Sense on Cents

Will Caveat Emptor once again be the order of the day as the City of Milan charges JP Morgan, Deutsche Bank, UBS, and Hypo Real Estate’s Depfa Bank unit with fraud in the sales of derivatives?

Bloomberg reports on this breaking story this morning in writing, Deutsche Bank, JP Morgan, UBS Are Charged with Derivatives Fraud:

Deutsche Bank AG, JPMorgan Chase & Co., UBS AG and Hypo Real Estate Holding AG’s Depfa Bank Plc unit were charged with fraud linked to the sale of derivatives to the City of Milan.

Judge Simone Luerti scheduled the trial of the four firms, 11 bankers and two former city officials for May 6, Prosecutor Alfredo Robledo said after a hearing in Milan today. The banks allegedly misled the city on swaps that adjusted interest payments on 1.7 billion euros ($2.3 billion) of borrowings.

Prosecutors across Italy are probing banks as local and national government agencies face potential losses of 2.5 billion euros on derivatives, lawyers say. The Milan probe may also affect cases as far away as the U.S., where securities firms have faced charges for price-fixing and bid-rigging in the sale of derivatives to municipalities, though not for fraud, according to former regulator Christopher “Kit” Taylor.

I addressed this activity across Italy last week in writing, Using Derivatives ‘Like Hard Drugs’:

Prescription drugs can only be accessed through a physician for a reason.  When used appropriately under the guidance of an ethical and informed doctor, the powers of prescription drugs can be life-changing and life-saving. When these prescription drugs are marketed by those more interested in their own bottom line than the health and well-being of their ‘patients’, then use often turns to abuse and the effects are crippling.

A similar dynamic plays out in the high and mighty halls of international finance. The Financial Times writes a captivating story on how the abuse of derivatives has overwhelmed cities and towns across Italy. This article, entitled An Exposed Position, is a riveting view as to how the abuse of financial derivatives will have untold costs for years to come.

As with any prescription medicine or financial product, the first question a potential buyer/investor needs to ask is whether to trust the ‘doctor.’ Who would knowingly ingest medicines or products if you thought the provider was less than totally ethical? The FT addresses this very point:

The scandal also raises bigger questions about the ethics of the financial industry in relation to complex products. In recent years, most bankers assumed they were allowed to sell anything they wanted to non-retail clients, since it was presumed that “sophisticated” investors would be able to protect their own interests.

However, what has become clear in Italy is that many public sector clients were unable to understand the maths of complex finance risks. This is likely to force investment banks to rethink their definition of “sophisticated” clients; it could also encourage politicians in Europe and elsewhere to clamp down much more aggressively on the entire derivatives trade.

Once again, Caveat Emptor is the order of the day. As the buyers of the products became more ‘hooked,’ the marketing and pricing became that much more aggressive.

The FT highlights this development:

The more complex the deals became the less the local authorities understood them, claim several lawsuits against the banks. Derivatives specialists and some political sources dispute this and say local politicians chose to ignore the risks because of the potential gains. Domenico Siniscalco, then finance minister, warned back in 2004 that local authorities were using derivatives “like hard drugs”.

I do not absolve the users of these hard drugs from their responsibilities and obligations. By the same token, not every distributor of the ‘hard drugs’ is necessarily unethical. Very simply, the risks of the derivatives do not come with sufficient transparency. Additionally, what is plainly obvious is that not only in Italy but literally everywhere around the globe, the pushers and distributors of these ‘hard drugs’ are not properly regulated. Why not?

All too often we see that the regulators are in bed with the pushers.

Who bears the ultimate costs? Society, that is the taxpayers of the towns, cities and states, not only in Italy but in every other country where these hard drugs have established a foothold.

What a world.

Again, a failure of regulation and regulators has caused the City of Milan, other Italian investors, and truly investors everywhere to live and invest by the mantra of CAVEAT EMPTOR.

Navigate accordingly.

LD

This entry was posted on Wednesday, March 17th, 2010 at 9:33 AM and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.