves to be impossible to juggle school, work, and family. Often, they re-enroll, but then life intervenes again.

Regardless of the reasons, we have to accept the fact that completion rates are far too low, because that’s the first step toward the goal of raising them.

Community colleges led the way on college access. Now it is time to lead the way on college completion.

I understand that what I am proposing would be extremely difficult under the best circumstances. And these are hardly the best circumstances. You face historic funding cuts and historic increases in enrollment.

More students, less money: For community colleges, this represents a crisis.

In a crisis, you can either keep doing what you’ve been doing, or you can change. In this case, if you stay on the same path, you will gradually find yourself able to meet fewer and fewer of your students’ needs. But if you change—if you innovate—you can teach your students in new ways that yield dramatically better results for a fraction of the cost.

I want to be clear that innovation doesn’t always involve a new technology. Sometimes, it’s just a smart idea that comes from looking at an old problem from a new angle. But no matter what form it takes, innovation can change the calculus of intractable problems—and make them tractable.

The area where the need for innovation is most urgent is remedial education. Our research indicates that improving remediation is the single most important thing community colleges can do to increase the number of students who graduate.

I understand that some of you don’t consider developmental education to be a core part of your job description. And it may be true that high school is supposed to prepare students for college. But while some of you say that high schools should live up to their end of the bargain, high schools answer that they meet the standards that have been set for them. In the meantime, about 60 percent of incoming community college students test into at least one remedial class.

The problem is that there’s a gap between high schools’ standards and colleges’ expectations. As a result, millions of students are falling through a giant crack in our public education system.

The Gates Foundation is working on the readiness problem at the high school level. And we’re seeing progress, especially the fact that 48 states have agreed to put common core standards in place. The goal is to make sure that all high school students graduate having taken the classes that prepare them for college.

That’s a step in the right direction, but it won’t fix the problem right away. For the foreseeable future, millions of unprepared students will continue to enroll in community colleges.

Yet developmental education is treated as an afterthought at many community colleges. It’s not that you don’t spend money on it. Remediation represents a huge investment on the part of community colleges. You devote more than $2 billion a year to it. And yet it is the stage at which the most students drop out.

Why?

Imagine you’re 18 years old, with high school diploma in hand. You’re optimistic about the future. You decide to go to college. You get a job, determined to pay your tuition while meeting all the other responsibilities that come with being an adult.

But according to your placement exam, you don’t have the skills you need to do college-level math, so you’re sent to a remedial class. Right away, your dreams of going to college are deferred, because technically you’re not in college. You’re paying college tuition, but you’re not earning college credits.

You failed the test because you’re shaky on a couple of key concepts, but the class doesn’t zero in on those concepts. Instead, it starts from the beginning of algebra again—and it covers all the material you already know. A few months and a few thousand dollars into learning very little that’s new and making no progress on your degree, you might start to wonder if your college dreams make any sense.

That is a common experience. If you start in a remedial class, the odds are that you will never finish a credit-bearing course in that subject. That is a pitiful return on investment.

The fact that we lose the majority of students who enroll in a remedial course amounts to a default on our promise of access for everyone. What kind of access is it when we send half the students into classes we know they probably won’t finish?

But innovation can help you avert this crisis. It can help you teach more students, more effectively—for less money.

There are dozens of proven examples of innovation in remedial education. El Paso Community College is coordinating with local high schools to make sure students making the transition to college know what’s expected. El Paso’s students take the college placement test while they’re still in high school, and they can take a summer course at the college if they don’t pass the first time.

Mountain Empire Community College in Virginia has designed new lesson plans and textbooks geared toward helping students get through the remedial phase much faster. Students in these fast track courses at MECC review arithmetic in a single week during the summer, and algebra in just two weeks.

Here in Washington state, a program called I-Best lets students do college-level work while they are still taking basic skills classes, instead of having to pass all their remedial classes first. In pilot studies, students in I-Best were four times more likely to graduate than their peers.

Some colleges are doing very innovative work in remediation with computer-based learning. The National Center for Academic Transformation was one of the first groups to experiment with technology in the classroom, starting about 10 years ago. N-CAT helps colleges redesign large lecture courses using technology-based approaches, especially educational software that stresses active learning. As one professor put it, “Students learn math by doing math, not by listening to someone talk about doing math.”

The redesigned courses also allow students to move from one module to the next by demonstrating mastery of the material, instead of by accumulating credit hours. Thirty colleges worked with N-CAT to redesign courses, and they spent less to get more. The cost of the redesigned courses was almost 40 percent lower, and course completion rates were 50 percent higher.

Educational technology also helps students beyond the remedial stage. Students I’ve talked to are ebullient about online learning. They tell me they really appreciate being able to do their work whenever and wherever it’s convenient, whether that’s at home, in a computer lab on campus, at the public library, or at the coffee shop around the corner.

These examples are reasons to be optimistic. Literally thousands of you are devising creative solutions to the problems you face on your campuses. But the innovations are scattered, they haven’t been replicated, and as a result their impact is diffuse.

The task ahead of you is to innovate at the necessary scale, so that your innovations have an impact on the entire community college system of more than 1,000 institutions and 6 million students.

We think the Gates Foundation can help with that. Our big bet is that we can invest strategically to make it much easier for you to reform remediation. The foundation will spend $100 million to work with dozens of partners to develop groundbreaking models for developmental education.

But it’s not enough to develop new models. You also have to spread them. That’s why we are also committed to helping community colleges work with each other to share ideas—to make it easier for you to adapt successful programs like I-BEST and N-CAT’s course redesigns. We’re excited to build on our relationship with the AACC, networks of community colleges like the Achieving the Dream Network, and state governments, because we believe that linking community colleges together is the best way to drive innovation at scale.

Your role is to make sure the best ideas in your field benefit your students in the classroom. You must translate what you learn into a higher completion rate at your college.

To that end, I urge you to calculate your graduation rate. Find out how many entering students plan to graduate, track them, and share the results. Then we can all be clear about where we are and where we need to go.

And I urge you to join networks of community colleges so that you can confront your common challenges together. You can do it on your own—many of you have been—but it’s difficult and expensive and time-consuming to reinvent the wheel 1,000 times.

On the other hand, if you work with partners, your combined insights will generate a positive feedback loop. Group innovation has many advantages. A group of colleges can draw on exponentially more expertise at the research and development phase, and it can spread good ideas much faster in the implementation phase.

We are confident that, working together, we can reach the goal of doubling the number of low-income young adults with a college certificate or degree.

Community colleges are an indispensible American institution. Almost two centuries ago, Thomas Jefferson dreamed of a system of district colleges that, he said, “place every father within a day’s ride of a college where he may dispose of his son.” You have finally made Jefferson’s dream come true, and you’ve done him one better. You provide access for mothers and daughters as well as fathers and sons. You provide access for students of all backgrounds. You provide access for everyone.

Cornell, Paris, and the other students we’ve met are grateful for the opportunity you provide. But we owe them even more. They put everything on the line for a better life. Their tenacious desire to succeed is the reason Bill and I—and all of you—do this work.

We owe them the same tenacity in return. We owe them the courage to innovate, even though it’s going to be hard work. When we can say with confidence that we can graduate all of our college students, then our society will be more democratic and more prosperous than even a dreamer like Thomas Jefferson ever dared to imagine.

How Mafia money launderers, terrorists and tax dodgers became smart !

Mafia money launderers, terrorists and tax dodgers may be accumulating 500-euro bills because they’re easy to hide and transport, the Bank of Italy said in a report.

As much as 6 million euros ($8.1 million) fit in an overnight bag, and 10 million euros in a 45-centimeter (18-inch) safe-deposit box, the central bank said in a 15-page internal study obtained by Bloomberg News.

“The wide diffusion of the 500-euro bill is a motive of possible concern in terms of fighting both money laundering and terrorism financing,” the June 2009 report prepared by the central bank’s financial intelligence unit said. “Cash is the ideal tool for illegal payment and movement of funds” and “the high-value banknote simplifies the logistical management of large sums of money,” according to the study.

The report may boost arguments by law-enforcement officials to do away with the 500-euro ($673) note, the second most- valuable bill among the world’s most-traded currencies. The Frankfurt-based European Central Bank reviewed the denominations of its banknotes in 2005, and has no plans to change the structure of its currency, an ECB spokesman said. The Bank of Italy report may foreshadow a split within the ECB on the merits of keeping the 500-euro note at the next review.

The dangers tied to the use of the 500-euro bill may “merit attention by monetary authorities and the institutions fighting money laundering and terrorism,” the report said.

Canada’s $1,000 Bill

The ECB had no comment on the Bank of Italy report, a spokesman said. A Bank of Italy spokeswoman had no immediate comment. The Bank of Canada withdrew its 1,000-dollar ($981) bill in 2000 “as part of the fight against money laundering and organized crime,” according to its Web site.

Latvia’s 500 lati ($951) bill is Europe’s highest-valued bill. Singapore’s 10,000 dollar ($7,248) note is the world’s most valuable, though rarely used. Among the six most-traded currencies, the 500-euro bills and the Swiss 1,000 franc ($939) note are the most valued, the Bank of Italy said. The $100 bill is the U.S.’s highest denomination.

Italy has one of the largest underground economies in Europe, worth as much as 19 percent of gross domestic product in 2008, or almost 300 billion euros, Rome-based research institute Censis says. The Italian mafias, the country’s biggest money launderers, prefer the large bills because they can transport higher amounts of cash in less space, said Maurizio De Lucia, a mob prosecutor who participated in the hunt and capture of Bernardo Provenzano, the boss of the Sicilian Mafia, in 2006.

The country’s main mafia groups boosted their profit by 12 percent to more than 78 billion euros last year, the anti- racketeering group SOS Impresa said in January.

Bills Rarely Seen

Cash payments, which unlike credit cards or checks are anonymous, are the basis for 91 percent of all transactions in Italy, compared with 59 percent in France and 78 percent in Germany, the Bank of Italy said in the report.

While the 566 million 500-euro notes in circulation outnumber the total population of the euro zone, Italians say they rarely run across them.

“We don’t see very many of them,” said Alessandro Migliacci, 28, a barber at the Antica Barbiere Peppino near the Spanish Steps in Rome. “The 20s and the 50s are by far the most common bills.”

Since the introduction of the euro to the public in 2002, the number of 500-euro bills in circulation has grown.

Fifty-euro bills made up almost 34 percent of the total euros in circulation in 2002, compared with 23 percent for the 500-euro note, the Bank of Italy said. In February of this year, the 500-euro note represented 36 percent of the total value of euros outstanding, surpassing the 50-euro note, which made up 31 percent of the total, according to the ECB.

‘Banning Banknotes’

The 500-euro bill’s use by money launderers and tax dodgers “is a strong argument for banning or at least reducing the quantity of these banknotes,” said Nicola Borri, a professor of economics at Luiss University in Rome. The big bill “makes it very easy for one person to carry across borders, say between Italy and Switzerland, large quantities of money.”

The Bank of Italy study found that there was a greater concentration of 500-euro bills per capita close to the borders of Switzerland and San Marino, where money-laundering regulations are less stringent. Italians who stashed their savings abroad to avoid taxes declared 95 billion euros last year as part of a tax amnesty passed by parliament, the country’s tax-collection agency said on Feb. 20. The amnesty expires at the end of April.

The Financial Action Task Force, the global money laundering watchdog based in Paris, recommended discarding large-denomination bills in 2005 to help fight crime and terrorism.

Drug Traffickers

“Countries should give consideration to the elimination of large denomination bank notes,” the FATF said. “These notes can be used by cash smugglers to substantially reduce the physical size of cash shipments being transported across borders and, by doing so, significantly complicate detection exercises.”

While the mafia isn’t named in the Bank of Italy report, investigators said the biggest money launderers are organized crime groups. Italy’s three main mafias boosted revenue 4 percent to 135 billion euros last year, compared with 83 billion euros in revenue for Eni SpA, the country’s biggest company, anti-racketeering group SOS Impresa estimates.

A Wad of Bills

“Large amounts of cash are needed in illegal transactions,” said De Lucia, the mob prosecutor. “Rather than use a suitcase to haul large amounts of 50-euro bills, criminals prefer to carry a wad of 500-euro bills in their pocket.”

Central and South American cocaine traffickers collect the 500-euro notes because they are easier to transport, Russell Benson, the Drug Enforcement Administration’s regional director for Europe and Africa said. A million dollars in $100 bills weigh about 22 pounds (10 kilograms), while $1 million in 500- euro bills at the current exchange rate of about $1.38 per euro weighs about 3.5 pounds, Benson said.

European-based Drug Trafficking Organizations possess “hundreds of millions of euros in illicit drug proceeds” which they must smuggle back to areas where the supplies originated, Benson said in an e-mailed comment yesterday.

“The 500 Euro note continues to be exploited by several of these trafficking groups to facilitate their money laundering efforts.”

China Begins Trading in Equity Futures

Now Derivatives for Hollywood movies

U.S. regulators approved the first futures market based on movie box-office returns over the concern of lawmakers and Hollywood executives that the exchange may expose studios to speculative harm.

The Commodity Futures Trading Commission voted 5-0 today to let Veriana Networks Inc.’s Media Derivatives Inc. unit open a market for professional traders to make financial bets on how well a new movie will do in ticket sales. A plan by Cantor Fitzgerald LP to create a market that includes retail investors is pending before the commission.

Media Derivatives’ market, to be called Trend Exchange, “will help better manage economic uncertainty and financial volatility,” Rob Swagger, chief executive officer of the Scottsdale, Arizona-based company, said in an e-mailed statement today after the vote.

CFTC Commissioner Bart Chilton called it a “popcorn prediction market,” and Senate Judiciary Committee members warned CFTC Chairman Gary Gensler in a letter yesterday of the risk of “creating perverse incentives for movie failure that may undermine the integrity of the industry.”

Hollywood studios that participate by hedging their films’ prospects will doom ticket sales, said Peter Guber, chairman and CEO of independent production company Mandalay Pictures LLC.

“The word will get out in three seconds and the picture will be a complete catastrophe,” said Guber, who was chairman and CEO of Sony Pictures Entertainment in the early 1990s.

‘Serious Concerns’

The CFTC must still approve the type of contracts to be dealt before Trend Exchange can begin. The company has said its first product will center on opening-weekend box office.

Product approval is “a very different question” from exchange approval and raises “significant concerns,” Chilton said in an e-mailed statement. He said he had “reluctantly” concurred in today’s vote.

“We have serious concerns regarding the trading of media contracts and we support a very thorough review of all of these first-of-a-kind products,” CFTC Commissioner Scott O’Malia said in an e-mailed statement.

U.S. Senator Blanche Lincoln, an Arkansas Democrat, today added language banning trade in movie futures to a broader derivatives bill she is writing. Lincoln is chairman of the Agriculture Committee that oversees the commodity commission.

Media Derivatives’ market plans to begin trading in the third quarter, Stephanie DiIorio, a company spokeswoman, said before the vote.

Potential for Manipulation

Activity on the exchanges would bring about “risky and manipulative” behavior, said Patrick Leahy, the Vermont Democrat who heads the Senate Judiciary Committee, and Senator Orrin Hatch, a Utah Republican.

“I’m worried about manipulation,” Chilton said in an interview on Bloomberg Television before the vote.

Media Derivatives said in a filing to the CFTC that a movie’s cast, plot, storyline, budget and “word of mouth” would be considered before exchange officials list the film.

Professionals would use the market to hedge risk to movie investments from “catastrophic events such as the World Trade Center bombing, to climate events such as severe snow storms,” the company said. It said its initial offerings would be based on domestic box office sales in a film’s opening weekend.

Media Derivatives told the commission its proposed market could transfer financial risk from producers, studios and theaters to “a community of speculators willing to assume these risks” in return for being paid a premium.

Movie Financing

The U.S. recession has reduced financing for movies, which cost an average of $107 million each to make in 2007, by studios that face declining DVD sales, increased piracy and more criticism on Internet sites, Media Derivatives said in a filing.

“Every other segment of our economy has had a means to offset risk,” Swagger said in an interview that aired today on Bloomberg Television. “The entertainment industry has not had an opportunity for futures-type contracts.”

Movies would be required to have a content rating, and show on at least 600 U.S. screens. Contracts wouldn’t be listed more than 30 days before a release. Trading would end the day before the opening.

“I just don’t know if this is something that makes sense,” said Representative Collin Peterson, a Minnesota Democrat and chairman of the House Agriculture Committee, in a conference call with reporters.

“A kernel of wheat is a kernel of wheat,” said Peterson, whose committee oversees the CFTC. “Movies are very subjective.”

He said he had “significant questions about this whole idea.”

Future of Swaps??

A proposal to rein in derivatives trading could translate to billions of dollars of lost annual revenue for banks including JPMorgan Chase & Co (JPM.N) and Goldman Sachs Group (GS.N).

Senate Agriculture Chairman Blanche Lincoln is expected to unveil a financial reform bill on Friday that would prevent banks with deposit insurance from also trading derivatives known as swaps.

Banks would have to find a way to separate their swaps trading operations from the rest of their business, although the mechanism for doing so is not spelled out. Under Lincoln's plan, over-the-counter derivatives -- those with common terms and wide sales -- would move onto regulated exchanges in many cases.

Globally, the $450 trillion over-the-counter derivatives market is big business for the banks. Scaling back these operations, or forcing high-volume contracts to move to exchanges, could make trading much less profitable for dealers. Customized contracts would continue but face higher costs.

Lawmakers have sought ways to rein in the opaque world of over-the-counter derivatives after the financial instruments were blamed for exacerbating the financial crisis and prompting the U.S. government bailout of companies such as American International Group (AIG.N).

Jamie Dimon, chief executive of JPMorgan Chase & Co (JPM.N), told bank analysts on Wednesday that forcing dealers to trade derivatives on exchanges could cost his firm up to a couple of billion dollars in revenue annually.

"It will be a negative," he said. JPMorgan has the largest derivatives exposure of the U.S. banks.

Just five banks account for 97 percent of the total $212.8 trillion worth of derivatives contracts held by U.S. commercial banks, according to a fourth-quarter survey by the Office of the Comptroller of the Currency.

Lincoln's effort will join proposals already on the table from the Obama administration and Senate Banking Committee chairman Chris Dodd and is be the most aggressive package.

Her proposal would prohibit any bailout of dealers, buyers or "swap entities." Derivatives like swaps take their value from underlying assets such as bonds, currencies or commodities, or can be tied to changes in interest rates.

But it is unclear how big banks like JPMorgan would shed their "swap entities." These companies could not likely exist as standalone entities, because they would lack both the funds and the trust to buy and sell swaps.

"Today, because of credit concerns, you would find it very hard to unbundle this market," said Christopher Whalen, co-founder of Institutional Risk Analytics.

If banks shed their swaps desks, they would essentially be getting out of the trading business, and focusing on areas like lending, said Kevin McPartland, senior analyst at research firm TABB Group.

"This is a back-door way to reinstate Glass-Steagall without actually doing so," McPartland said.

"For the swap desk to be successful and continue providing the service they do, it's important that they have bank capital behind them," McPartland added.

JPMorgan, Bank of America (BAC.N), Goldman, Morgan Stanley (MS.N) and Citigroup (C.N) had the largest derivative exposures of all holding companies in the fourth quarter at $78.66 trillion, $72.53 trillion, $48.85 trillion, $41.51 trillion and $39.35 trillion, respectively, according to the OCC survey.

SURVIVAL CHANCES

But Lincoln's proposals still have to withstand hearings, lobbying, and Republican opposition before becoming law.

Some Senate staff workers believe banks enjoy the cushion of Federal Reserve backing that other market participants do not have, a potentially unfair advantage.

If approved by the Agriculture Committee, the package would be wrapped into an omnibus regulatory reform bill approved by the Banking Committee and awaiting Senate debate.

Treasury Secretary Timothy Geithner praised Lincoln's plan. "Based on what she's laid out in public it looks like a very strong bill," he said at the White House on Wednesday.

Lawmakers are under pressure to address voters' outcry over the billions of taxpayer dollars spent to prop up financial institutions during the crisis.

"There's a kind of ill-defined feeling on the part of both parties that they have to do something, because when they go home people yell at them," said Whalen.

Lincoln's proposals, as outlined by committee staff, are the most aggressive on the table, according to McPartland, and that could make it less likely for them to survive to the final legislation.

"We don't need to kill the existing model, we just need to figure out how to have better oversight and reduce systemic risk," McPartland said.

EASY CONNECTIONS

THERE was a time when mobile applications were developed only for smart phones.Now,even low-end phones sport apps that are fun to use and give access to information at the click of a button.Mobile startup firm Mobisy was among the first to tap this large segment.
We have shown that this is the fastest way to develop your app,and then be able to run it across any of the various platforms like Windows Mobile and Android, says Lalit Bhise,chief executive officer of Mobisy,or mobile made easy.Traditionally,an application used to take around six months to develop,or even more,depending on its complexity and sophistication.Now,on Mobisys platform it takes just two weeks from start of development to its completion,a remarkable improvement,which is the USP.This time saved,simply means more money,which is why the platform named Mobitop has been selling like hot cakes.
The success today has,however,come on the back of some risk-taking acumen.It also was about the belief I had after working for some years developing software, says Bhise,who graduated with an engineering degree in 1999 from Walchand College of Engineering,Sangli in Maharashtra.He then worked with various companies,including Wipro Technologies and Siemens.He got some good programming experience when he worked for a couple of years in San Diego and then,for another couple of years,in Birmingham in the UK.While working for Sendo Mobiles,he was exposed to the latest in mobile technology.By 2004,Bhise had decided it was time to make the move back home.
I was eager to start something on my own as I was aware of the work I wanted to do.I understood the market and had the ability to lead a team, says Bhise.Mobisy was born in December 2006,with just two employees.Even now,in four years,the team is just 15 people.We mainly need people to maintain the technological edge that we have, says Bhise.
Our platform uses standard technology.So,the publisher of the apps need not know anything about mobile platforms.He can just use existing computer platforms, says Bhise.And best of all,the publisher can develop the app for any platform he chooses,which makes this very efficient.This is the product they started selling in 2006 and still remains their flagship.Revenues have grown to around Rs 1 crore and the next fiscal should ring in the first million dollars (Rs 4 crore).
The good part is that their clients,like Reliance Entertainment or Nokia,have stayed put,as has the core team.The company has enough to cover its operational expenses,so the new funding is set to go towards scaling up abroad,in Europe.
Mobisy is already looking for $1-2 million funding to develop new products.They also need quality manpower to create a first in Indiaa whole new app store,which currently only companies like Apple,Nokia and Blackberry have.This one will be with a difference that it will offer apps targeted only at Indians,which means work in more regional languages and games that make use of local cultures and geographies.That will be our great leap forward, Bhise says.

Lehman may act against Goldman

LEHMAN Brothers Holdings may have grounds to sue Goldman Sachs Group and Barclays after they demanded $1.2 billion in additional margin to assume trading positions auctioned by a Chicago exchange,bankruptcy examiner Anton Valukas said.
Goldman Sachs was the high bidder for Lehmans equity derivatives at options and futures exchange CME Group Inc., and took $445 million of those assets at a private auction in September 2008,according to previously censored details of Valukass March 11 report.Barclays was the high bidder for Lehmans energy derivatives and took $707 million in assets from CME.
DRW Trading was the highest bidder for Lehmans foreign exchange,agricultural and interestrate derivatives,Valukas said.The transfer of $2 billion in Lehman deposits for its proprietary trades at the CME cost the defunct investment bank $1.2 billion,Valukas said,adding that CME also may be sued.
The examiner concludes that an argument can be made that the transfers at issue were fraudulent transfers, Valukas said in the report,released in its form yesterday.Under bankruptcy law,Lehman may be able to undo the auction,he said.
Part of Valukass job was to explore Lehmans grounds for suing companies that contributed to,or benefited unfairly from,the demise of the investment bank and its affiliates including the brokerage Lehman Brothers Inc., and to say which kinds of lawsuits are most likely to succeed and what the possible defenses are.
Thus,LBI may have a colorable claim against CME,or any of the firms that bought LBIs positions at a steep discount during the liquidation ordered by the CME,for the losses that LBI sustained as a result of the forced sale of house positions held for the benefit of LBI and its affiliates. Bloomberg

Around 60 percent CDS(Credit Default Swaps) could clear centrally say experts

Around 60 percent of the $24.8 trillion credit derivatives market can rapidly move to central clearing and reduce systemic risk, but moving much beyond that could be counterproductive, according to market experts.

If overzealous regulators drive central clearing houses to take much more than that, they could end up actually increasing risk in the global financial system, bankers and analysts said.

Regulators are pushing the market to move to central clearing of credit default swaps, which have been blamed for contributing to the financial crisis. Significant strides have been made so far, with most index trades already going through central counterparties.

UBS estimated that 60 percent of credit default swaps (CDS) are currently clearable after assessing the CDS it trades.

"Let's not penalize ourselves by trying to push a market that doesn't work that way into this structure, creating more risk that doesn't help anybody," said Stu Taylor, a managing director in fixed income at UBS.

This week, clearinghouses urged lawmakers not to recklessly force inappropriate products through them.

Used for decades in liquid markets such as equities and foreign exchange, clearing houses step in following a trade to take the counterparty risk for both sides.

They reduce risk by netting out the offsetting short and long positions of multiple players. The derivatives industry has created standardized contracts to enable netting, but investors have not moved all old CDS to the new contracts.

Clearing houses also minimize risk by adjusting counterparties' collateral daily to reflect market values, which means CDS must trade frequently for confidence in pricing.

CITIGROUP ESTIMATES

At Citigroup, traders estimate that 70 to 80 percent of the market is clearable, but it will take at least two or three years to reach that number due to clearers' operational constraints, said credit strategist Michael Hampden-Turner.

Several clearing houses declined to comment. They will be reluctant to commit to any specific number, Hampden-Turner said.

IntercontinentalExchange Inc. (ICE.N) is the only player so far to have cleared a substantial volume of CDS.

Its web site showed ICE has cleared about $7.1 trillion in CDS, about 29 percent of the $24.8 trillion total shown by the Depository Trust and Clearing Corp (DTCC) as of April 2.

Indexes accounted for $6.7 trillion, indicating ICE is likely to already cover what is clearable of the $7.3 trillion index total.

An area not yet tackled by clearers is one of the most complex. Nearly half of the $2.7 trillion market in so-called tranches consists of bespoke deals created for investors before the crisis and is not suitable for clearing. Analysts estimate around $1 trillion in standard tranches is clearable.

The biggest uncleared part of the market, however, is the $14.9 trillion in CDS for single corporate names, with the 1,000 largest names accounting for $13.7 trillion of that.

ICE has reached less than $360 billion in single names.

"The main question is single names, and the key bit is liquidity," Hampden-Turner said. "By clearing the top 200 most liquid names out of the 2,000 or so that trade, clearers should be able to get to the 50 percent level pretty quickly."

More than 460 of the largest names are liquid enough to eventually be cleared, he estimated.

Over time, the clearable portion of the market is bound to increase as old, illiquid contracts expire and clients gravitate toward cleared products, knowing they are more liquid.

Furthermore, proposed new banking regulation, dubbed Basel III, includes a provision requiring banks to hold capital reserves against all CDS, not just net exposure, Hampden-Turner said. That means trading in CDS contracts that are not cleared would become much more expensive

How Derivatives burnt a French city

The worst global financial crisis in 70 years arrived in Saint-Etienne this month, as embedded financial obligations began to blow up.

A bill came due for 1.18 million euros ($1.61 million) owed to Deutsche Bank AG under a contract that initially saved the French city money. The 800-year-old town refused to pay, dodging for now one of 10 derivatives shocks on contracts so speculative no bank will buy them back, said Cedric Grail, the municipal finance director. They would cost about 100 million euros to cancel today, he said.

“It’s a joke that we’re in markets like this,” said Grail, 38, from the 19th-century city hall fronted by an arched facade and the words Liberte, Egalite, Fraternite. “We’re playing the dollar against the Swiss franc until 2042.”

Saint-Etienne is one of thousands of public authorities across Europe that tried to shave borrowing expenses by accepting derivatives deals whose risks they couldn’t measure. They may be liable for billions of euros, according to the Bank of Italy and consulting and law firms in France and Germany. As global economies climb out of recession, the crisis is hitting Saint-Etienne in central France, Pforzheim in western Germany and Apulia, an Italian regional government on the Adriatic. They may pay for their bets into the next generation.

Alabama’s Jefferson County

From the Mediterranean Sea to the Pacific coast of the U.S., governments, public agencies and nonprofit institutions have lost billions of dollars because of transactions officials didn’t grasp. Harvard University in Cambridge, Massachusetts, agreed last year to pay more than $900 million to terminate swaps that assumed interest rates would rise.

For Jefferson County, Alabama, the day of reckoning came earlier than in Saint-Etienne, but the common denominator was the use of complex, unregulated financial instruments known as derivatives that are typically linked to changes in market interest rates, currencies, stocks or bonds. Billionaire investor Warren Buffett, chairman of Berkshire Hathaway Inc., in 2003 called derivatives “financial weapons of mass destruction.”

They pushed Jefferson County close to bankruptcy two years ago. It had refinanced $3 billion of debt with variable-rate bonds and purchased interest-rate swaps to guard against borrowing costs rising. Its interest rates soared when insurers guaranteeing the bonds lost their top credit grades, and the rate the county received under the swap deals fell.

Under the interest-rate swap deals popular with European municipalities, a bank would agree to cover a locality’s fixed debt payment and the government or agency would pay a variable rate gambling its costs would be lower -- and taking on the risk that they could be many times higher.

‘Hopes of Gain’

The deals were often based on differences between short- and long-term rates or currency movements.

“This is speculating in the hopes of gain,” said Peter Shapiro, managing director at Swap Financial Group LLC, in South Orange, New Jersey, an adviser to companies and governments. “The investor is taking a chance in hopes of a high return. It has nothing to do with hedging.”

Use of swaps in Europe soared in the late 1990s and early 2000s because banks pitched them as the easiest way to reduce costs on fixed-rate loans, according to Patrice Chatard, general manager of Finance Active, which helps more than 1,000 localities across Western Europe manage their debt.

The financial institutions that sold the derivatives were many of the same ones that received government bailouts to weather the worst global credit crisis since the 1930s.

1.21 Trillion Euros

They include the Royal Bank of Scotland Group Plc and Dexia SA, based in Brussels and Paris. Frankfurt-based Deutsche Bank, which packaged and resold subprime U.S. mortgage loans and sold swaps in Europe, didn’t take government funds.

City and regional governments in Europe mainly get their financing from banks, while in the U.S. they primarily raise funds by selling bonds to investors. Municipalities and other local authorities in the European Union’s 27 member states had a combined debt of 1.21 trillion euros in 2008, according to Eurostat, the EU’s statistics agency.

Government officials used up-front cash payments from guaranteed rates at the beginning of swap contracts to artificially lower their short-term financing costs and live beyond their means, said Emmanuel Fruchard, who is a city council member in Saint-Germain-en-Laye, near Paris.

“These municipal swaps are the same thing as Greece,” said Fruchard, a former banker at Credit Lyonnais, now a unit of Credit Agricole SA, who designed swaps in the early 1990s. “It’s all trying to dress up your accounts.”

Greek Rescue

Greece, plagued by tax evasion and soaring pension costs, made a series of agreements with banks to help defer interest payments, helping to understate its budget deficit for years, the finance ministry reported in February. The country’s credit ratings were cut in December after estimates for the 2009 deficit doubled. Greece imposed new levies on large companies, raised the value-added tax, increased tariffs on fuel, alcohol and tobacco and cut public-employee wages to shrink the shortfall and restore investor confidence in its debt.

Those measures didn’t work. The yield demanded by investors on 10-year Greek bonds soared to 7.36 percent by April 8, from 4.42 percent six months earlier, while the euro fell by 9.7 percent against the dollar over the same period. European governments on April 11 offered Greece a rescue package worth as much as 45 billion euros at below-market interest rates in a bid to stem its fiscal crisis and restore confidence in the euro.

12 Percent Cut

Germany, Italy, Poland and Belgium also used derivatives to manage fiscal deficits, Walter Radermacher, the head of Eurostat told EU lawmakers in Brussels yesterday without being specific.

Municipalities are having to rewrite their budgets. Saint- Etienne raised taxes twice, slashed by three-fourths a plan to renovate a museum commemorating the region’s extinct coal mining industry and sparked the cancellation of a tram line. Pforzheim, on the edge of the Black Forest in Germany, is scrimping on roads, schools and building renovations.

Known as Gold City for its historic jewelry and watch- making industry, Pforzheim was ordered by the Baden-Wuerttemberg regional government office in Karlsruhe to cut its budget by 240 million euros, or about 12 percent annually, over the next four years because of a 55 million-euro loss on derivatives and a projected 50 million-euro annual shortfall from a decline in tax revenue and rising social costs.

The town followed the advice of Deutsche Bank in taking out bets on interest rates in 2004 and 2005, according to Susanne Weishaar, Pforzheim’s budget director until March.

‘Painted Hand Grenade’

The bank gave her a 10-year chart showing long-term rates were consistently higher than short-term, she said. During an initial phase of guaranteed rates, the town paid 1.5 percent to the bank on 60 million euros of debt while receiving 3 percent to 3.75 percent.

In 2005 and 2006, the difference between long- and short- term rates collapsed. As potential losses soared in 2006, Weishaar bought more swaps from JPMorgan Chase & Co. in a vain attempt to protect the town budget. Today Pforzheim owes 55 million euros to New York-based JPMorgan, she said. That’s 11 percent of this year’s spending.

The Deutsche Bank swaps have a positive value for the city of about 9 million euros, Weishaar said, offset by the negative value of JPMorgan swaps set up to protect the city.

“It’s like Easter eggs,” said Weishaar, 45, who holds a degree in math and economics from the University of Ulm. “You want to buy one and somebody sells you a painted hand grenade instead.”

If the grenades explode -- or when local officials decide to cut their losses and get out of long-term contracts when the market is against them -- taxpayers foot the bill.

Risks Versus Savings

More than 1,000 municipalities in France had 11 billion euros in “risky” contracts at the end of 2009, according to Paris-based Finance Active. In Italy, about 467 public borrowers faced losses of 2.5 billion euros on derivatives as of the end of September, according to the Bank of Italy.

In Germany, Deutsche Bank sold contracts based on the difference between long- and short-term rates to about 50 municipal governments and utilities. Local authorities also bought swaps from regional banks and Commerzbank AG. No national consolidated figures exist, according to Roland Simon of Simon & Partner, a law firm in Duesseldorf.

For cities like Saint-Etienne, the risks from buying swaps were out of proportion to the potential savings.

Saving 126,377 Euros

The town borrowed 22 million euros in 2001 from Dexia at 4.9 percent to consolidate borrowings for civic projects. The rate would rise if the benchmark three-month London interbank offered rate, or Libor, exceeded 7 percent.

Under Mayor Michel Thiolliere, Saint-Etienne signed six swap contracts on that loan between 2005 and 2008, the last three with Deutsche Bank. That lowered the city’s effective costs to 4.35 percent in 2006, to 4.07 percent in 2007 and 4.3 percent in 2008 and 2009. The difference in 2009 was a saving of 126,377 euros.

The risks in the equation hit the town this month. The contract obligated Saint-Etienne to pony up on April 1 a quarterly payment of 1.18 million euros -- equivalent to an annual 24 percent on the debt -- while Deutsche Bank would pay 241,886 euros. The swap is based on the strength of the British pound against the Swiss franc. The U.K. currency has slumped by 21 percent in the two years since the deal was signed.

“This isn’t traditional asset management,” Fruchard said in reference to swaps based on currency moves in general. “It’s speculative, like a hedge fund. And it’s done in bad faith. An elected official who takes the benefit from the guaranteed low rates without understanding what happens after his mandate ends is acting in bad faith.”

Fighting Deutsche Bank

Saint-Etienne sued Deutsche Bank in November, alleging the bank had failed to warn officials with sufficient detail of the risks in the contract, and claiming the city didn’t have the right to sign the agreement because it was “speculative.”

The city hasn’t paid what it owes the bank, and returned Deutsche Bank’s January net payment of 30,735 euros, according to Chantal Bayet, who is in charge of debt service and financial analysis. Saint-Etienne has increased the amount it has set aside for financial risks to 6.5 million euros, from less than 400,000 euros in 2008.

Deutsche Bank disputed the claims. “Deutsche Bank, as in any transaction of this kind, worked closely with the client to ensure that risks and opportunities of the transaction were well understood by all parties,” the bank said in a statement in November. The bank has no further comment, spokesman Christian Streckert said in an e-mail.

‘Daily Risks’

For his part, Thiolliere had little choice for reducing Saint-Etienne’s interest costs, he said. After the area’s last deep coal mine closed in 1983, the city faced terminal decline, he said. The local team in France’s top professional soccer league holds the record for championships with 10 but hasn’t won since 1981.

“Managing a town is like running a company: It’s taking risks daily,” said Thiolliere, mayor for 14 years before being voted out of office in 2008. He still represents the Loire region in the French Senate.

Accounting rules in Europe help keep derivatives deals hidden. Most local governments have no obligation to set aside cash against potential losses, and reflect only current-year cash flows in balance sheets.

“It’s only transparency that will make elected officials scared to invest in dangerous products,” said Jean-Christophe Boyer, deputy mayor of Laval, in western France, which has swaps covering about 25 percent of its total debt of 86 million euros. “Even if we banned them today, the impact is coming now, tomorrow and 10 years from now,” he said, because of the number of derivatives contracts still in force.

Ban on Swaps

European towns desperate for cash jumped into the global derivatives experiment that loaded the financial system with leverage and led to the credit crisis in late 2008. Epitomized by Lehman Brothers Holdings Inc.’s collapse, the fallout cost banks and brokerages alone $1.28 trillion in writedowns and credit losses, according to data compiled by Bloomberg, and required at least $15 trillion in support from central banks and governments in the U.S., the U.K. and the euro zone, based on Bank of England data.

Efforts to regulate derivatives sales to local governments are patchy. The European Commission isn’t working on EU-wide rules. In France, the central government oversaw a voluntary good-conduct charter, inked in December, that wasn’t signed by all banks operating there nor by all local government associations. In Italy, a Senate committee in March proposed a ban on swaps for smaller towns except for provincial capitals.

Generational Impact

A judge charged Deutsche Bank, JPMorgan, Zurich-based UBS AG and Depfa Bank Plc with fraud linked to the sale of derivatives to the City of Milan, Italy’s financial and fashion capital. The trial is scheduled to start May 6.

Deutsche Bank spokesman Streckert referred to the firm’s March statement that said, “We continue to believe that our case is compelling and that we will be cleared.” JPMorgan spokesman David Wells declined to comment.

“We are convinced that neither Depfa nor the accused employees have violated any law or regulation,” Depfa’s parent, Hypo Real Estate Holding AG, said in an e-mailed statement last month. Spokeswoman Nina Lux said the company stands by that. UBS reiterates its March statement that “no fraud was committed by UBS nor by any of its exponents,” spokesman Richard Morton said in an e-mail.

‘Shouldn’t Buy It’

The use of derivative contracts by some Italian municipalities will weigh on their debt for “generations,” said Tullio Lazzaro, chairman of the state audit court, on Feb. 17 in Rome.

Under the French voluntary agreement, banks pledge not to sell local authorities interest-rate contracts based on debt principal, commodities or foreign currencies. The accord also excludes so-called snowball swaps, which move in steps where each payment is based on the previous payment. This works to magnify any trend. Calculations in swaps also may contain multipliers that exaggerate any change.

“I’m not against all structured products, but if you can’t explain the real utility to a mayor in under a minute, you shouldn’t buy it,” said Sandra de Pinho, finance director for the city of Lille in northern France.

Understanding agreements like these requires complex software, mathematical and financial expertise that local governments often don’t have, said Fruchard, the former banker.

Snowball Swaps

Take Saint-Etienne’s two snowball swaps with Royal Bank of Scotland. In one of the contracts, the town pays a fixed rate of 3.92 percent until May 2011 on an underlying debt of 7.2 million euros while RBS pays 9.69 percent, less 10 times the difference between 10-year and 2-year interest rates, capped at 12 percent and with a floor at zero.

The contract with RBS was a counter-agreement for a swap that Saint-Etienne had signed with Paris-based Natixis SA. The swaps are based on an underlying loan by Dexia at 4.94 percent that runs until 2026.

Under the other contract, Saint-Etienne is paying 3.77 percent until June 2011 on 8.3 million euros while RBS picks up the payment of 9.71 percent less the same formula in the previous swap. The underlying loan from Dexia is also at 4.94 percent and lasts until 2026.

Permanent Rate Increase

After the dates specified in both contracts, the city each quarter must pay the previous rate if the difference between the 20-year constant maturity swap rate less the three-month Euribor rate, another interest-rate benchmark, is greater than or equal to negative 0.3 percentage point. If that rate is less than negative 0.3 percentage point, Saint-Etienne must pay the previous rate plus three times the difference between 0.1 percentage point and the 20-year versus 3-month spread. Any increase is permanent until the contracts end in 2020 and 2021.

Saint-Etienne would need to pay RBS 3.18 million euros to cancel the first snowball swap and 4.05 million euros to cancel the second, according to a Jan. 29 presentation by the mayor’s office.

Claire Gorman, a spokeswoman for RBS, declined to comment on the contracts, discussions with Saint-Etienne or on the bank’s policies on sales of derivatives to local governments.

Saint-Etienne asked Eric Gissler, a French finance ministry official named last year to mediate disputes over swaps, to help negotiate a settlement with Natixis, according to Jean-Claude Bertrand, the deputy mayor in charge of finances since 2008. The town has been unsuccessful in discussions to alter its contracts with RBS, he said.

Looking for Deals

Saint-Etienne has derivative contracts with at least six banks, according to a chart of the city’s finances. “They put people into competition with each other in some ways and searched for products with different characteristics,” said Christian Le Hir, chief legal officer for Natixis.

Natixis is ready to negotiate with Saint-Etienne under the aegis of the mediation system set up by the French government, he said. The voluntary charter creates a level playing field for banks and will prevent local governments from signing inappropriate contracts, he said.

Speaking generally about what happened in municipal finance and not specifically about Saint-Etienne, Le Hir said banks and local governments were both looking for deals.

“Banks were looking to sell products,” Le Hir said. “Local governments were looking to buy them because it suited them, at least in the short term, with accounting rules that weren’t suitable and a government that didn’t look into these transactions because local authorities needed to refinance themselves with better conditions. It was a whole context.”

Renegotiation Pattern

Saint-Etienne and other towns renegotiated their finances repeatedly. After Thiolliere lost local elections in 2008, the new administration discovered Saint-Etienne had at least 26 swaps, many of them renegotiated several times, according to the complaint the city filed against Deutsche Bank.

“The number of people who believed, in good faith, even in big cities, that when you renegotiate your debt you win, is crazy,” said Michel Klopfer, the author of “Financial Management for Local Governments,” a how-to handbook used throughout France. Klopfer has consulted for 31 out of the 37 French cities with more than 100,000 residents. “Banks accelerated their renegotiation proposals while making clients believe, incredibly, that renegotiating means winning.”

For Dexia, the largest lender to local governments in France and Belgium, “restructuring debt was an important factor in the profitability of this business in the past,” said Pierre Mariani, the bank’s chief executive officer, on a Feb. 24 conference call. “It will continue, but in safe conditions for the bank and for our clients.”

Pforzheim Deals Probed

It would cost Saint-Etienne 20 million euros today to cancel the Deutsche Bank swap, Grail said, while still leaving the town to pay off the 19 million euros left in the underlying loan from Dexia.

“Our goal isn’t to go to war with the banks,” Grail said. “Our goal is to protect Saint-Etienne citizens from the aberrant decisions made by the prior team.”

Pforzheim, a town of 117,000 that traces its history back 1,900 years to Roman times, hasn’t sued Deutsche bank over its swap deals. The Mannheim prosecutors’ office is investigating Weishaar, the former budget chief, and former Mayor Christel Augenstein over the decision to buy the swaps, according to Peter Lintz, a spokesman.

‘They Cheated Me’

Augenstein denied any wrongdoing, saying she relied on the advice of Deutsche Bank. Weishaar said she did nothing wrong, and that she thought Deutsche Bank’s 10-year chart on interest rates was misleading. Her resignation in November took effect at the end of March.

“I think they cheated me, and I want my money back, my city’s money back,” she said.

Deutsche Bank declined to comment through spokesman Streckert.

In December 2004 and August 2005, Deutsche Bank sold Pforzheim three contracts known as spread-ladder interest-rate swaps, Weishaar said. The transactions functioned in part like the snowball swaps that Saint-Etienne bought because each period’s rate was based on the previous rate, plus a formula.

Weishaar was trying to reduce the town’s costs on 60 million euros of debt so it could spend more on education, she said. The contracts hinged on the difference between short-and long-term interest rates.

What went wrong was that short-term rates rose faster than long-term rates. The European Central Bank doubled short-term rates to 4 percent from 2 percent between December 2005 and June 2007. This caused the spread compared with long-term costs to narrow to 0.07 point by October 2006 from 0.63 point on Dec. 1, 2005, faster than Weishaar says she expected.

Counter-Swaps

The amount that Pforzheim potentially owed surged to 20 million euros in October 2006 from 644,000 euros a year earlier, Weishaar said, scanning spreadsheets on the computer screen in her home office. After that, she decided to try to protect Pforzheim from any further losses, she said.

Johannes Banner, a banker at JPMorgan in London, had given a presentation on swaps at a conference in Potsdam, Germany, attended by one of Weishaar’s colleagues. Weishaar called Banner, explained the contracts she held, and asked him to come up with a way to limit the town’s exposure, she said. The bank set up a series of contracts capping Pforzheim’s loss at 77.5 million euros.

“We didn’t have the money to buy out the Deutsche Bank contracts, but we had to limit the danger,” Weishaar said. “Even if the cap was very high, at least it was a cap.”

JPMorgan’s Wells declined to comment.

Three-Decade Payback

JPMorgan set up swaps as the exact reverse of the Deutsche Bank contracts. Pforzheim agreed to pay 77.5 million euros to JPMorgan beginning in 2014, less the value of three options.

In February, the city council voted to cancel that contract and pay off the net 54.96 million euros it owed to JPMorgan at the time, said Bernhard Enderes, head of human resources, who led internal investigations by the city into the way the debt was handled. It decided to borrow the funds at a fixed rate over 30 years to cover the cost, Enderes said.

That would cost about 3 million euros a year for the next three decades, or the same as the combined annual operating budgets of the city library and jewelry museum. Enderes hasn’t yet secured the loan or paid JPMorgan, according to Michael Strohmayer, a spokesman for the town.

Deutsche Bank wouldn’t discuss its dealings with Pforzheim. Standard warnings in the bank’s spread-ladder swap contracts with local governments included: “A worst-case scenario cannot be quantified” and said there was a “theoretical risk of unlimited losses.” It’s written in bold face on the fourth page of six in a typical term sheet obtained by Bloomberg News.

Likely to Lose

Clients were aware of the potential benefits and risks, said Christian Duve, a lawyer representing Deutsche Bank in German cases over spread-related swaps.

“Six separate appellate courts in Germany have ruled that the bank provided all necessary information to the municipalities and companies and have dismissed their claims,” Duve said in an e-mailed statement.

A German appeals court said in a Feb. 26 ruling that Deutsche Bank didn’t provide enough information to a corporate customer, who wasn’t identified. The bank constructed the swap so that the customer was likely to lose money, the court found. The appeals court, the Stuttgart Higher Regional Court, ordered Deutsche Bank to pay 1.5 million euros. The bank appealed.

Pforzheim, bombed by the British Royal Air Force in the final months of World War II, will cut investment spending by about 80 million euros between 2010 and 2013 to compensate for losses on swaps and slumping revenue from changes to local tax law, the city said in March.

‘Real Pain’

It has postponed until at least 2014 the construction of a sports complex for the Hilda-Gymnasium school, scrapped 11 million euros of planned refurbishments for Nordstadtschule, a vocational school, and canceled plans to turn a century-old building into a design and business center.

“We trusted Deutsche Bank that the transactions complied with all applicable laws and weren’t speculative,” Augenstein, the former mayor, said. “Otherwise, I would never have agreed to them.”

In Saint-Etienne, the consequences of losing gambles on rates include tax increases of 7.5 percent in 2009 and 2 percent this year. The government slashed 19 percent, or 50 million euros, from its 2008-2014 investment plan. The city reduced by three-quarters an 80 million-euro project to update the museum commemorating the coal-mining industry, Bertrand said. Its woes forced the cancellation of a 120 million-euro plan for a new tram line, he said.

“The real pain for us is just starting now and is coming over the next several years,” said Grail, the finance director.

Saint-Etienne’s guaranteed rates under eight remaining swaps or structured loans end between this month and September 2012, while one allows the city to pay nothing until 2020.

“The problem is no bank today will take on a swap where you’re betting on 10 times the yield curve, or on foreign currencies,” Grail said. “So we’re stuck, and the explosions are starting to go off.”