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Opinion

Macaskill on markets: Government trades are not one-way bets for investment banks

The focus on the role of Goldman Sachs in structuring currency and interest rate swaps for Greece a decade ago has highlighted the upside and downside of providing complex liability advice and trades to governments.

Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks

Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks

The potential upside is obvious. Goldman Sachs booked profits that are variously estimated at about $300 million from swapping Greek foreign-currency debt to euros around the time of its entry to the single currency in ways that helped the sovereign to manage its reported debt levels.

Effective liability management for borrowers also typically leads to rewards in the form of underwriting mandates. Goldman took a leading role in sales of Greek debt issues after its work to tailor the sovereign’s debt profile ahead of euro entry.

A close relationship with sovereign treasury officers also brings less tangible benefits, such as access to politicians and the politically connected. This can be invaluable in pitching for advisory, underwriting and structuring mandates with the many corporations and quasi-state bodies that take a cue from their treasuries and finance ministries.

The potential downsides for bankers to tight relationships with sovereign and municipal borrowers are becoming more obvious as strains on public finances grow. One downside is the threat of regime change. Greece has an unusually politicized civil service, as recent wrangles over manipulation of statistics have demonstrated. Debt management is set to take an increasingly high profile in most countries as absolute borrowing levels rise, however.

This is likely to increase the chance that one side in a political battle over debt management will leak details of an individual bank’s role in any structured trades. This trend, combined with an understandable move to force more transparency on debt managers, could lead to further embarrassment and reputational risk for banks.

The trend is also likely to lead to the worst of all possible worlds for banks – a reduction in their ability to squeeze hefty undisclosed fees from complex liability management trades that have an inbuilt hedge for the dealer.

Structured sovereign trades by dealers – like similar deals done for corporates or major investors – used to also have an implied reputational hedge for dealers that was quite distinct from an actual hedge of financial exposure.

A derivatives-based trade that met its stated goal of lowering or containing costs would be viewed as a success by both the borrower and the bank counterparty. It might even throw up a windfall profit for the client.

A trade that went wrong would be quietly buried by all involved, never to be spoken of again. A sovereign funding officer might be sidelined and the bank involved might go through a dry spell of missed mandates. But neither side wanted the embarrassment of public disclosure of a mistake.

That compact is ending, though at different paces even within individual countries, as the case of Italy demonstrates. Italian sovereign and municipal borrowers adopted derivatives-based liability management with gusto in the 1990s and remain heavily exposed to swaps.

The Italian finance ministry has resolutely resisted calls for detailed explanation of its derivatives use through the years. It has been helped in this stonewalling by its broad success in managing its debt costs.

Until the start of the financial crisis in 2007, Italy’s use of interest rate and currency swaps produced net profits of billions of euros. Even in 2007 and 2008 its losses were limited to a few hundred million euros.

This strong performance contrasts with the track record of Italian municipalities, which are further down the structuring food chain because of their limited ability to award fees to banks and an even more limited capacity for understanding why bankers are so keen to tout a particular structure. Italian municipalities are now trying to shame banks out of collecting in full on some existing derivatives. The highest-profile attempt to renege on old deals is being made by Milan.

This led to a suit against Depfa, Deutsche Bank, JPMorgan and UBS that accuses the dealers of collecting €101 million in hidden fees to which they are not entitled.

Even when banks successfully defend cases like these the victory can be Pyrrhic, as embarrassing publicity casts a shadow over attempts to win other business. In extreme cases bank executives become unwilling to visit particular jurisdictions for fear of arrest, which definitely puts a crimp in pitching for new deals.

This can lead to a decision to withdraw from a particular sector. JPMorgan shut down its municipal derivatives operation in the US in 2008 as it became involved in a growing number of legal cases alleging malpractice, for example.

Major dealers do not want to pull back from offering full-service liability management to sovereign borrowers, just as government borrowing explodes across the globe. But there is a growing risk that they will be treated as utility service providers by sovereigns, and paid accordingly.

If routine primary-dealer functions cannot be augmented with lucrative accompanying structuring mandates, the appetite to help governments might start to wane at investment banks. And that could hurt the ability of some governments to service their debts when global rates start their eventual upward march.

The rise in default swap quotes and spreads to Bunds for Greece has drawn attention to potential credit problems at relatively small nations.

Some long-dated prices also signal challenges in the future for much bigger borrowers such as the UK and the US. Both the sterling and US dollar interest rate swap markets have suffered from persistent inversion of spreads to government bond yields in the 30-year maturity, for example.

There are plausible technical explanations for this inversion, including swap illiquidity, hedging of exotic derivatives by dealers and liability balancing by insurers.

Negative swap spreads also reflect concern about likely future government debt issuance volumes, however. And even liquid tenors such as the 10-year maturity have seen swap spreads tightening to US and UK government bond yields. Ten-year sterling swap rates moved decisively below gilt yields in late February in the latest indication of looming funding problems for the UK. This indicates a change in the relative perception of the creditworthiness of the UK and a collective of global banks.

As public borrowers increasingly compete with the private sector for capital and tiering of sovereign credit becomes more pronounced, governments will be forced into increasingly symbiotic relationships with major dealers. This in turn is likely to complicate the process of reforming bank regulation. As strains on public finances mount across the globe, dealers might feel they have a stronger hand to play as they try to head off fundamental changes to their business practices. They would be advised not to overplay this hand, though. Serious strains in the public financing markets for sovereign borrowers could quickly spread to a renewed loss of confidence in global banks.

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