The sad, bonkers story of the derivatives battle between investment banks and Italian municipalities received another footnote on Friday:
Milan, March 25, 2011 — Moody’s Investors Service has today downgraded the City of Florence’s debt rating by one-notch to Aa3 from Aa2. The rating outlook is negative.
Florence’s debt is quite high relative to its operating base (€548 million, or 106 per cent) but that’s not why Moody’s took its rating action. Rather:
“Today’s rating action is in response to the city’s decision to halt payments due on six interest-rate swap contracts with three major banks covering a residual amount of EUR173 million, or 30% of the city’s direct debt as at year-end 2010,”
Between 2001 and 2008, 525 Italian municipalities conducted 1,000 interest rate swaps valued at a total of €35bn — corresponding to about one-third of total Italian municipal debt. FT Alphaville and the FT took a long look last year at Italy’s history of using these derivatives to try to lower borrowing costs.
The problem: when eurozone rates rose, municipalities borrowing costs rose, too. Cue funding difficulties. The additional, alleged problem: banks not adhering to their fiduciary duties when selling these complex problems. A familiar story.
But unlike, say, the city of Milan, which took four investment banks to court over the allegedly fraudulent sale of interest-rate swaps, Florence took a different step and, like Pisa, just stopped paying.
The rating agency notes that the suspension of swap payments follows the enactment of a self-protection procedure (autotutela) that may void the administrative acts behind these swaps.
Autotela, a.k.a. the municipal Fifth Amemdment.
All this explains why the three banks involved are currently suing Florence in UK courts over its refusal to cough up. This excellent background piece by Bloomberg explains why there has been a rush to obtain “home” court advantage in these disputes:
If municipalities sue first in their jurisdiction, banks have to go there to argue where the case should be heard. That’s used as a tactic in Italy to slow down litigation and try to reach a 10-year deadline after which a lawsuit and any appeals will be thrown out if a ruling hasn’t been made, Harris [DN: Laurence Harris, a litigation lawyer at Edwards Angell Palmer & Dodge LLP] said.
Cases last year suggest British courts will allow the Italian derivates suits to be heard in the U.K. A British court ruled in May that the Italian bank Dexia Crediop SpA and Irish lender Depfa Bank Plc could sue the city of Pisa in London. UBS also won a ruling in October allowing a dispute with a German municipal utility to be heard in the U.K.
But it’s interesting to note that municipalities are willing to accept downgraded and commensurate increases in the cost of borrowing in exchange for pursuing these cases. Good on them — but they could be waiting a while for resolution.
Any verdict in a UK court would have to be enforced by an Italian court (though any non-Italian assets could be seized) so expect this interesting and long-running saga to continue for a while yet.
Update (3:20 AM, GMT): Big tip of the hat to commenter Mr B, who points out how the issue of exclusive jurisdiction has been passed to the ECJ. The case, then, will run and run even longer than expected. See this background briefing from A&O for more.
Related links:
Florence Suspends Payments on Swaps Amid Dispute – Bloomberg
An Italian derivatives headache for JP, UBS, Deutsche and Depfa – FT Alphaville
Italy hearts currency swaps too – FT Alphaville