Although Agence France Presse relates today that Italian authorities are denying buying derivatives contracts to bolster their portfolio to gain access to the EU membership, Bloomberg reports that the Italian government asserts it was done to reduce interest-rates and currency fluctuations and that the transactions are alien to the country's public finances.
What the Italian authorities are trying to do is muddle the picture. They don't, in the end, deny buying the risky derivatives, but they are saying that it was not done to bolster their Euro bid, or even that the 'loss' of 10.5 billion Euro on the derivatives contracts is real.
The problem however remains that such derivatives, and the loss they could entail, is still very much real. The tally so far, according to the Financial Times is close to 10.5 billion dollars, or a third, on just one tranche of contracts for swap options worth 39 billion dollars. And that is only for that tranche, not for the entire derivatives load.
But the problem might not even be this disclosure. The bigger news is the fact that Italy holds derivative contracts worth more than 200 billion dollars, which is close to 10% of government securities. And since the amounts and nature of the contracts are not divulged, there is no way of telling how many of these contracts pose what loss risk.
Italian Finance MInister Saccomani insists that the country is not in peril and that public accounts are safe, reiterating the fact that the risky investments contracts are solely employed to limit interest rate fluctuations losses.
The Treasury, assert Italian financial authorities, is overseen by the Corte dei Conti, the auditing entity, who then forwards to the Guardia di Finanza, or Fiscal Police, data sent from the Treasury for review if there are any irregularities. The Treasury furthermore insists that data on the derivatives is forwarded to the auditing agency every six months, as part of an ongoing audit process. But that data too remains undisclosed.
So the news that there are potentially very large losses from the contracts was indicated, and calculated, by media entities outside the country, specifically the Financial Times, without any input data from the Guardia di Finanza or the auditing office, the Treasury insists. And that, the finance authorities say, places the report of the loss in a position where it can be easily dismissed, since it did not rely on any of the audit's real data.
But the Financial Times did obtain official documents from the Treasury through an internal leak, 29 pages of it, in which are detailed transactions that occurred right before Italy was to join the Euro zone, although important details were left out to obscure the potential losses. The transactions, which were 're-structured' in the 1990s allowed Italy lower its debt from 7.7 to 2.7 right before the approval process to enter the EU was underway. And since government spending and tax receipts remained about the same as before the re-structured contracts, they played no part in bettering the financial picture of the country. The person who was at the helm of the Treasury during that period was none other than Mario Monti. But the re-structuring was very damaging to the Italian Treasury, since the condition of the restructuring were much more unfavorable to it than the ones originally held.
What is happening however, in the 39 billion tranche, is that the loss is calculated in the mark-to-market valuation of the derivatives by the Financial Times. What this means is that the loss would be incurred if the derivatives were to be unwound as of June 20, something that is not foreseeable says the Treasury, since the unwinding of such contracts can only be demanded under certain 'particular' circumstances or by contract clause. But the truth remains, that this is the 'current' value of that 39 billion tranche.
But such circumstances have already been imposed on the Treasury when they had to pay Morgan Stanley 3.4 billion contracts to unwind contracts dating back to the mid-1990s when Morgan Stanley exercised a 'break clause', a transaction that was under review by the GdF. At that time, Bloomberg News calculated that Italy had lost 39 billion dollars in the value of its total derivative holdings. Furthermore, the auditing entity, the Corte dei Conti had issued a report saying that "the damage done to the state's income constituted by the negative outcomes of the derivatives contracts is particularly critical and delicate." The report however, has never been made public.
An Italian economist Gustavo Piga had this to say about the risk of derivatives contracts held by Italy : "Derivatives are a very useful instruments. They just become bad if they’re used to window-dress accounts,” i.e. when they are used to delay until later a debt that is due, which appears to be the tactic employed by the Treasury to qualify for entry in the EU.
So who can say that the derivative contracts are 'safe', and for how long? And when and if they are to be 'unwound', will the loss be greater or smaller?
This type of doubt, in a country that is literally on the brink, does nothing to reassure the people. Furthermore, if there is consistent risk, borrowing rates could skyrocket. Already the 10 year bond yield has lost 12 basis points, to 4.74% since the news.
In addition, debt is now over 130% of GDP, with a shrinking growth trend, which could make that percentage higher. Let us not forget that Greece reached its breaking point when its debt was 120% of GDP.
The stubborn refusal of Italy's government to ask for a bailout which could bring scrutiny of the 'master books', could spell a disaster that could rival that of its neighbors Greece and Cyprus.
Source: AFP/Bloomberg/Financial Times 6.26.13
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