Flirting with danger

Major blow-ups in the derivatives market have been few and far between, but disaster tends to stick in people's minds. Those with even scant knowledge of the industry will probably be able to reel off a long list of firms that have lost money - and in some cases, collapsed spectacularly - after using derivatives.

Orange County and Hammersmith and Fulham are likely to be near the top of those lists, alongside a handful of other A-list blow-ups such as Barings, Procter & Gamble and Gibson Greetings.

In the case of Orange County, a series of rate hikes by the US Federal Reserve, starting in February 1994, caused the municipality to rack up $1.6 billion in losses after derivatives were used to express a view that rates would stay steady or would fall.

Hammersmith and Fulham, meanwhile, ended up with sizeable losses in the late-1980s after entering into a series of swaps contracts with various counterparties. In this case, the House of Lords ruled that the swaps were ultra vires - in other words, that the London borough did not have the authority to engage in derivatives in the first place - and so were legally unenforceable.

Derivatives can be useful tools to help municipal treasuries manage interest rate exposures on financing. But if nothing else, Orange County and Hammersmith and Fulham should highlight the dangers of using leveraged swaps without the requisite systems and in-house expertise.

In Germany, however, there seem to be a few instances of inexperienced and under-resourced city treasuries using derivatives to manage bloated budget deficits. German state treasury officials concede that the level of sophistication within municipal finance departments varies greatly, and some question whether the cities fully understand the risks of these products. Despite this, city treasurers have the flexibility to use derivatives to manage budget deficits, with virtually no oversight from state or federal government.

There has already been one lawsuit, with a municipal-owned utility in the state of Saxony-Anhalt winning damages from an unnamed German bank for not providing sufficient risk advice on a 10-year currency swap - despite testimony from the managing director of the company that he had understood the risks involved.

It does not take a huge leap of the imagination to imagine more lawsuits coming from municipals nursing heavy derivatives losses - perhaps even with the concept of ultra vires raising its ugly head once again. Banks need to think carefully before they enter into derivatives transactions with municipalities, and at the very least make sure they have the relevant permissions in place.

Nick Sawyer, Editor