The City That Got Swapped

In 1995 an ambitious Frenchman from the Loire city of Saint-Étienne took a trip to Baltimore. Michel Thiollière had been elected mayor that year, and he was visiting faded industrial cities—Cleveland, Pittsburgh, Glasgow—to pick up urban renewal ideas he could apply in Saint-Étienne, a coal and textile town of 180,000 that had been in decline for decades. A former English teacher at the Lycee Honoré d'Urfé, Thiollière came home with big ideas but needed capital to implement them. By 2001, with the help of his deputy mayor for finance, Antoine Alfieri, he began buying complex financial products to reduce the city's debt and free up cash.

The products—interest rate swaps and other derivatives whose values were based on such exotic metrics as the difference between long-term rates in the U.K. and short-term rates in Japan—performed as advertised for a while. Thiollière and Alfieri cut finance costs by 12 million euros as the city signed deals with French banks Dexia, Natixis, and Crédit Agricole, and foreign lenders Depfa, Royal Bank of Scotland, and Deutsche Bank. The moves allowed Saint-Étienne and its neighboring towns to build a design center, a 7,200-seat theater, a second streetcar line, even a new business district near the train station. Four years ago, Thiollière was named the fifth-best mayor in the world by City Mayors, a London-based think tank.

Saint Étienne's luck changed in 2008 as the global financial crisis turned interest rates on their head, sparked wild currency swings, and made some banks unwilling to renegotiate contracts. Thiollière was turned out of office. And, inevitably, the bills started coming due. The first arrived this month, two years after he left, as the embedded financial obligations he agreed to began to blow up.

The 800-year-old town owed 1.18 million euros ($1.61 million) to Deutsche Bank as of Apr. 1. The new administration, led by Mayor Maurice Vincent, refused to pay; last November it filed a lawsuit arguing that the bank hadn't adequately explained the risk and that Thiollière didn't have the right to sign the contract. (Deutsche Bank disputes those claims.) The move dodged, for now, the fallout from one of the 10 contracts still in force, deals so exquisitely speculative that no bank will buy them back, says Cedric Grail, 38, who was brought in as municipal finance director in October 2008. The 10 contracts, he says, would cost about 100 million euros to cancel today.

The savings Saint-Étienne generated were far smaller than the risk it loaded onto itself during what Grail describes as "a constant sprint to stay out front. It wasn't a race to keep the city hedged. It was a race to mask potential losses, because the more risk you take, the more potential losses you can hide." Sitting in his office in Saint-Étienne's 19th-century city hall, a grand stone building whose arched facade is inscribed with the words Liberté, Egalité, Fraternité, Grail points to a chart of the 10 contracts. "It's a joke that we're in markets like this," he says. "We're playing the dollar against the Swiss franc until 2042."

Saint-Étienne 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. Now they may be on the hook for billions of euros in debt, a burden that will likely plague them for the next generation. From the Mediterranean to the Pacific coast of the U.S., officials in government, public agencies, and nonprofit institutions have lost billions of dollars because of transactions they didn't grasp. Harvard University last year agreed to pay more than $900 million to terminate swaps that assumed interest rates would rise. Jefferson County, Ala., almost went bankrupt two years ago because of interest rate swaps it bought to hedge a portfolio of variable-rate bonds. Swaps and other complex, unregulated derivatives are what Warren Buffett famously called "financial weapons of mass destruction." (Another form of credit derivative, the synthetic collateralized debt obligation, is at the heart of the SEC's civil suit against Goldman Sachs.)

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 that its costs would be lower but taking on the risk that they could be many times higher. "This is speculating in the hopes of gain," says Peter Shapiro, managing director at Swap Financial Group, which advises companies and governments on derivatives. "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. Understanding the products requires complex software and financial expertise that local governments often don't have. The banks that sold the derivatives were many of the same ones that later received government bailouts. "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," says Sandra de Pinho, finance director for Lille in northern France.

City and regional governments in Europe mainly get their financing from banks, while in the U.S. they tend to raise funds by selling bonds. Local authorities in the European Union's 27 member states had a combined debt of 1.21 trillion euros in 2008, according to the EU. Government officials used up-front cash payments from guaranteed rates at the beginning of swap contracts to lower their short-term costs and live beyond their means. "These municipal swaps are the same thing as Greece," says Emmanuel Fruchard, a former banker who is now a city council member in Saint-Germain-en-Laye, near Paris. "It's all trying to dress up your accounts. This isn't traditional asset management; it's like a hedge fund. And it's done in bad faith. An elected official who takes the benefit from the guaranteed low rates [in the early years of a deal] without understanding what happens after his mandate ends is acting in bad faith." Goldman Sachs arranged a currency swap in 2002 that helped Greece hide the size of its annual deficit and national debt. Last fall the country doubled its deficit estimate for 2009, triggering a crisis that eventually led the EU to offer a 30 billion euro rescue package.

Unlike Greece, towns and cities in France can't count on the EU to bail them out. More than 1,000 municipalities in France had 11 billion euros in "risky" contracts at the end of 2009, according to Finance Active. In Italy, about 467 public borrowers faced losses of 2.5 billion euros on derivatives as of the end of September. In Germany, Deutsche Bank sold contracts based on the difference between long- and short-term rates to about 50 municipal governments and utilities. One town, Pforzheim, on the edge of the Black Forest, is taking a 55 million-euro loss after following the bank's advice and taking out bets on interest rates in 2004 and 2005, says former budget director Susanne Weishaar. The town also has a projected 50 million euro annual shortfall thanks to a decline in tax revenue and rising social costs.

Deutsche Bank, Weishaar says, presented her with a 10-year chart showing that long-term rates were consistently higher than short-term. During an initial phase of guaranteed rates, the town paid 1.5% to the bank on 60 million euros of debt while receiving 3% to 3.75% from the bank. In 2005 and 2006 the difference between long- and short- term rates collapsed and potential losses soared. Weishaar bought more swaps from JPMorgan Chase in a vain attempt to protect the town budget. Pforzheim now owes JPMorgan the equivalent of 11% of its annual budget. The Baden-Württemberg regional government recently ordered the town to cut its budget by 240 million euros, or about 12% annually, over the next four years.

"It's like Easter eggs," said Weishaar, 45, whose decision to buy the swaps is being investigated by a German prosecutor's office. "You want to buy one and somebody sells you a painted hand grenade instead."

Cedric Gail jumps up from his chair and charges over to a whiteboard. With a few strokes of a black marker, Saint-Étienne's finance director shows why some of these contracts are so noxious—because currency fluctuations will determine how much his town owes Dexia and Deutsche Bank.

"Am I angry? No," he says. When he was hired away from the Lyon metro area authority 18 months ago, Grail looked into Saint-Étienne's cupboard and found a nest of snakes: contracts for more than two dozen derivatives, many already renegotiated several times. "My fundamental response is that a city shouldn't bet on the dollar or yen when it has resources only in euros," he says. "And betting on 10 times the yield curve is never right. Some people said we were crying wolf because we started making noise about this before there was any actual impact on our accounts," he adds. "But that impact is coming now and is really going to hit, some later this year and especially next year and the year after."

Saint-Étienne began its gambling spree in 2001. That year, Alfieri, Thiollière's finance director, signed a 22 million euro loan from Dexia at 4.9% to consolidate civic projects. The rate would rise if the benchmark three-month London interbank offered rate, or Libor, exceeded 7%. Alfieri, who declined to comment for this story, signed six swap contracts on that loan between 2005 and 2008, the last three with Deutsche Bank. They lowered the city's effective costs to 4.35% in 2006, 4.07% in 2007, and 4.3% in 2008 and 2009—for a savings of 126,377 euros in the final year alone.

European accounting rules help keep such deals hidden, because most local governments have no obligation to set aside cash against potential losses. Their budgets reflect only current-year cash flows. "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% 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.

In April 2010 the risks finally hit Saint-Étienne. A 2008 Deutsche Bank swap based on the strength of the British pound against the Swiss franc obligated Saint-Étienne to pay the bank a quarterly payment of 1.18 million euros, equivalent to an annual 24% on the debt—while the bank would pay the city 241,886 euros. The pound has slumped 21% since the deal was signed.

It would cost Saint-Étienne 20 million euros today to cancel that swap, Grail says, running his fingers through his salt-and-pepper hair. That would still leave the town on the hook for the 19 million euros left on its underlying loan from Dexia. "Our goal isn't to go to war with the banks," he says. "Our goal is to protect Saint-Étienne's citizens from the aberrant decisions made by the prior team."

With its suit against Deutsche Bank now pending, the city hasn't paid what it owes the bank and returned the bank's January net payment of 30,735 euros. It has increased the amount set aside for financial risks to 6.5 million euros, from less than 400,000 euros in 2008.

Two of Saint-Étienne's swaps with Royal Bank of Scotland are especially exotic. Called "snowball swaps," they move in steps, with each payment based on the size of the previous one, thus magnifying the trend. Saint-Étienne would need to pay RBS 3.18 million euros to cancel the first snowball and 4.05 million euros to cancel the second, according to the mayor's office. A spokeswoman for RBS declined to comment.

Saint-Étienne asked Eric Gissler, a 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 for finance. The town has been unable to alter its contracts with RBS, he said. Christian Le Hir, chief legal officer for Natixis, said his firm is ready to negotiate. "Banks were looking to sell products," Le Hir says. "Local governments were looking to buy them because it suited them, at least in the short term."

To begin clawing its way back, Saint-Étienne trimmed 19%, or 50 million euros, from its 2008-14 investment plan and raised local taxes twice—by 7.5% in 2009 and 2% this year. Local authorities also canceled a 120 million-euro streetcar line and slashed by 75% a plan to renovate the local coal-mining museum. "The real pain for us is just starting now and is coming over the next several years," says Grail. That's because Saint-Étienne's guaranteed rates under eight remaining swaps end between now and September 2012, while one allows the city to pay nothing until 2020. (After that, a complex and potentially costly formula based on currency fluctuations kicks in.) They can't be restructured, Grail says, because "no bank today will take on a swap where you're betting on 10 times the yield curve, or on currencies. So we're stuck, and the explosions are starting to go off."

Efforts to regulate derivatives sales to local governments remain patchy. The EC isn't working on EU-wide rules. In France, the central government negotiated a voluntary good-conduct agreement in which banks pledged not to sell local authorities interest-rate contracts based on debt principal, commodities, or foreign currencies; it wasn't signed by all banks operating there or by all local government associations. In Italy, a Senate committee in March proposed a ban on swaps for smaller towns, except provincial capitals. And a Milan judge has charged Deutsche Bank, JPMorgan, UBS, and Depfa Bank with fraud linked to the sale of derivatives to that city. The trial is scheduled to start on May 6. The firms deny wrongdoing.

Thiollière, the former mayor, is curiously unruffled by the financial cataclysm he invited into his hometown. "If I put myself in the context of 10 years ago, I don't really see what I could reproach myself for," he says, sitting in the gilded conference room of the French Senate, in Paris, where he represents the Loire Department. "I made sure I had a professional team, with a clear goal to lower debt, lower taxes, lower financial charges. There are useful debts, ones that allow you to rebuild a city."

Four years after being voted fifth-best mayor in the world and two years after being voted out of office, Senator Thiollier, now 55, appears placid. "Managing a town is like running a company," he says. "It's taking risks daily."

    Before it's here, it's on the Bloomberg Terminal.