They're not happy in Saint-Etienne right now.
It's not just that the local football team is near the bottom of the French league. A far more serious problem has hit the 800-year old city. The global financial crisis has just arrived in town.
A few years ago, officials at Saint-Etienne tried to cut their borrowing costs by dabbling in derivatives. This has now very badly backfired.
And the damage won't be confined to the south of France. We could all feel the knock-on effects...
Saint-Etienne took a gamble - and it's gone badly wrong
Saint-Etienne's plight shows what can happen when the smart financial salesmen call.
What they're selling seems like a good idea at the time. But later, the buyers realise they didn't understand what they were getting into. And they find it's all gone horribly wrong.
Back in 2001, Saint-Etienne borrowed €22m at a 4.9% interest rate to consolidate its civic project loans. Simple enough. But then, between 2005 and 2008, Saint-Etienne tried to cut its borrowing costs. It signed several 'swap' deals – intricate, unregulated, derivatives contracts that can change the interest rate to be paid – on the loan.
The immediate impact was to cut the city's effective debt costs. In 2009, for example, the interest bill saving was a handy €126,377 as the rate fell to 4.3%.
Smart thinking, it seemed – until now. Because what Saint-Etienne's financial bosses of the time failed to grasp (or perhaps preferred to brush aside), was what lay on the flipside of these deals.
A swap deal is so named because you are swapping one thing for another. In this case, a fixed interest rate of 4.9% for a variable one. You're gambling that the variable rate will stay lower than the fixed rate. Trouble is, Saint-Etienne's gamble has gone horribly wrong.
The guaranteed interest rate period on one of their swaps has just ended. Under the terms of the deal, the new rate is based on how the British pound has performed against the Swiss franc. Unfortunately, sterling has slumped by 21% against the franc in the two years since the deal was done.
So on 1 April this year, Saint-Etienne got a quarterly interest bill – which it's refusing to pay – for €1.18m. That tots up to a 24% annualised interest rate – high enough to make a sub-prime lender blush. Worse still, to cancel all of the ten derivative deals to which the city has signed up would cost about €100m, because no bank would be willing to buy them back now. Remember – this all stems from an original loan of just €22m.
"It's a joke that we're in markets like this", as Cédric Grail, Saint-Etienne's current municipal finance director, tells Bloomberg. "We're playing the dollar against the Swiss franc" – another high risk bet – "until 2042".
Thousands of local authorities are punting tax payers' money
Why on earth was a French local authority effectively punting taxpayers' money on the currency markets? Good question. But the answer is that Saint-Etienne was far from the only one. It's just one of thousands of public authorities across Europe that got mixed up in highly risky derivatives.
The city of Pforzheim in Germany, for example, has made a €55m derivative loss. Susanne Weishaar at Pforzheim says that taking on a swap deal is like going to buy an Easter egg, only to find "somebody sells you a hand-painted grenade instead."
Multiply the likely losses across the region and soon you're talking about real money. Municipalities and other local authorities in the European Union's 27 member states had combined debts of €1.21 trillion in 2008, according to Eurostat. Not all of that will have become tied up in derivatives. But the Bank of Italy and various French and German law firms reckon these bodies "may be liable for billions of euros,", says Alan Katz at Bloomberg.
Nor is it just a European problem. Six months ago we wrote about how Jefferson County, in Alabama in the US, had faced similar problems as a result of betting on interest-rate swaps to fund their new sewers.
So how will all this play out?
Several countries could be pushed back into recession
On the one hand, this is another cautionary tale of snake-oil salesmen selling booby-trapped derivatives to naïve investors. And this is relevant to individual investors. The complexity and lack of transparency of such derivatives is one reason we dislike structured products, as we noted in a recent edition of MoneyWeek magazine: Four reasons to avoid structured products. (If you're not already a susbscriber, you can claim your first three issues free here.)
But the root cause isn't toxic financial products. It's too much debt being run up by government departments in the first place. Local authorities now say they were mis-sold these derivatives by banks. Maybe they were.
But if you're under pressure to maintain spending on services you should really be cutting, it's all too tempting to ignore the long-term risks of such big bets in favour of the short-term pay-offs. Especially if you're betting with other people's money.
It shows that the big risks don't just lie with the likes of Dubai and Greece. If a local authority goes bust, its costs will have to be chopped savagely. Public services will be slashed and staff fired. And as we've seen from almost all the other bailouts over the two years, taxpayers will end up picking up the tab.
With most governments already under heavy pressure to cut their spending, a series of crises at local level could push several countries back into recession.
It's also yet another sign that the fallout from the financial crisis is by no means over. There could be many more big shocks from over-extended local authority borrowers who've tried, and failed, to gamble their way out of debt. And the more markets rise, the more vulnerable they'll be to extra unpleasant surprises.
In addition, if lenders start to worry about more potential dodgy debt time bombs lurking in the system, they'll become more wary about lending. So the price of money – i.e. the long-term interest rate – will rise.
This is yet another reason – on top of those we pointed out on Monday why the price of many bonds is increasingly likely to fall from here.
One of the most important things an investor can do is to get asset allocation right. Exchange traded funds offer one of the easiest ways to do this. Bengt Saelensminde explains how, and offers some ideas on which to buy.
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