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Disaster for the municipalities By Jan Dams

By Jan Dams
“Die Welt” (Germany), 5th January 2010

In order to reduce the heavy burden of interest, hundreds of communities have resorted to investing in high-risk financial products. Pforzheim is now threat-ened with the loss of nearly 80 million euro. Now the city wants to reclaim the money from the banks. However it has a very thin chance of success.

2004 must have been a terrible year for Susan Weishaar. Money was scarce, the debts large - so large that Pforzheim's city treasurer wondered how she could pay the interest on the loans. There seems to be no other explanation as to why she signed a contract that today is deemed by a good many to be a pact with the Devil. In the case of Pforzheim this is the Deutsche Bank. How much worse must the year 2006 have been when Weishaar tried in desperation to drive out the Devil with Beelzebub - this time it was the American investment bank JP Morgan. Since something like this never works, these financial transactions could cost the town 80 million euro. Pforzheim is now considering taking legal action to reclaim from the Deutsche Bank the millions it stands to lose with JP Morgan.

What sounds so confusing has its origins in a popular development. For years many municipalities have not known how to pay their expenses. They have saved as best they could: public baths were closed, jobs in the administration sector deleted, kindergarten no longer closes at 4p.m. but at midday. Still there is not enough money. In most cases the decline of the communities be-gan with the economic decline. Collieries in the Ruhr area were closed. Tax revenues declined as opposed to the rise in social welfare costs for the unem-ployed and their families. This leads to a vicious circle of rising debts, high credit, and new debt. Even in the boom years 2007 and 2008 with their high tax revenues, in North Rhine Westphalia alone there were more than 100 communities in which the situation was so bad that their affairs were adminis-trated directly by the regional government.

It is no wonder that the offers of the Deutsche Bank and its competitors ap-peared attractive and sounded convincing to many municipalities. Usually cities and communities take out loans which they agree to pay off in ten, twenty or thirty years. Since the interest rates on long-term loans are usually higher than on short-term loans the Deutsche Bank offered Susan Weishaar special conditions. In simple terms; the bank pooled the long-term interest rates on the loans given to the town and exchanged them on the money market for short-term interest rates. Long versus short or what is known in German banking terminology as ladder swap spread. The higher the interest rates diverged , the more profit the town would have made. And since Susan Weishaar wanted to reduce the interest burden of her community she concluded one such contract, then another. In the end she had signed 17 contracts for a volume of 60 million euro. The treasurer was neither greedy nor particularly irresponsible. Simply naive. As were many others at this time. In Germany alone allegedly more than 200 municipalities made similar arrangements with the Deutsche Bank. Ravensburg, Hagen, Neuss and Solingen to name but a few.

To understand this procedure one has to go back a few years in time. Then, the world capital market was booming. Fabulously designed financial products promised to solve every financial problem. One could earn money with rising prices on the stock market , with falling prices as well. One could bet on currencies, on commodities, even on the weather - and on interest rates. The more complicated the business, the greater the profits - at least for the banks, who earned high sales commissions.

These investments sounded so unbelievably good that a city treasurer needed a lot of backbone to withstand the temptation. "They are standing with their backs to the wall," is how Torsten Albig, Mayor of Kiel, describes the predica-ment. Had these cities done nothing in the situation they would have been faulted for that , too. Contracts which now - five or ten years on show losses did reduce the interest expense of the cities in those years. Even the contro-versial cross-border transactions in which communities sold property and then leased it from the new owners were profitable. Until the financial crisis appeared.

For Susan Weishaar the debacle began earlier. In early 2006 it was as though the market had turned against her. Gradually the short-term interest rates rose in value and very soon were higher than the long-term ones: a development with which the woman in the Pforzheim City Hall had not reckoned . And who is to know whether or not the bankers who sold the financial products to the communities had foreseen this trend. Thus in February 2006 the plus of 2.7million euro in Pforzheim books became a minus of 11 million. Could it have been fear that caused the treasurer to fail to react earlier? Ac-cording to the recently released report of the community's auditing department, she did not inform Mayoress Christel Augenstein of the situation until early October. At that point in time the Deutsche Bank had already reconstructed the portfolio once. Unfortunately the market value of the three swaps fell even more . A loss of 17.4 million euro meant the worst case scenario for Pforzheim.

The longer the mayoress and her treasurer thought about it, the more desper-ate the situation must have seemed to them. The market seemed to have con-spired against them. In the end their only chance was to hope for the one big throw. Just as players whose gaming debts are so enormous that they cannot afford to leave the gaming table because only the jackpot can save them, so the two politicians decided to stake everything on the one chance. This last card was JP Morgan , the investment bank. In her hour of need Weishaar turned to the Americans . After all the bank knew of ways and means by which the town , and with it the mayoress and the treasurer could escape from their dilemma. The magic word was “mirror trades” (meaning hedging trades with the opposite position or reversed deals). JP Morgan wanted to copy the Deutsche Bank swaps , only in reverse. The bet was turned around. If the contracts with the Deutsche Bank showed a loss then the JP Morgan Bank booked these as a profit. In the balance sheets this would appear as zero. On behalf of the city of Pforzheim Christel Augenstein signed five con-tracts with a value of a further 60 million euro. Today, three years later everybody in the town knows what a mistake this was. In the meantime the contracts with the Deutsche Bank are worth over 5 million euro, but not those with JP Morgan. These were reversed contracts. However matters are not quite so simple. JP Morgan's three investments ; Momentus, CarryMax and Momentus Quattro have a deficit of 53 million euro. If the worst comes to the worst the city may have to pay the legendary sum of 77.5 million euro in the years 2014 -2017. The bankers who pocketed the commissions are the only ones laughing. The rate of a commission in the Deutsche Bank is 5% which makes 3 million euro on the 60 million. It is hard to believe that the com-petitors will be satisfied with any less. Nobody at JPMorgan is willing to com-ment on the situation.

How can anyone be so stupid is the question which observers have been ask-ing for months. The answer is simple. The mayoress and the treasurer were out of their depth. Albig, Kiel , is familiar with such situations: Suddenly one is confronted with a 1000-page contract in English. One should be in a position to understand every detail. Who, apart from qualified lawyers employed by large concerns for astronomical salaries is in such a position. "For many this is asking too much," says Albig. Only those who are cautious and set themselves limits can survive such a predicament. This was not the case with Weishaar and her boss. They did not even become suspicious when the bank spoke of theoretically high risk of losses.

In spite of all this the town wants its money back.. Not from JP Morgan, but from the Deutsche Bank. "After all, the bank is to blame that Pforzheim agreed to the reverse deals with the Americans," said Jochen Weck from the firm Rössner which is representing Pforzheim in court. "The bank should never have sold such highly speculative deals to the town. And it knows it." It all boils down to one argument: the treasurer and the city of Pforzheim were as investors so inexperienced in the handling of structured finance products that the Deutsche Bank should never have presented them with the offer of spread ladder swaps. This was done in such a way as to suggest that the professional treasurer was an old lady who never takes risks beyond the limits of state bonds, such as offered in Germany because there should be enough left for her grandson. A town spokesman was recently quoted as saying: "Only if Pforzheim loses its case against the Deutsche Bank will it consider taking JP Morgan to court."

The chances do not look particularly good. A trial observer commented that during a similar court case , Ravensburg versus the Deutsche Bank in Ulm, the judge took out her pocket calculator and reckoned the negative effect on the swaps if the acquisitions were changed. Like Pforzheim , Ravensburg had tried to have the interest reduced on a credit portfolio. The town lost their case. The verdict: The city fathers should have known what they were doing.