Milan Swaps Breached Rules, Judge-Appointed Expert Witness Says

Swaps used by the city of Milan may have breached rules on how municipalities may use derivatives to manage their debt, partly because they were used to raise funds, a judge-appointed witness said during a trial of the banks that arranged the trades.

Francesco Corielli, a finance professor at Milan’s Bocconi University, said he applied a “financial” reading of Italian laws and decrees to find the swaps breached regulations, since he’s not a lawyer. He was responding to questions from a defense lawyer in a Milan courtroom today. “I had to think about it hard,” Corielli said.

JPMorgan Chase & Co., UBS AG, Deutsche Bank AG and Depfa Bank Plc, the four banks that arranged the swaps, are accused of misleading Milan and earning 101 million euros ($128 million) in hidden fees from the deals. The companies, which have denied the charges, in March settled with the city government and agreed to unwind its interest-rate swaps, which adjusted payments on 1.7 billion euros ($2.2 billion) of bonds sold in 2005.

The swaps were “very distant” from being hedges on the municipality’s interest-rate risk after they were restructured multiple times, Corielli wrote in a report filed to the court earlier this month. The city used swaps in part to fund expenses, which may have breached rules governing such contracts, he wrote.

Default Risk

Municipalities were prohibited from raising funds by selling options, and could use swaps only to contain the cost of their debt, said Corielli. Milan used derivatives with the four banks in part to help pay for closing an existing swap with another lender that was losing money for the city, according to Corielli.

In addition to the banks’ fees on the swaps, which Corielli estimates at about 30 million euros for the first transaction in 2005, the city assumed the risk that the banks might default, Corielli wrote. That so-called credit risk should have been accounted for as an additional 18.1 million-euro cost incurred by the city, he said.

Milan should have sought offers for alternative financing packages, Corielli wrote, and an accurate valuation of any bid would have required detailed costs of each transaction, he said.

The trial continues on May 30.

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