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).

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.

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.”

AIG unit, Goldman unwind CDS positions: source

NEW YORK - American International Group Inc (AIG.N) realized a loss of up to $2 billion last year as its Financial Products unit ended most of its remaining trades with Goldman Sachs Group Inc (GS.N), a source familiar with the matter said on Sunday.

AIG realized a loss of $1.5 billion to $2 billion as it ended credit default swaps, or insurance like guarantees, with Goldman on about $3 billion of mortgage collateralized debt obligations, according to the source.

That leaves the unit's swaps with Goldman on $1.3 billion in CDOs, called Abacus, according to the Wall Street Journal, which first reported the news.

It added that AIG officials felt these assets could do better than what their prices would show.

AIG and Goldman declined to comment.

AIG Financial Products, the unit behind AIG's near-collapse in September 2008, has been unwinding its businesses.

Last year, it reduced the notional amount of its derivative portfolio by 41 percent to $940.7 billion at December 31 from $1.6 trillion a year earlier. It reduced the number of its outstanding trade positions by about 18,900, to about 16,100.

AIG has said it would keep derivatives with $300 billion to $500 billion in notional value as it unwinds positions. AIG Financial Products will cease to exist, and either AIG or an external party may manage the positions that remain.

The unit, which operated separately from the insurance operations that AIG was best known for, sold credit default swaps and other hedging and investment products covering currencies, energy, equities and interest rates to clients around the globe.

Once the world's largest insurer, AIG almost collapsed because of these bets, as it was left on the hook for tens of billions of dollars in collateral payouts to some of the biggest U.S. and European financial institutions.

AIG Financial Products has also been a cause for public outrage against AIG, as it made large retention payments to its employees.