The diffusion of the “financial derivative” in the budgets of the local Governments represents an unknown aspect of the financial crisis, more persistent in the effects than in macroeconomic repercussions of the crisis itself (connected to unemployment and to the economic trend), certainly more understandable and known, insofar as it is a daily subject of public debate. The amount of existing contracts is at the origin of an economic- financial entanglement, in which the local Government is “guided” in its choice, by advisors who are not always independent in their evaluations, and who create transactions in which, often, the financial interests of the public administrations and those of the investment banks, proponent of the contracts, diverge. Such financial imbalance is compensated by the political “proceeds” – such proceeds for the administrators of the local authorities – to obtain immediate liquidity, or postpone the expiry of reimbursement relative to loan agreements, in effect, signed by previous administrative management. The vulnerability of the current situation is elevated: sudden defaults on the part of the local Government subscribers (caused by insolvency or non-delivery) could determine negative effects (in terms of problems of liquidity or credit) and a chain of panic behaviour, which are seriously prejudicial for the public finance stability, not only local, but national. The problem connected to the derivatives underwritten by the Public Administrations is certainly financial, but also political for the presence of hidden costs which exacerbate the strong pressures that the sustainability of the national public debts is undergoing. Beyond the legislative modifications (which have effect only on the future behaviour) an “ongoing” and “territorial” management of this problem is necessary. In this sense, the expertise of financial intelligence by the National Information Services, flanked by the local Administration and Supervisory Bodies, could furnish an important contribution in protecting the local finance system.

A silent and pervasive germ

Last August 26th, the City Council of Ariano Irpino, in the Province of Avellino, deliberated the payment of 285 thousand Euros to the Banca Nazionale del Lavoro (BNL), to terminate swap contracts stipulated in 2002.
A greater elaboration for the better understanding of the operation will be given further ahead, but this example serves to introduce the subject we shall be dealing with; i.e. the diffusion of the “financial derivative” in the budgets of the local Administrations (1) , immediately highlighting the geographic capillarity concerning a community of 23 thousand inhabitants, but also much smaller constituencies.
To make other small examples of the galaxy of local Administrations implicated in the business of derivatives, also the Municipality of Pollutri -2,300 inhabitants in the Province of Chieti), in January 2010 decided, wisely, to close the derivative signed in 2005, with Intesa Sanpaolo, until now in surplus for the Administration, but at the risk of rising interest rates.
Similarly, the swap contract of the Municipality of Lecco with Deutsche Bank, to cover the issue of a debt of 36.5 million Euros, to date an excellent hedging instrument against rises in interest rates, according to some experts would present “hidden costs” for one million Euros -equal to 3% of the notional- (2) .
The Municipality of Acqui Terme, on the basis of a “theoretic” calculation of such costs, filed charges of contract fraud against Unicredit, relative to “hidden commissions” for one million Euros (caused by inadequacy of the financial product and by implicit funding) connected to a derivative issued by the bank on a notional debt of 36 million Euros.
The case of Ariano Irpino (which we shall utilize here, insofar as reported by both Il Sole 24 Ore and, in a very clear manner, by the publication on the web, of the documents relating to the Municipality in question (3) , just as the others mentioned above, the underwriting by local Administrations of contracts in derivative instruments are the symbol of an aspect of the financial crisis which is more persistent than the macro-economic reflections of the crisis itself (connected to the unemployment and to the trend), certainly more understandable and known, since it is a daily object of public debate. The risks – in terms of the reduction in spending power of the local Administrations – connected to the underwriting of such contracts are known.
On the 11th March 2010, the Financial Commission of the Senate terminated the cognitive investigation on derivatives and securitization in the Public Administrations, revealing how “the conclusion of particularly complex operations by territorial Authorities, not only of reduced dimensions, also organizational, give rise to strong perplexity, critical details having emerged in relation to the contracts concluded by them”.
Concomitantly, the Banca d’Italia, in its recent evaluation of the situation of the derivative contracts stipulated by private and by Italian Public Bodies has shown how, in the first quarter of 2010, the market value (Mark-to-Market) of such contracts is negative and has increased to 57.5 billion Euros, from the 47.9 of the period 30th September – 31st December 2009.
In practice, this means that it is almost 60 billion Euro which more than 42 thousand operators (between businesses, local bodies, families and financial societies) must pour into the coffers of the Italian banks (or in the foreign ones that operate in Italy), in the case in which they wish to prematurely terminate (or are forced to do so because of the economic situation) the swap contracts entered into for hedging against changes in interest rates (or exchange).
According to the Banca d’Italia, in the first quarter of 2010, the losses for the Public Administrations, by entering into derivative contracts, have increased -2.5 billion Euros, + 10% compared to 2009-, and are more concentrated -from 470 public administration subscribers to 404-.
An estimate very similar to that of the Senate, 31st December 2009, -35.3 billion Euros- is the one of the Ministry of Economy which, in 2008, estimated a notional value of the exposure in derivatives of the local authorities equal to circa 36 billion Euros, shared between approximately 600 institutions.
This amount of contracts has its origin in an economic-financial machination, in which the local governmental institution is “guided” in its choice by “advisors” who are not always independent in their assessments, and who often create “biased” transactions due to conditions of disequilibrium between the financial interests of the public administrations and those of the investment banks, proponents of the contracts.
Such financial imbalance is compensated by the political “return” – for the local governmental administrators – to obtain immediate liquidity, or to defer the expiry deadlines of reimbursement relative to outstanding loan agreements, signed by previous administrative managements.
The vulnerability of the present situation is very high: unexpected default by the subscriber institutions (caused by insolvency or non-delivery) could cause negative effects (in terms of problems of liquidity or credit) and chain-panic behaviour) severely injurious to the stability of the public finance, not only local, but also national.
The problem related to the derivatives subscribed to by public Administrations is certainly financial, but also (and above all) political because of the presence of hidden costs which exacerbate the strong pressures already existing on the sustainability of the national public debt.
Beyond the legislative modifications (which have effects only on future behaviour), an “on-going” and “territorial” management of the problems presented here is necessary. In this sense, expertise in financial intelligence by the National Information Services, alongside the local Administrations and the Regulatory Bodies, could provide an important contribution in protecting – at a territorial level – the local Financial System.
The objective of the analysis of the financial intelligence, proposed here, is not the “demonization” of the financial derivative, which, if used properly, allows the realization of “hedging” effectiveness of the risks of volatility and of variability of the markets and of their indicators.
The focus is on the frequent “casual” behaviour of administrators (and their delegates) of Municipalities, Provinces, Regions and Public Institutions at a local level, which, in an absolutely incautious manner and not oriented to the collective good, have utilized these contracts to finance reckless policies and, often, suggested by advisors directly involved in blatant conflicts of interest.
In confirmation of this argument is the decision of the City of Milan to declare itself the “injured party” in the trial in progress (in both civil and criminal court) at the Court of Milan with regard to the judicial dispute with four foreign banks in relation to the issuance of bonds “City of Milan 2005-2035” and of the connected synthetic debt. Such decision is, in fact, also at the expense of the Municipal administrators who, in the past, subscribed to derivative contracts included in the enquiry.
The negative repercussions on the Public Budget, local and national, the waste and the amount of inefficiency caused by misuse of such contracts could represent a threat to national economic security, even more so, if put into a “hidden” context of conflicts of interests which have, as aware dealers, foreign financial operators.
The emphasis on the participants, rather than on the phenomenon in itself, is supported also by the many warnings made by the Court of Auditors which, as the highest Authority in the auditing of public bodies, has more than once found the disproportion between the risk assumed by the local Bodies compared to that of the financial operators, quantified by the mechanism of determining the payable interest rates. In this sense, the Court has advanced perplexity about the “economic advantage” of many operations, in the absence of a specific provision on the conditions and costs of withdrawal, as well as adequate evaluations on possible genetic defects of the cause and form of the contract. da gestioni amministrative precedenti.



The subject of the “hidden charges”

From January 2009, when the two swap contracts existing between the City of Ariano Irpino and the BNL recorded a negative market value equal to 1.1 million Euros, the situation has progressively improved up to reaching a positive Mark-to- Market (MtM) of 285 thousand Euros.
The MtM is the value of the derivative financial instrument in question, the so-called Interest Rate Swap. It is a theoretical value and not “effective” of the derivative, reported at a certain date, and deduced from an estimate made in a range of probability. It is, therefore, a subjective assessment, depending on the mathematical model utilized, changing on the basis of any market variation, insofar as it is determined by the expectations on the evolution of interest rates.
Following what is expressed by Mottura (4) , a “regulatory” definition of MtM can be deduced from Para 3. of the Article 2427 bis of the Civil Code (Information relative to the fair value of the financial instruments), which establishes that the fair value of a financial instrument is “determined with reference : a) to the market value, for the financial instruments for which it is possible to easily identify an active market…; b) to the value which results from generally accepted models and techniques of assessment, for the instruments for which it is not possible to easily individuate an active market” and further establishes that “such models and techniques of assessment must ensure a reasonable approximation to the market value”.
It follows from the regulatory definition that:
- if an “official” market exists, the MtM value of the derivative is the market price;
- if an official market does not exist – as in the case of Exchange derivatives in an OTC (Over-the-Counter) market (5) – the MtM value of the derivative is an estimated value, obtained on the basis of a mathematical assessment in conditions of uncertainty.
From the utilization of derivative instruments, the City of Ariano Irpino, ensuring itself against adverse trends of interest rates, also realized a financial benefit, from 2002 to 2010, equal to more than 820 thousand Euros, given from the difference between 1,105 million Euros received from the Municipality in the period in question and the 285 thousand Euros paid to BNL to extinguish the swaps. Against this advantage, however, the “hidden costs” applied by the banks in the same years (estimated by two independent consulting societies called in by the Municipality in question) (6) they were equal to approximately 600 thousand Euros.
The subject of the “hidden charges” lies at the bottom of the hazard in the misuse of contracts involving derivative instruments. The value itself of the “implicit charges” borne by the local Administration subscribers is highly unpredictable, being equal to the difference between the “theoretical” MtM value of the derivative instrument (at the initial date of the contract) and the MtM value of the derivative resulting from the contract. This method of calculation, probabilistic and utterly subjective, has also become subject of litigation in civil and criminal courts (7) with dangerous repercussions in terms of jurisprudence.


The subject of dispute: the Interest Rate Swap

The derivative instruments proposed to the local administrators by national and international financial dealers present significant risks, ascribable, principally, to their technical complexity which renders them extremely difficult:
- the assessment of the financial effects on the management over the short-medium period (8) ;
- the potential distortion of the financial balances in the budgeting of the same Body.
Technically, the derivative instruments are financial activities, the value of which “derive” from the progress and performance of an underlying activity, which can be of a financial nature (interest rate, exchange rate, the price of an asset) or real (a produced amount). The financial result (pay-off) of the instrument depends on the relation that ties the value of the derivative contract to the value of the underlying asset/activity (9) .
The derivative contracts are exchanged on the OTC markets, therefore, there does not exist – as happens for all the non-quoted contracts in official markets – a market price which is single and equal for all the market operators.
The CONSOB -with Regulation 11522/1998- established that “at the stipulation of the contract, the value of a swap is always void”. The contract, therefore, must be fair, that is, the derivative, at the date of stipulation, must be structured in such a way as to attribute to the parties exactly the same probability of gain or loss. If this is not so, the advantaged party must pay a premium (an up-front) to the disadvantaged party, which brings the contract back into balance.
The purposes for which the derivative instruments are used:
- hedging of the financial risk (for example, through the transformation of an adjustable rate loan into a fixed-rate loan: is representative of risk-adverse conduct;
- scalping, taking risky exposure aimed at achieving high profits: is representative of risk-seeking conduct;
- arbitrage, seeking risk-free profits through transactions combined on the derivative and on the underlying: is representative of a risk-neutral conduct.
Different types of derivative instruments exist. The most common forms are:
- future and forward, where the parties undertake – at the moment of the stipulation of the contract – to exchange a certain asset, at a future date, and at a set price. The futures are exchanged on the markets regulated according to standard schemes (10) and provide for the liquidation at a Clearing House, contrary to the forwards, the liquidation of which is carried out on the non-regulated OTC markets, according to bilaterally and privately established schemes, with the assistance of dealers;
- options, which attribute to an operator, after payment of a premium, the right to buy (call options) or to sell (put options), at a certain date, a certain underlying activity (asset);
- swap, in which the parties undertake to exchange cash flows at a pre-established date and according to an agreed scheme. The exchange of said flows refers to a financial asset or real (so-called principal) or aspects thereof (interest rates, exchange rates). Also the swaps are negotiated on the OTC markets, on a bilateral and personalized basis, according to needs.
As suggested by an authoritative piece of literature (11) , among the simple derivatives can be included also the “contango contract” (or repurchase agreements), that is, operations in which one of the parties undertakes to spot sell a portfolio asset and repurchase it at term at an increased price. It is not necessary that the selling and repurchasing operations are materially realized, but can act as a reference for the operation.
The most common instrument used in the financial management of local Administrations is the swap, structured to cover the risk of interest rate (so-called Interest Rate Swap or IRS). For its enormous diffusion in the contracts regarding Local Administrations (and for obvious reasons of space), we shall concentrate only on this form of derivative contract.
The IRS is a contract where two counterparts undertake to exchange, for a certain period of time (tenor), interest flows. The principal elements of an IRS contract are:
- the personalization, which renders difficult, an early prediction of exchange of ones own contractual position with another operator;
- the symmetry, that is, the gain of one party corresponds to a specular loss for the other;
- the absence of a physical exchange of capital, that is, the notional principal is not transferred between the parties, but is utilized solely as an amount of reference for the calculation of the interests.
The most elementary type of IRS is the “plain vanilla”, which provides for the exchange -on the dates t=1, 2, 3, …, T- of adjustable interest against fixed interests, calculated by reference to a same notional principal, X. The fixed interests are calculated on the basis of the so-called swap rate, while the adjustable interests are calculated on the basis of the LIBOR rate (12) observed in the -t-1- period before the exchange. As a typical example, a case is taken from the Rubinstein text, cited in Note 9.


For the needs of the local Administrations, this typology is particularly advantageous. The local Administration is the purchaser of the swap, that is, the subject who pays a fixed interest rate and receives an adjustable interest rate. The adjustable interest rate is, instead, paid by the seller of the product against a fixed rate received by the purchaser.
In this way, a local Administration which has previously contracted an adjustable rate loan with Bank X and which, to cover itself against interest rate fluctuations, decides to stipulate a IRS with Bank Y, at the expiry of payment of the interests, it will find itself in the following position of:
- paying to Bank X an amount equal to the notional principal multiplied by the adjustable interest rate;
- receiving from Bank Y an amount equal to the notional principal multiplied by the adjustable interest rate;
- paying to Bank Y an amount equal to the notional principal multiplied by the contractually fixed interest rate.
The IRS contracts may provide for an optional content. In these cases the determination of cash flows depends on conditions that can be verified in moments subsequent to the stipulation of the contract. The options to integrate in the principal IRS may take the following forms:
1. “Cap” Option
With this option, the local Administration pays a premium (or commission) against which it acquires the right to receive, in the case in which the interest rate of reference (LIBOR or EURIBOR) (13) exceeds a certain ceiling (“Cap”), the difference between the interests calculated with the interest rate of reference and those calculated with the ceiling percentage.
In this way, the local Administration, which has previously contracted a loan at adjustable interest rate with Bank X and which, today, stipulates a IRS with Cap option with Bank Y, at the next date of payment of the interests, it will find itself in the following position of:
- paying to Bank X an amount equal to the notional principal multiplied by the adjustable interest rate of reference;
- paying a premium to Bank Y for the purchase of the Cap option;
- if the interest rate of reference exceeds a certain threshold, then the local Administration will receive from Y the difference between the interests calculated on the notional with the rate of interest of reference and the interests calculated on the notional with the Cap rate.
In synthesis, the local Administration, against payment of an initial premium to Bank Y protects itself from the higher hypothetical cost which it could incur towards Bank X due to the increase of rates above a certain Cap. Such increased charge, in fact, would be compensated by the takings of the differential interests to be received from Bank Y due to the purchase of the Cap option.
2. “Floor” Option
On the basis of such option, the local Administration receives a “premium” against which it acquires the obligation to pay – in the case in which the rate of interest of reference (LIBOR or EURIBOR) falls below a certain minimum (“floor”) – the difference between the interests calculated with the “Floor” percentage and those calculated with the rate of reference.
In this way, the local Administration which has previously contracted a loan at adjustable interest rate with Bank X, and which, today, stipulates an IRS with “Floor” option with Bank Y, at the next date of payment of the interests, it will find itself in the following position of:
- paying to Bank X an amount equal to the notional principal, multiplied by the adjustable interest rate of reference;
- will receive a premium from Bank Y for the sale of the Floor option;
- if the interest rate of reference goes below a certain Floor percentage threshold, then the local Administration will pay to Y the difference between the interests calculated with the Floor percentage and those calculated with the rate of interest of reference.
In synthesis, the local Administration immediately receives takings due to the sale of the Floor option to Y, against the annulment of the hypothetical saving which it could realize from Bank X, due to the fall of interest rates below a certain threshold. Such saving, in fact, would be offset by the payments of differential interests to be paid to Bank Y due to the sale of the Floor option.
3. “Collar” Option
Such option is constituted by the combination between the purchase of a Cap option and the concomitant sale of a Floor option. The effectiveness of the instrument depends, therefore, on the definition of the band fluctuations of the rate.
Again, taking as reference what is expressed by Mottura -2008- (14) , a Collar Swap is a contract in which a bank and a local Administration decide to exchange, periodically, a fixed interest rate against an adjustable interest rate, including (the latter) between a minimum level (floor) and a maximum level (Cap). The interests exchanged between the parties are calculated on a same capital of reference (payable at maturity) or on different residual capital (as it is, for example, in the case of a Collar Swap with a sinking fund).The market value of the Swap (the so-called Mark-to-Market initially “quoted”):
- is equal to zero, if, at the stipulation date, the market values of the two flows generated by the derivative, with opposite sign books, are equal;
- is equal to the so-called ‘upfront’ (difference between the amount paid by the party that receives the flow with greater value) (15) if the market values of the two flows are different.


Framework of legislation reference

During the 90’s a legislation framework was delineated, which permitted the Local Administrations to turn to the private capital markets to find the necessary resources for the financing of the investments. The downturn of interest rates and the starting up of a recovery policy of Public Accounts induced the Legislator to include elements of major flexibility in the policies of Local Administration Budgets.
The following is a review of the principal legislative moments:

1.Financial Law 1995
The Financial Law of 1995 (16) eliminated, on the subject of access to credit by Regions, Provinces and Municipalities, the monopoly of the Deposits and Loans Bank, and granted, to the local Administrations, the facility of direct access to the capital market, also through the issuance of security bonds. The regulation implemented by the Financial Bill provides, for the first time, recourse to derivative instruments as obligatory hedging to the exchange risk in the case of bond issues in currency, through the activation of a currency swap (17) . .

2. Financial Law 2002
The Financial Law 2002 (18) has enriched the instruments of possible financing, as well as introduced a greater flexibility in the management of the financial liabilities.
As far as the first aspect is concerned, the Local Administrations have been authorized to issue bonds or contract loans with reimbursement of the capital at maturity, in a single solution, (the so-called bullet). In this last contractual type, the Local Administration pays the passive interests to the creditor, setting aside the individual capital shares in a re-investible sinking fund or stipulate an amortization swap (19) , with the purpose of avoiding that the burden of the restitution of the loan weighs entirely on the Budget of the year of the maturity of the loan.
In the case of the sinking fund – not falling within the system of the single treasury (being managed by an intermediary with adequate credit rating) it is fed by periodical contributions of financial activities by the Local Administrations (20) – it can produce active interests and reduce, in this way, the actual cost of the operation.
Through an amortization swap, instead, the Local Administration undertakes to make periodic payments to the intermediary including principal and interests. The dealer, on his part, undertakes to pay a flow of interests calculated on the original notional value and a final sum which the Administration will utilize for the reimbursement of the bond at maturity.
As far as the management of the debt is concerned, Article 41 of the Financial Law has accepted the recourse, by the local Administration, to derivative instruments different from those already allowed to hedge the exchange risk.
The Financial Law of 2002 has, furthermore, delegated to the Ministry of Economy, the task of coordinating the access to the capital market, by the Local Administrations and to define the criteria on the use of the derivative instruments.

3. Ministerial Decree N° 389/2003
With the MD N° 389/2003 the operations allowed in matters of derivatives for the local Administrations have been specified. The principal new operational constraints are thus summarized:
- the utilization of the derivatives is allowed only in relation to the management of actual liabilities, and therefore, for the exclusive purposes of hedging of the risks, excluding, ergo, any speculative intention.
- the hedging operations of the risk of interest rate can only be of the “plain vanilla” type;
- the recourse to derivatives is allowed in operations of restructuration of the debt, within certain specific conditions and according to well defined requirements. For example, the taking of cash premiums at the stipulation of the contract (up-front) superior to 1% of the underlying liabilities is forbidden (21) .
- the derivative operations are possible only with intermediaries with adequate credit rating;
- the hedging of the exchange risk (currency swap) in the operations in foreign currency is obligatory.
Such provisions have been further clarified in the Circular N° 27 of the Ministry of Economy and Finance of the 27th May 2004, in which is specified that:
- the Cap and Collar options of the swap contracts must be finalized exclusively to the hedging of the risk of interest rate;
- possible thresholds to the Interest Rate Swap must be consistent with the rates in force on the markets and with the original cost of the liabilities;
- in the case of amounts superior to 100 million Euros, a bank cannot hold more than 25% of the operations of a same Administration.

4. Financial Law 2007
The Financial Law 2007 (22) has further increased the transparency of the operations, defining more rigorous regulations in matters of the use of derivatives. In particular, it was set out:
- the obligation of prior communication of the contracts in derivative instruments to the Treasury Department of the Ministry of the Economy and Finance, required to verify their conformity to regulations in force;
- the communication to the Court of Auditors of the signed contracts without the prior submission to the Treasury Department for the adoption of the jurisdictional measures.
- the obligation of three-monthly communications to the Ministry of Economy and Finance of the operations, together with data relative to the net use of the short-term bank credit, to the loans granted to subjects outside of the Public Administration;
- the storage for at least five years, on the part of the local Administrations, of the appropriate updated lists containing the details on debts and all the financial transactions.

5. Financial Law 2008
The financial Law 200 (23) repeats the principle of maximum transparency on the derivative operations made by the Local Authorities (24)
- delegating to the Ministry of Economy the issuance of an explanatory decree of the information content that the contracts must present, to allow an easier evaluation and reading of the document underwritten by the Public Administrations;
- to establish the assumption of responsibility by the administrators of the Local Administrations, who must certify their full awareness of the characteristics of the financial operations undertaken and of the possible risks thereby connected;
- have the obligation to demonstrate explicitly, in a note appended to the budget, the financial burdens and uses connected to the derivative contracts, particularly indicating:
1. the differential flows from the moment of the stipulation (25) ;
2. the potential flows expected (26) ;
3. the Mark-to-Market of the contract;
4. a report on the financial progress of the operation.
6. Financial Law 2009
With Art. 3, the Financial Law 2009 (27) has forbidden the Local Administrations to stipulate contracts relative to derivative financial instruments until a new regulation comes into force or, in any case, for at least 12 months from the enactment of the Law. Notwithstanding, the possibility remains valid for the Administrations to restructure the already existing derivative contracts, under certain conditions. The derivative contracts stipulated in violation of the regulations to be issued on the matter or without attestation to the awareness of the risks may be declared null and void on the part of the subscriber Administration.
The block has limited enormously the derivative activities of Municipalities, Provinces and Regions. At August 2010, there were almost 200 Local and Territorial Authorities that had closed (on expiry or early extinctions) swap contracts and other types of derivatives on an underlying notional debt for over 3 billion Euros (28) .
This decision has its pros and cons. The early extinction (“closure”) of a derivative with an MtM negative market value – for the subscriber Administration – transforms, in fact, a “virtual” capital loss into an actual cash outflow. Therefore, there cannot be any advantage, either political or economic, in achieving a similar operative result. Vice versa, the closure of a derivative with an MtM positive market value – for the subscriber Administration – may represent a political tool of immediate realization of cash, even if it can have, in certain operative conditions, financial spin-offs.
The Municipal Administrator, in fact, collects current revenue with no allocation constraints. In this way, however, it annuls both the hedging against a negative trend in future rates (compared to the underlying debt), and the advantage of an interest flow paid on the debt with the swap, less than a flow without swap.

MiFID Directive (29)
The regulatory framework applicable to the placement of derivative instruments has been further integrated with the entry into force of the MiFID Directive, which has provided a gradation of protection according to the type of clientele with whom the credit dealer has to deal.
With the purpose of guaranteeing conscious investment choices, an obligation has been introduced for the banks to furnish clients with information appropriate to their qualifications. The subdivision in classes of investors (retail, professional investors and qualified counterparts) responds to the need of highlighting the different level of “financial sophistication” to which differentiated disclosure requirements must be associated. The category of professional clients of Law includes the Public Administrations, which the Ministry of Economy and Finance will have to individuate with a special discipline, after consulting the Consob and the Banca d’Italia.
According to the Directive, in the placement and negotiation services of the derivatives, the intermediary must ascertain that the client has the level of knowledge and experience necessary to understand the risks connected to the proposed operations, but is not required to assess the consistency of the characteristics of the instruments or of the services offered with regard to the financial situation or to the investment objectives of the client.
The Regulation scheme, provided with the Financial Law 2009, was prepared by the Ministry of Economy and on 22nd September 2009, a wide public consultation of the draft with about 20 Administrations was launched.
Its structure included the list of the derivative operations considered to be admissible and what characteristics they must contain.
A specification is provided also for the counterparts with whom the contracts are stipulated. On the subject of transparency of the operations, the inclusion of an attachment “written in the Italian language” is required, which explains, in detail, the value of the contract, the structure of the financial portfolio and, above all, a representation, “both graphical and numerical” of the implicit cost of the derivative operations. Whoever signs the derivative on behalf of the Administration must also declare to have fully understood the characteristics of the operation. A tight network of preventive control is also provided: the Ministry Of Economy will verify the presence of all the elements of information provided for by Law; subsequently, the contracts will be transmitted to the Banca d’Italia and to the CONSOB for further inspection.


The derivative market for the Local Administrations

Recourse to instruments of derivative finance on the part of the Local Administrations was, in particular, connected to the collection increase on the bond market and to the restructuring of the existing debt.
With regard to the increased collection on the bond market, the development of the derivative instruments was associated, alternatively:
- to the introduction of the bullet type bonds (with reimbursement of the capital on maturity), in relation to which we have seen – the Legislation provides for the obligation to constitute a sinking fund, to distribute, evenly over time, the burden of the repayment of the bond loan (30) ), or to make an amortizing swap (31) to transform the bond issue in a bond with amortization;
- to the diffusion of the bond issues, prevalently at adjustable rate, which favoured recourse to the Interest Rate Swap (IRS). In relation to the restructuration of the existing debt, such activity takes place in the ambit of the active management of the stock (32) of existing debt, through the possible redefinition of the contractual financial conditions.
A correct administration of the stock, in fact, allows the Local Administration not to passively suffer the oscillations of the market relative to the rates of interest, but to exploit them to their own advantage, modifying, on the basis of the needs and expectations on the evolution of the market, and the structure of their debts. The active management of the debt is realized through restructuring operations of the debt, such as the renegotiation or the early extinction of the loans (through the lengthening of the maturities of loans and bond loans) or the remodeling of the amortization schedules (33) .
According to the Court of Auditors (34) from 2000 to 2007, there was a “negative spiral” sparked by the rise of the interest rates and by the renegotiations of previous derivates in loss, restructured in new derivatives at “always more hazardous, unbalanced and unclear” conditions, with repeated deferred losses with a cascade effect on the future managements and with progressively growing and unsustainable financial exposures.
In particular, in 2007, again according to the Court, the greatest activity was that of the Southern Italian Regions (with an average incidence of 22.8% of the notional swaps compared to the total debts) and of the North (with an average incidence of 42.1%. The same Court found it was the smaller Administrations which had privileged financial derivative instruments in the restructuration operations of the debt, rather than the renegotiation and conversion of the existing loans. In fact, these result more costly and the conversion of the loans into bond loans, given the modest amount, are not easily renegotiable.
A photograph of the exposure in derivatives for the Local Administrations is inferable from data supplied by the Treasury Department which, for 2010, indicate a notional value of the swap contracts stipulated by the Local Administrations of 335 billion Euros (35) . .


The Authority of Accounting Control has distinguished the criticalities connected to the diffusion of the derivatives between structural criticality and specific criticality.
The structural criticalities are ascribable to the complexity of assessment of the effects of the instruments and, consequently, to the distortion of the long-term financial balances.
In the contractual standards procedure, the assessment of the derivative operations is made extremely arduous by difficult clauses, and the confusion increases in the absence of adequate expertise, on the part of the Local Administration, in the correct evaluation of the characteristics and the timing of the effects of the more sophisticated financial instruments. This deficiency is at the origin, for example, of renegotiation operations of the derivative contracts connected to past debts which have often presented, already at the outset, very unfavourable conditions for the Administration (36) .
It was found that Local Administrations, without even a formal qualification as “professional operators” (37) (inasmuch as without specific professionalism in the sector), had, however, subscribed to derivative contracts. Their administrators ( or, better, the delegates in financial material) rarely had technical knowledge such as to be able to foretell, with a sufficient level of reliability, the occurrence, the consistency and the economic cost of the future and uncertain events which influence the contract (38) . Notwithstanding this, the Court of Auditors has often reported the signing, by those in charge of small and medium sized Local Administrations, of the contractual clause of “qualified operator” (39) . In certain occasions, the Accounting Judiciary has even individuated derivative contracts stipulated by the administrators who had not been conferred the necessary powers by the Councils of reference.
The same Court has also found the stipulation of derivative contracts with foreign banks prepared solely in the English language and the regulations of such contracts drawn up under the Anglo-Saxon Law. The submission of the contract on the derivatives to the Anglo-Saxon jurisdiction poses problems of private international law and presupposes a specific knowledge of the legislation and jurisprudence of reference. Such a choice requires, therefore, more careful consideration which takes into account also the eventual greater costs, in the case of litigation brought before the foreign Courts.
A specific criticality, instead, regards an over-articulation of the operation, cause of probable distortion of the financial balances of the Local Administrations. This aspect is relevant, above all, when the subscribed instrument presents a cash premium (an up-front), paid by the bank. In fact, in this case, the derivative contract assumes, in the intention of the Local Administration, the characteristics of a financing, signed in order to obtain the up-front and expand its current spending.
Analogously, the use of the derivative instrument to postpone the profile of the costs of the operations is likely to determine a “break-up” between the Administration which promotes them and the Administration which will have to manage them and support the burden, together with a strong risk of a loss of responsibility in the work. This aspect adds to the financial loss, a considerable political risk in the use of derivative instruments. By deferring potential huge losses, these contracts create a conditioning of the actions of the future Local Administrations (40) . Such conditioning is likely to result in loss of political autonomy of the Local Administrations, thanks to the fact that the banks, assuming the role of “shareholders” of the Local Administrations, could arrogate the power to influence the decisions, both political and economic, relying on their contractual weakness.
The Court of Auditors has repeated more than once that the motivation underlying the contract must be ascribable to two purposes only: “reduction of the final cost of the debt” or “reduction in the exposure to the risks of the market”. Different motives are likely to generate specific critical elements with relative deviations from the typical causes and consequent misuse of this kind of contract.
The institutional purpose of the Local Administrations of protecting the interests of the administrated, that is, the local communities, is totally incompatible with the excessively sophisticated derivative contracts, given the extreme unpredictability of same. Particular attention should be given to the concept, already treated previously, of the Mark-to-Market.
Whatever estimate of an MtM of a derivative is to be considered “arbitrary” insofar as, principally, it depends on the model of evaluation used for its determination and, given the model, from the hypotheses on the parameters of the model at the date of evaluation. In these contracts, small differences in the hypotheses can determine significant differences in the “theoretic” MtM, just as it is possible to determine different groups of hypotheses that produce the same MtM.
In this framework, the activity of the so-called Office of Technical Consultants can contribute to the generation of misunderstandings, distorting the “true” nature of “estimate” of the derivatives, during civil and criminal disputes.
For example, although referring to the same object of investigation (the same operations and same valuation dates), in the above cited trial on the derivatives stipulated by the City of Milan, the damages defrayable by the Local Administration, as calculated by the Prosecutor (41) result, for all the operations, significantly different from those calculated by the Municipality (42) .
The example of the Trial of Milan on the derivatives stipulated by the City, as a “pilot trial” (43) introduces a further criticality, where there is the possibility that a Court can decide on the correct methodology for the valuation of damages deriving from the derivative contracts.
The Court of Milan, in fact, in judging in both civil action or criminal trial, whether, or not, the City of Milan was swindled by the banks in relation to the issue of the bonds “City of Milan 2005-2035” and of the connected synthetic debt, can adopt modality and hypothesis for the evaluation of the damage which, if used as case law, would constitute a dangerous precedent, initiating de facto an homogenization of the evaluation techniques both during trial and in the market of reference, attributing legislation dignity to techniques of evaluation per se probabilistic and considered – by anyone – disputable. Such homogenization could generate a System risk in the case in which numerous other Local Administrations or the banks themselves, in light of the estimates calculated on the basis of the so-defined criteria of evaluation, felt able to bring a criminal litigation
When the principal reason of the underwriting of contracts in derivative finance by Local Administrations was just the possibility of obtaining immediate liquidity, through the up-front, the Court found that, on the contrary, the up-front must be considered real borrowing and its destination to cover current expenses constitutes a financial crime.
The decisions in the preparation of the budgets of the Local Administrations must be assumed by taking into account the potential liabilities and the consequent resources necessary to deal with them. Instead, in the majority of cases analyzed by the Court of Auditors, a negative MtM of the derivative contracts was found, this means – alternatively – that the Local Administrations could have assumed excessive risks with respect to the market trend of certain financial variables, or that the up-front initially received at the stipulation of the derivative was too low compared to the risks accepted by the Administrations.
With regard to the accounting of the differential amounts due under the clauses of the derivative contract, the Court of Auditors considers it correct that the up-front should be used exclusively for expenses of investment, given the extraordinary nature of the “premium” of liquidity. The negative differential (44) , instead, from which a charge for the year derives, should be included in a special appropriation to be charged to current expenses, and not postponed from year to year (45) .
A further problem regards the application, by the bank, of “implicit commissions” to the operations, deriving from the insufficient upfront payment of the Local Administrations.
It is likely that certain institutions, both Italian and foreign, could have received pressure – both commercial and personal – on the administrators of the Local Administrations, with the purpose of inducing them to renegotiate the derivative contracts at advantageous conditions for the banks. The same banks could have relied on the contractual weakness of the Administrations (threatening retaliation on other commercial fronts), but also on the incorrect assessment of the long-term financial effects of the stipulated contracts (which, on further confirmation, have often been prepared only in the English language).
The proof of this state of affairs is in the commencement (also sensitized by the recent action of the Treasury Department and the Court of Auditors) of actions to bring to justice executives of many credit institutions. The Court of Auditors, nevertheless, considers that it is up to the Local Administrations to prove the relationship of causality between the damage suffered and the conduct of the bank in violating the duties of information (i.e. the supplying of adequate information) provided for by the CONSOB regulations and the principles of the Unified Code of the Finance (46) . Furthermore, in the case of violation of the duties of information and of correct execution of the contract, one could, in any case, have the compensation of the damages and not the nullity of the contracts.


Consequences and role of the Intelligence

According to the Assistant Prosecutor, Alfredo Robledo (Public Prosecutor in the already mentioned Milan trial against the four foreign banks, with which the City of Milan underwrote derivative financial products finalized to the “transformation” of the fixed rate of a loan of 1.8 billion Euros in adjustable rate), “the problem of the derivatives in Italy is greater than that in Greece” (47) .
According to Robledo, in Italy, the diffusion of the derivatives is capillary with regard to Municipalities, Provinces, Regions and small Administrations, all subjects which, at different times and with different modalities, will have to face their budgetary difficulties.
The Milan case is exemplary. At the stipulation, the banks grossed, according to the charge, “hidden commissions” in the amount of 100 million Euros, exposing the City to the risks of the market, and ignoring the technical advice which they should have rendered by law. Today, the City of Milan, with the transformation of the fixed rates to adjustable rates, earns between 20 and 30 million Euros, but with the underwritten credit default swap (48) , it is also exposed to a potential default from 150 million Euros (49) I.
Generally, the swap operations of amortization are accompanied by contractual agreements with which the Administrations guarantee the banks in the case in which one of the issuers of the deposited bonds in the collateral account (50) should fail, configuring – de facto – operations of credit default swaps. In the presence of agreements of this type, notwithstanding that the Administration is not legal owner of the bonds kept in the collateral account (as, instead, happens in a sinking fund), the risk of credit relative to these bonds falls on the Administration itself, the position of which, furthermore, becomes analogous to a speculative position.
In these cases, therefore, there exists a risk, which is not only theoretical, that a Local Administration A, which guarantees the “insurance” of the credit default swap fails, putting the Local Administration B – which stipulated the derivative – in the conditions of having to remunerate the bank over and beyond acceptable financial and economic limits, creating the conditions for a collapse of the Administration itself.
Notwithstanding the recent legislative innovations in the direction of a greater transparency and responsibility in the matter of derivatives, and the regulations of greater caution in the operation, many risk areas still exist, principally, in relation to the effective transparency and communication of the Local Administrations with the Bodies of Control, and to the possibility, in force at the summit of the Local Administrations, of renegotiating the derivative contracts previously stipulated according to potentially speculative schemes.
In this sense, from January 2008, the Guardia di Finanza have been working on – delegated by the Judicial Authorities – 27 investigations concerning derivative products, for a value of circa 10 billion Euros. In particular, 16 enquiries, ordered by the ordinary Judiciary and Accounting Authorities, concern 44 territorial Administration (i.e. 2 Regions, 1 Province, 9 Municipality Capitals and 32 non-Capital Municipalities) and a Public Society, which, between 2002 and 2006, stipulated derivative contracts on rates of interest linked to underlying notional values totaling an overall amount of nine billion Euros.
The economic-financial intertwinement generated by the mass of presently existing derivative contract is likely to determine a Systemic risk which could grip the economic-financial security of the State.
The evolutionary prospects of the economic situation in the medium and long-term, which foresee a progressive increase in the interest rates of reference, according to a cyclical trend, read in conjunction with the long-term average of the swap contracts, gives rise, in fact, to a situation of instability in the financial perspective, in which there could potentially be many Local Administrations.
Such Administrations would be severely penalized by an increase in the rates of interest, implying – the latter – greater financial burden with regard to the commitments assumed through the stipulation of the swaps. Beyond the existing legislation, therefore, a strong organic input of professional staff of their own inclusion (who are able to oppose – in terms of knowledge – the Business Units of the international investment banks that deal in derivatives) could compensate for the extreme weakness of the balances of the Regional Budgets (harbingers of the highlighted systemic risks) in meeting the debtor commitments, in short, consequent to a derivative contract.
In this respect, a strong action of economic-financial Intelligence, to protect the National security, could supply a fundamental help in matters of surveillance on the accounting and budgets of the territorial Local Administrations, in order to favour the understanding of the mechanisms of diffusion on the territory of this type of product and, above all, of the financial effects that this expansion may have on the polices of the Budget of the State, central and local.