A £516 trillion derivatives 'time-bomb'

Not for nothing did US billionaire Warren Buffett call them the real 'weapons of mass destruction'

By Margareta Pagano and Simon Evans
Sunday, 12 October 2008

The market is worth more than $516 trillion, (£303 trillion), roughly 10 times the value of the entire world's output: it's been called the "ticking time-bomb".

It's a market in which the lead protagonists – typically aggressive, highly educated, and now wealthy young men – have flourished in the derivatives boom. But it's a market that is set to come to a crashing halt – the Great Unwind has begun.

Last week the beginning of the end started for many hedge funds with the combination of diving market values and worried investors pulling out their cash for safer climes.

Some of the world's biggest hedge funds – SAC Capital, Lone Pine and Tiger Global – all revealed they were sitting on double-digit losses this year. September's falls wiped out any profits made in the rest of the year. Polygon, once a darling of the London hedge fund circuit, last week said it was capping the basic salaries of its managers to £100,000 each. Not bad for the average punter but some way off the tens of millions plundered by these hotshots during the good times. But few will be shedding any tears.

The complex and opaque derivatives markets in which these hedge funds played has been dubbed the world's biggest black hole because they operate outside of the grasp of governments, tax inspectors and regulators. They operate in a parallel, shadow world to the rest of the banking system. They are private contracts between two companies or institutions which can't be controlled or properly assessed. In themselves derivative contracts are not dangerous, but if one of them should go wrong – the bad 2 per cent as it's been called – then it is the domino effect which could be so enormous and scary.

Most markets have something behind them. Central banks require reserves – something that backs up the transaction. But derivatives don't have anything – because they are not real money, but paper money. It is also impossible to establish their worth – the $516 trillion number is actually only a notional one. In the mid-Nineties, Nick Leeson lost Barings £1.3bn trading in derivatives, and the bank went bust. In 1998 hedge fund LTCM's $5bn loss nearly brought down the entire system. In fragile times like this, another LTCM could have catastrophic results.

That is why everyone is now so frightened, even the traders, who are desperately trying to unwind their positions but finding it impossible because trading is so volatile and it's difficult to find counterparties. Nor have the hedge funds been in the slightest bit interested in succumbing to normal rules: of the world's thousands of hedge funds only 24 have volunteered to sign up to a code of conduct.

Few understand how this world operates. The US Federal Reserve chairman, Ben Bernanke, tapped up some of Wall Street's best for a primer on their workings when he took the job a few years ago. Britain's financial regulator, the Financial Services Authority, has long talked about the problems the markets could face on the back of derivative complexity. Unfortunately it did little to curb the products' growth.

In America the naysayers have been rather more vocal for longer. Famously, Warren Buffett, the billionaire who made his money the old-fashioned way, called them "weapons of mass destruction". In the late 1990s when confidence was roaring in the midst of the dotcom boom, a small band of politicians, uncomfortable with the ease with which banks would be allowed to play in these burgeoning markets, were painted as Luddites failing to move with the times.

Little-known Democratic senator Byron Dorgan from North Dakota was one of the most vociferous refuseniks, telling his supposedly more savvy New York peers of the dangers. "If you want to gamble, go to Las Vegas. If you want to trade in derivatives, God bless you," he said. He was ignored.

What is a Derivative?

Warren Buffett, the American investment guru, dubbed them "financial weapons of mass destruction", but for the once-great-and-good of Wall Street they were the currency that enabled banks, hedge funds and other speculators to make billions.

Anything that carries a price can spawn a derivatives market. They are financial contracts sold to pass on risk to others. The credit or bond derivatives market is one such example. It is thought that speculation in this area alone is worth more than $56 trillion (£33 trillion), although that probably underestimates the true figure since lax regulation has seen the market explode over the past two years.

At the core of this market is the credit derivative swap, effectively an insurance policy against the default in the interest payment on a corporate bond. One doesn't even need to own the bond itself. It is like Joe Public buying an insurance policy on someone else's house and pocketing the full value if it burns down.

As markets slid into crisis, and banks and corporations began to default on bond payments, many of these policies have proved worthless.

Emilio Botin, the chairman of Santander, the Spanish bank that has enjoyed phenomenal success during the credit crunch, once said: "I never invest in something I don't understand." A wise man, you may think.

Simon Evans

Taking Hard New Look at a Greenspan Legacy

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October 9, 2008

The Reckoning

By PETER S. GOODMAN

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” — Alan Greenspan in 2004

George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.” Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.”

And Warren E. Buffett presciently observed five years ago that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives — exotic contracts that promised to protect investors from losses, thereby stimulating riskier practices that led to the financial crisis. For more than a decade, the former Federal Reserve Chairman Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street. “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Mr. Greenspan told the Senate Banking Committee in 2003. “We think it would be a mistake” to more deeply regulate the contracts, he added.

Today, with the world caught in an economic tempest that Mr. Greenspan recently described as “the type of wrenching financial crisis that comes along only once in a century,” his faith in derivatives remains unshaken.

The problem is not that the contracts failed, he says. Rather, the people using them got greedy. A lack of integrity spawned the crisis, he argued in a speech a week ago at Georgetown University, intimating that those peddling derivatives were not as reliable as “the pharmacist who fills the prescription ordered by our physician.”

But others hold a starkly different view of how global markets unwound, and the role that Mr. Greenspan played in setting up this unrest.

“Clearly, derivatives are a centerpiece of the crisis, and he was the leading proponent of the deregulation of derivatives,” said Frank Partnoy, a law professor at the University of San Diego and an expert on financial regulation.

The derivatives market is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them.

If Mr. Greenspan had acted differently during his tenure as Federal Reserve chairman from 1987 to 2006, many economists say, the current crisis might have been averted or muted.

Over the years, Mr. Greenspan helped enable an ambitious American experiment in letting market forces run free. Now, the nation is confronting the consequences.

Derivatives were created to soften — or in the argot of Wall Street, “hedge” — investment losses. For example, some of the contracts protect debt holders against losses on mortgage securities. (Their name comes from the fact that their value “derives” from underlying assets like stocks, bonds and commodities.) Many individuals own a common derivative: the insurance contract on their homes.

On a grander scale, such contracts allow financial services firms and corporations to take more complex risks that they might otherwise avoid — for example, issuing more mortgages or corporate debt. And the contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur.

Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable that they required federal oversight to protect the financial system. In meetings with federal officials, celebrated appearances on Capitol Hill and heavily attended speeches, Mr. Greenspan banked on the good will of Wall Street to self-regulate as he fended off restrictions.

Ever since housing began to collapse, Mr. Greenspan’s record has been up for revision. Economists from across the ideological spectrum have criticized his decision to let the nation’s real estate market continue to boom with cheap credit, courtesy of low interest rates, rather than snuffing out price increases with higher rates. Others have criticized Mr. Greenspan for not disciplining institutions that lent indiscriminately.

But whatever history ends up saying about those decisions, Mr. Greenspan’s legacy may ultimately rest on a more deeply embedded and much less scrutinized phenomenon: the spectacular boom and calamitous bust in derivatives trading.

Faith in the System

Some analysts say it is unfair to blame Mr. Greenspan because the crisis is so sprawling. “The notion that Greenspan could have generated a totally different outcome is naïve,” said Robert E. Hall, an economist at the conservative Hoover Institution, a research group at Stanford.

Mr. Greenspan declined requests for an interview. His spokeswoman referred questions about his record to his memoir, “The Age of Turbulence,” in which he outlines his beliefs.

“It seems superfluous to constrain trading in some of the newer derivatives and other innovative financial contracts of the past decade,” Mr. Greenspan writes. “The worst have failed; investors no longer fund them and are not likely to in the future.”

In his Georgetown speech, he entertained no talk of regulation, describing the financial turmoil as the failure of Wall Street to behave honorably.

“In a market system based on trust, reputation has a significant economic value,” Mr. Greenspan told the audience. “I am therefore distressed at how far we have let concerns for reputation slip in recent years.”

As the long-serving chairman of the Fed, the nation’s most powerful economic policy maker, Mr. Greenspan preached the transcendent, wealth-creating powers of the market.

A professed libertarian, he counted among his formative influences the novelist Ayn Rand, who portrayed collective power as an evil force set against the enlightened self-interest of individuals. In turn, he showed a resolute faith that those participating in financial markets would act responsibly.

An examination of more than two decades of Mr. Greenspan’s record on financial regulation and derivatives in particular reveals the degree to which he tethered the health of the nation’s economy to that faith.

As the nascent derivatives market took hold in the early 1990s, and in subsequent years, critics denounced an absence of rules forcing institutions to disclose their positions and set aside funds as a reserve against bad bets.

Time and again, Mr. Greenspan — a revered figure affectionately nicknamed the Oracle — proclaimed that risks could be handled by the markets themselves.

“Proposals to bring even minimalist regulation were basically rebuffed by Greenspan and various people in the Treasury,” recalled Alan S. Blinder, a former Federal Reserve board member and an economist at Princeton University. “I think of him as consistently cheerleading on derivatives.”

Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, says Mr. Greenspan opposes regulating derivatives because of a fundamental disdain for government.

Mr. Levitt said that Mr. Greenspan’s authority and grasp of global finance consistently persuaded less financially sophisticated lawmakers to follow his lead.

“I always felt that the titans of our legislature didn’t want to reveal their own inability to understand some of the concepts that Mr. Greenspan was setting forth,” Mr. Levitt said. “I don’t recall anyone ever saying, ‘What do you mean by that, Alan?’ ”

Still, over a long stretch of time, some did pose questions. In 1992, Edward J. Markey, a Democrat from Massachusetts who led the House subcommittee on telecommunications and finance, asked what was then the General Accounting Office to study derivatives risks.

Two years later, the office released its report, identifying “significant gaps and weaknesses” in the regulatory oversight of derivatives.

“The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole,” Charles A. Bowsher, head of the accounting office, said when he testified before Mr. Markey’s committee in 1994. “In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers.”

In his testimony at the time, Mr. Greenspan was reassuring. “Risks in financial markets, including derivatives markets, are being regulated by private parties,” he said.

“There is nothing involved in federal regulation per se which makes it superior to market regulation.”

Mr. Greenspan warned that derivatives could amplify crises because they tied together the fortunes of many seemingly independent institutions. “The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence,” he said.

But he called that possibility “extremely remote,” adding that “risk is part of life.”

Later that year, Mr. Markey introduced a bill requiring greater derivatives regulation. It never passed.

Resistance to Warnings

In 1997, the Commodity Futures Trading Commission, a federal agency that regulates options and futures trading, began exploring derivatives regulation. The commission, then led by a lawyer named Brooksley E. Born, invited comments about how best to oversee certain derivatives.

Ms. Born was concerned that unfettered, opaque trading could “threaten our regulated markets or, indeed, our economy without any federal agency knowing about it,” she said in Congressional testimony. She called for greater disclosure of trades and reserves to cushion against losses.

Ms. Born’s views incited fierce opposition from Mr. Greenspan and Robert E. Rubin, the Treasury secretary then. Treasury lawyers concluded that merely discussing new rules threatened the derivatives market. Mr. Greenspan warned that too many rules would damage Wall Street, prompting traders to take their business overseas.

“Greenspan told Brooksley that she essentially didn’t know what she was doing and she’d cause a financial crisis,” said Michael Greenberger, who was a senior director at the commission. “Brooksley was this woman who was not playing tennis with these guys and not having lunch with these guys. There was a little bit of the feeling that this woman was not of Wall Street.”

Ms. Born declined to comment. Mr. Rubin, now a senior executive at the banking giant Citigroup, says that he favored regulating derivatives — particularly increasing potential loss reserves — but that he saw no way of doing so while he was running the Treasury.

“All of the forces in the system were arrayed against it,” he said. “The industry certainly didn’t want any increase in these requirements. There was no potential for mobilizing public opinion.”

Mr. Greenberger asserts that the political climate would have been different had Mr. Rubin called for regulation.

In early 1998, Mr. Rubin’s deputy, Lawrence H. Summers, called Ms. Born and chastised her for taking steps he said would lead to a financial crisis, according to Mr. Greenberger. Mr. Summers said he could not recall the conversation but agreed with Mr. Greenspan and Mr. Rubin that Ms. Born’s proposal was “highly problematic.”

On April 21, 1998, senior federal financial regulators convened in a wood-paneled conference room at the Treasury to discuss Ms. Born’s proposal. Mr. Rubin and Mr. Greenspan implored her to reconsider, according to both Mr. Greenberger and Mr. Levitt.

Ms. Born pushed ahead. On June 5, 1998, Mr. Greenspan, Mr. Rubin and Mr. Levitt called on Congress to prevent Ms. Born from acting until more senior regulators developed their own recommendations. Mr. Levitt says he now regrets that decision. Mr. Greenspan and Mr. Rubin were “joined at the hip on this,” he said. “They were certainly very fiercely opposed to this and persuaded me that this would cause chaos.”

Ms. Born soon gained a potent example. In the fall of 1998, the hedge fund Long Term Capital Management nearly collapsed, dragged down by disastrous bets on, among other things, derivatives. More than a dozen banks pooled $3.6 billion for a private rescue to prevent the fund from slipping into bankruptcy and endangering other firms.

Despite that event, Congress froze the Commodity Futures Trading Commission’s regulatory authority for six months. The following year, Ms. Born departed.

In November 1999, senior regulators — including Mr. Greenspan and Mr. Rubin — recommended that Congress permanently strip the C.F.T.C. of regulatory authority over derivatives.

Mr. Greenspan, according to lawmakers, then used his prestige to make sure Congress followed through. “Alan was held in very high regard,” said Jim Leach, an Iowa Republican who led the House Banking and Financial Services Committee at the time. “You’ve got an area of judgment in which members of Congress have nonexistent expertise.”

As the stock market roared forward on the heels of a historic bull market, the dominant view was that the good times largely stemmed from Mr. Greenspan’s steady hand at the Fed.

“You will go down as the greatest chairman in the history of the Federal Reserve Bank,” declared Senator Phil Gramm, the Texas Republican who was chairman of the Senate Banking Committee when Mr. Greenspan appeared there in February 1999.

Mr. Greenspan’s credentials and confidence reinforced his reputation — helping him to persuade Congress to repeal Depression-era laws that separated commercial and investment banking in order to reduce overall risk in the financial system.

“He had a way of speaking that made you think he knew exactly what he was talking about at all times,” said Senator Tom Harkin, a Democrat from Iowa. “He was able to say things in a way that made people not want to question him on anything, like he knew it all. He was the Oracle, and who were you to question him?”

In 2000, Mr. Harkin asked what might happen if Congress weakened the C.F.T.C.’s authority.

“If you have this exclusion and something unforeseen happens, who does something about it?” he asked Mr. Greenspan in a hearing.

Mr. Greenspan said that Wall Street could be trusted. “There is a very fundamental trade-off of what type of economy you wish to have,” he said. “You can have huge amounts of regulation and I will guarantee nothing will go wrong, but nothing will go right either,” he said.

Later that year, at a Congressional hearing on the merger boom, he argued that Wall Street had tamed risk.

“Aren’t you concerned with such a growing concentration of wealth that if one of these huge institutions fails that it will have a horrendous impact on the national and global economy?” asked Representative Bernard Sanders, an independent from Vermont.

“No, I’m not,” Mr. Greenspan replied. “I believe that the general growth in large institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically — I should say, fully — hedged.”

The House overwhelmingly passed the bill that kept derivatives clear of C.F.T.C. oversight. Senator Gramm attached a rider limiting the C.F.T.C.’s authority to an 11,000-page appropriations bill. The Senate passed it. President Clinton signed it into law.

Pressing Forward

Still, savvy investors like Mr. Buffett continued to raise alarms about derivatives, as he did in 2003, in his annual letter to shareholders of his company, Berkshire Hathaway.

“Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers,” he wrote. “The troubles of one could quickly infect the others.”

But business continued.

And when Mr. Greenspan began to hear of a housing bubble, he dismissed the threat. Wall Street was using derivatives, he said in a 2004 speech, to share risks with other firms.

Shared risk has since evolved from a source of comfort into a virus. As the housing crisis grew and mortgages went bad, derivatives actually magnified the downturn.

The Wall Street debacle that swallowed firms like Bear Stearns and Lehman Brothers, and imperiled the insurance giant American International Group, has been driven by the fact that they and their customers were linked to one another by derivatives.

In recent months, as the financial crisis has gathered momentum, Mr. Greenspan’s public appearances have become less frequent.

His memoir was released in the middle of 2007, as the disaster was unfolding, and his book tour suddenly became a referendum on his policies. When the paperback version came out this year, Mr. Greenspan wrote an epilogue that offers a rebuttal of sorts.

“Risk management can never achieve perfection,” he wrote. The villains, he wrote, were the bankers whose self-interest he had once bet upon.

“They gambled that they could keep adding to their risky positions and still sell them out before the deluge,” he wrote. “Most were wrong.”

No federal intervention was marshaled to try to stop them, but Mr. Greenspan has no regrets.

“Governments and central banks,” he wrote, “could not have altered the course of the boom.”

Fannie and Freddie, R.I.P.

July 14, 2008

Bush Offers Plan to Save Fannie, Freddie

By STEPHEN LABATON

WASHINGTON — Alarmed about the sharply eroding confidence in the nation’s two largest mortgage finance companies, the Bush administration will ask Congress to approve a rescue package that would give the government the authority to buy billions of dollars in stock in Fannie Mae and Freddie Mac and also lend to the companies to meet their short-term funding needs, people briefed about the plan said on Sunday.

Separately, the Federal Reserve voted on Sunday to also open a lending facility for Fannie Mae and Freddie Mac, if they need emergency capital. The two companies would be able to post their own securities as collateral.

The plan calls on Congress to give the government the authority over the next two years to buy an unspecified amount of stock in the two companies. Over the same period of time, it would permit the companies to have greater access to the Treasury, by expanding the credit line that each company has from the Treasury. Each company now has a $2.25 billion credit line, set nearly 40 years ago by Congress. At the time, Fannie had only about $15 billion in outstanding debt. It now has total debt of about $800 billion, while Freddie has about $740 billion.

Today the two companies also hold or guarantee mortgages valued at more than $5 trillion.

As part of the plan, the administration will also call on Congress to raise the national debt limit, people briefed on the plan said. And it will ask Congress to give the Federal Reserve a role in setting the rules for how big a capital cushion each company must hold. Giving the Fed a consulting role in the companies’ oversight is seen as yet another way to reassure nervous markets.

Treasury officials declined to comment on the plan but indicated that a statement would be issued later on Sunday. It was described by lawmakers and officials at other agencies that have been briefed on it.

They said that the Bush administration was hoping that Congress would adopt it quickly as part of a measure intended to help the housing markets and overhaul the regulation of Fannie and Freddie. Last Friday, the Senate approved the measure, and the House is hoping to take it up this week.

Announcement of the plan on Sunday evening was intended to send a sharp signal to both stock markets and debt markets that the government was standing behind the beleaguered companies.

Throughout the weekend, senior officials from the Treasury and the Federal Reserve closely monitored preparations by Freddie Mac to raise money help meet its short-term funding needs. Top officials spent Saturday and Sunday being briefed on Wall Street’s appetite for a $3 billion debt offering by Freddie Mac that was set for Monday. Officials said they were watching to see if the steep declines last week of Freddie and Fannie stock would spill into the debt market and undermine the confidence of lenders.

Fannie and Freddie have grown to become central to the nation’s housing markets. They buy mortgages from banks and other lenders, hold some of them, and sell others in the form of mortgage backed securities. Together, they own or guarantee nearly half the nation’s mortgages. In recent months, the stocks of the two companies have plunged as a wave of foreclosures has eroded confidence in the companies.

The credit line provided by the Treasury to the companies has always been seen by the market place as evidence that the two companies would be rescued by the government if they ever encountered severe financial problems. Yet for many years, a steady of stream of leaders from the Federal Reserve and to officials from Republican and Democratic administrations has denied the existence of a so-called “implicit guarantee.” Those who denied the existence of the guarantee included Treasury secretaries Robert Rubin, Lawrence Summers and Henry M. Paulson Jr., and Federal Reserve Chairmen Alan Greenspan and Ben S. Bernanke.

The implicit guarantee was a useful device both for the companies and the federal government. It has enabled the companies to get money in the debt markets at rates far lower than other companies and close to the same as treasury securities. At the same time, the Federal government did not have to record on its budget any significant liabilities for the large subsidy it was, in effecting, providing to the companies. Yet it also raised concerns among critics, who said it was unfair to rival companies and that it promoted a management laxity since executives knew that the companies could always count on a hand from the government if they began to falter.

Now, in the face of market turmoil in recent days, a quiet yet dramatic policy shift has occurred. Government officials no longer deny the existence of a guarantee. Instead, senior officials at both the Fed and the Treasury have been talking in recent days of possibly taking steps to “harden the guarantee.”

Motivating the change was the central role of the two institutions and the depth of ownership in the paper they have issued. Every major bank, and many mutual funds and pension funds and foreign governments, hold significant amounts of securities issued by Fannie and Freddie, which have been viewed over the years as being almost as safe as treasury securities. A default by either one of the companies could be catastrophic for the financial system.

worldwide

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April 14, 2008

Housing Woes in U.S. Spread Around Globe

By MARK LANDLER

DUBLIN — The collapse of the housing bubble in the United States is mutating into a global phenomenon, with real estate prices swooning from the Irish countryside and the Spanish coast to Baltic seaports and even parts of northern India.

This synchronized global slowdown, which has become increasingly stark in recent months, is hobbling economic growth worldwide, affecting not just homes but jobs as well.

In Ireland, Spain, Britain and elsewhere, housing markets that soared over the last decade are falling back to earth. Property analysts predict that some countries, like this one, will face an even more wrenching adjustment than that of the United States, including the possibility that the downturn could become a wholesale collapse.

To some extent, the world’s problems are a result of American contagion. As home financing and credit tightens in response to the crisis that began in the subprime mortgage market, analysts worry that other countries could suffer the mortgage defaults and foreclosures that have afflicted California, Florida and other states.

Citing the reverberations of the American housing bust and credit squeeze, the International Monetary Fund last Wednesday cut its forecast for global economic growth this year and warned that the malaise could extend into 2009.

“The problems in the U.S. are being transmitted to Europe,” said Michael Ball, professor of urban and property economics at the University of Reading in Britain, who studies housing prices. “What’s happening now is an awful lot more grief than we expected.”

For countries like Ireland, where prices were even more inflated than in the United States, it has been a painful education, as homeowners learn the American vocabulary of misery.

“We know we’re already in negative equity,” said Emma Linnane, a 31-year-old university administrator.

She bought a cozy, one-bedroom apartment in the Dublin suburbs with her fiancé, Paul Colgan, in May 2006, at the peak of the market. They paid $575,000 — at least $100,000 more than it would fetch today. “I sometimes get shivers thinking about it,” Ms. Linnane said, “but I’ll let the reality hit me when I go to sell it.”

That reality is spreading. Once-sizzling housing markets in Eastern Europe and the Baltic states are cooling rapidly, as nervous Western Europeans stop buying investment properties in Warsaw, Tallinn, Estonia and other real estate Klondikes.

Further east, in India and southern China, prices are no longer surging. With stock markets down sharply after reaching heady levels, people do not have as much cash to buy property. Sales of apartments in Hong Kong, a normally hyperactive market, have slowed recently, with prices for mass-market flats starting to drop.

In New Delhi and other parts of northern India, prices have fallen 20 percent over the last year. Sanjay Dutt, an executive director in the Mumbai office of Cushman & Wakefield, the real estate firm, describes it as an erosion of confidence.

Much of the retrenchment seems to be following the basic law of gravity: what goes up must come down. With low interest rates helping to inflate housing bubbles in many countries, economists said the confluence of falling prices was predictable, if unsettling.

This is not the first housing downturn to cross borders, but its reverberations have been amplified by the integration of financial markets. When faulty American mortgages end up on the books of European banks, the problems of the United States aggravate the world’s problems.

Consider Britain, which had one of Europe’s most robust housing markets, with less of an oversupply than in Ireland or Spain. Then last summer came the subprime crisis across the Atlantic.

Within two months, mortgage approvals dropped 31 percent, compared with the previous year. And by March, average housing prices had fallen 2.5 percent, the largest monthly decline since 1992.

“The boom in house prices was actually much bigger here than in the U.S.,” said Kelvin Davidson, an economist at Capital Economics in London. “If anything, people should be more worried than in the U.S.”

Britain has one of the most developed home-financing industries, not far behind that of the United States. The amount of outstanding mortgage debt, as a share of total economic output, is higher there than in the United States, according to a study by the International Monetary Fund.

“The U.K. followed the U.S. into never-never land, pushing mortgages out the door, believing that prices would go up forever,” said Allan Saunderson, the managing editor of Property Finance Europe, a newsletter for investors.

Still, the problems in Britain pale next to those of Spain and Ireland. Residential investment accounts for 12 percent of the Irish economy and 9 percent of the Spanish economy, compared with 5 percent in Britain and 4 percent in the United States, according to the I.M.F.

The glut of housing has brought new construction to a standstill, driving up unemployment and dimming the prospects for two of Europe’s stellar performers over the last decade.

“We’re waking up from the property dream and finding ourselves in a situation where prices are falling in Spain for the first time,” said Fernando Encinar, a founder of Idealista.com, a real estate Web site.

In Spain, more than four million homes were built in the last decade, more than in Germany, Britain and France combined. Average house prices tripled in parts of the country, as Spain’s torrid economy attracted immigrants and Northern Europeans snapped up holiday homes along the Costa del Sol.

Now, though, thousands of those houses stand empty. The I.M.F. estimates that property is overvalued by more than 15 percent. With mortgages drying up and prices swooning, speculators who once viewed Spanish property as a no-lose proposition are confronting hard reality.

In 2005, Julian Felipe Fernandez bought three small apartments, as an investment, in a huge development being built outside Madrid. He paid 100,000 euros as a deposit for the units, and now he is eager to sell them to avoid having to taking on a costly mortgage. But with the market stalled, Mr. Fernandez’s asking price is what he paid for them.

“Three years ago, it looked like I would be able to flip them for a nice profit before they were finished,” he said. “I just want to get them off my hands, to get rid of this headache.”

If he unloads them, he will be lucky. Enric Bueno, head of marketing for Ibusa, a real estate company in Barcelona, said his firm was closing six or seven sales a month, compared with 40 a month a year ago.

“Things are really bad,” Mr. Bueno said. “If this goes on for five years, we won’t make it.”

Economists have been busy cutting their growth forecasts for Spain, with a few saying that it may stagnate this summer. BBVA, a leading Spanish bank, forecasts that unemployment will rise to an average of 11 percent this year, from 8.6 percent in 2007.

Such cutbacks are well under way in Ireland, where the taxi drivers complain that their ranks are being swollen by laid-off home builders. The housing collapse has brought an abrupt end to more than a decade of pell-mell growth that earned Ireland the nickname “the Celtic tiger.”

Today, the mood in this country feels like a wake, and not an Irish one. Average house prices fell 7 percent last year, the most in Europe, according to the Royal Institution of Chartered Surveyors, a British real estate group. They are likely to fall by a similar amount this year.

After a 16-year boom that was interrupted only briefly after the Sept. 11 terrorist attacks, Ireland has the most overvalued housing market among developed countries, according to the I.M.F. In its recent economic outlook, the fund calculated that prices are 30 percent higher than they should be, given Ireland’s economic fundamentals.

For many Irish, accepting that reality is like passing through the seven stages of grief. Some homeowners are still in denial, brokers said, asking $5 million for houses worth no more than $4 million. But developers have begun cutting prices for smaller apartments like the one owned by Emma Linnane.

“Last year was our ‘wake up in the middle of the night with sweat pouring down your face’ period,” said David Bewley, a director at the Lisney real estate agency. “Now we’ve grown up.”

Not all the omens are negative. Mr. Bewley said houses were selling again, albeit for 25 percent less. Ireland has not yet suffered widespread incidences of defaulting mortgages or foreclosures in this downturn, in part because lenders have not been as aggressive as those in the United States.

But some worry that the housing meltdown could spoil Ireland’s recipe for success. Like Spain, it attracted lots of foreign workers, many of whom came for well-paying jobs in the construction industry. That fueled the Irish rental market, which has remained buoyant and been a source of income for Ireland’s many real estate speculators.

“If the immigrants go back home, will this hurt the rental market?” asked Ronan O’Driscoll, a director in the Dublin office of Savills, a real estate firm. “If that happens, it would definitely cause foreclosures.”

Got popcorn?

Largest U.S. Municipal Bankruptcy Looms in Alabama: Joe Mysak

Commentary by Joe Mysak

April 11 (Bloomberg) -- They're talking more about Chapter 9 municipal bankruptcy in Jefferson County, Alabama, the home of the largest city in the state, Birmingham.

Who can blame them?

The county is now being whipsawed by an ill-thought-out debt policy and the collapse of the bond insurers. Credit-rating downgrades all around have triggered a series of events that are no longer in the county's control, leaving it at the mercy of securities firms that have little room for maneuver themselves.

This has produced a steady series of stories in my new favorite newspaper, the Birmingham News, all about how the county is preparing to declare bankruptcy any day.

Perhaps the best article ran on Sunday, April 6. It began: ``Jefferson County officials have laid the groundwork for the largest municipal bankruptcy in the nation's history while publicly saying they have no imminent plans for a filing.''

The one that ran on Wednesday, April 9, was no less compelling: ``Talks on the sewer system's debt crisis aren't making progress, increasing the odds that the county will file municipal bankruptcy, Jefferson County Commission President Bettye Fine Collins said Tuesday.''

This is how it ends for the little county that was going to teach America how to use interest-rate swaps.

Make no mistake. This is a story all about public finance and ``derivatives,'' whose use by states and localities exploded during the past decade.

Orange County

The Jefferson County bankruptcy, if it comes, and it's hard to see how it can be avoided, will eclipse that of the 1994 filing by Orange County, California. ``Derivatives'' are at the center of both death-spirals.

Orange County invested in them -- securities whose value was tied to other securities and markets. The county investment pool, which for years spun off handsome returns for the school districts and local governments that were its participants, found itself holding a bunch of junk when its investors asked for their money back.

Jefferson County played the derivatives game as part of financing a $3.2 billion sewer cleanup. The county engaged in a batch of interest-rate swaps with the banks that helped underwrite the debt, in a strategy designed to save the county and its taxpayers some money. The strategy backfired, demonstrating the speculative, risky nature of swaps.

Two Acts

The bankruptcy will be the biggest in the municipal market's history by virtue of the county's debt load, according to the News. Jefferson County has $3.2 billion in sewer debt; Orange County lost $1.6 billion in its investment pool. I'm sure the matter will be debated. I'm also sure Orange County will be happy to pass the crown to Jefferson County.

There are going to be two acts to this drama.

First, of course, is the actual filing itself. The county seems to think that this will allow it to hold its creditors at bay and proceed in a business-as-usual fashion.

County officials have stated they have no intention of cutting back services or raising taxes or sewer fees. The most the county seems willing to do is to earmark part of a school construction sales tax to pay off its now-overdue debt.

``We are dealing with a virtual immovable force on Wall Street,'' the News quoted Commissioner Collins as saying.

I have a feeling that it's not going to work out precisely this way for Jefferson County and its residents. Every municipal bankruptcy is different, as is everything else in Muniland, but go ask Orange County how Chapter 9 worked. It's not going to be painless, no matter how well it's planned out.

The Bottom

The first act is humiliation. The second is recrimination.

The second act of the Jefferson County bankruptcy is going to focus on Wall Street and all the banks, law firms, advisers and consulting firms that helped put the county where it is today. The county was not well-served, for all the money that changed hands. In this act, the county sues to get some of that money back.

And there was a lot of money, which seems to be at the heart of the Securities and Exchange Commission's inquiry into the county and its infatuation with swaps and derivatives. The agency has said it is looking at pay to play, or bankers and others forking over cash in exchange for jobs.

The SEC's investigation is just part of a larger probe into the reinvestment-of-proceeds business across the municipal market in general. This has been going on for years, but there are signs it will erupt with a barrage of criminal prosecutions.

The stock-market guys say you have to reach a bottom before you can recover, and that a bottom is often signaled by the collapse of some big entity. Many people thought it was Bear Stearns Cos. In reality, it's Jefferson County.

Fed's rescue halted a derivatives Chernobyl

When the Federal Reserve stepped in to save Bear Stearns, most people had no idea what was at stake, writes Ambrose Evans-Pritchard

We may never know for sure whether the Federal Reserve's rescue of Bear Stearns averted a seizure of the $516 trillion derivatives system, the ultimate Chernobyl for global finance.

The financial crisis in full Read more by Ambrose Evans Pritchard The rollercoaster week: Click to enlarge "If the Fed had not stepped in, we would have had pandemonium," said James Melcher, president of the New York hedge fund Balestra Capital. "There was the risk of a total meltdown at the beginning of last week. I don't think most people have any idea how bad this chain could have been, and I am still not sure the Fed can maintain the solvency of the US banking system." All through early March the frontline players had watched in horror as Bear Stearns came under assault and then shrivelled into nothing as its $17bn reserve cushion vanished. Melcher was already prepared - true to form for a man who made a fabulous return last year betting on the collapse of US mortgage securities. He is now turning his sights on Eastern Europe, the next shoe to drop. advertisement "We've been worried for a long time there would be nobody to pay on the other side of our contracts, so we took profits early and got out of everything. The Greenspan policies that led to this have been the most irresponsible episode the world has ever seen," he said. News and analysis from the banking sector Fed chairman Ben Bernanke has moved with breathtaking speed to contain the crisis. Last Sunday night, he resorted to the "nuclear option", invoking a Depression-era clause - Article 13 (3) of the Federal Reserve Act - to be used in "unusual and exigent circumstances". The emergency vote by five governors allows the Fed to shoulder $30bn of direct credit risk from the Bear Stearns carcass. By taking this course, the Fed has crossed the Rubicon of central banking. To understand why it has torn up the rule book, take a look at the latest Security and Exchange Commission filing by Bear Stearns. It contains a short table listing the broker's holding of derivatives contracts as of November 30 2007. Bear Stearns had total positions of $13.4 trillion. This is greater than the US national income, or equal to a quarter of world GDP - at least in "notional" terms. The contracts were described as "swaps", "swaptions", "caps", "collars" and "floors". This heady edifice of new-fangled instruments was built on an asset base of $80bn at best. On the other side of these contracts are banks, brokers, and hedge funds, linked in destiny by a nexus of interlocking claims. This is counterparty spaghetti. To make matters worse, Lehman Brothers, UBS, and Citigroup were all wobbling on the back foot as the hurricane hit. "Twenty years ago the Fed would have let Bear Stearns go bust," said Willem Sels, a credit specialist at Dresdner Kleinwort. "Now it is too interlinked to fail." The International Swaps and Derivatives Association says the vast headline figures in the contracts are meaningless. Positions are off-setting. The actual risk is magnitudes lower. The Bank for International Settlements uses a concept of "gross market value" to weight the real exposure. This is roughly 2 per cent of the notional level. For Bear Stearns this would be $270bn, or so. "There is no real way to gauge the market risk," said an official "We don't know how much is backed by collateral. We don't know what would happen in a crisis, and if we don't know, nobody does," he said. Under the rescue deal, JP Morgan Chase will take over Bear Stearns' $13.4 trillion contracts - lock, stock, and barrel. Ben Bernanke, the Fed chairman, took decisive action when Bear Stearns began to collapse But JP Morgan is already up to its neck in this soup, with $77 trillion of contracts. It will now have $90 trillion on its books, a sixth of the global market. Risk is being concentrated further. There are echoes of the old reinsurance chains at Lloyd's, but on a vaster scale. The most neuralgic niche is the $45 trillion market for credit default swaps (CDS). These CDS swaps are a way of betting on the credit quality of companies without having to buy the underlying bonds, which are less liquid. They have long been the bête noire of New York Fed chief Timothy Geithner, alarmed that 10 banks make up 89 per cent of the contracts. "The same names show up in multiple types of positions. These create the potential for squeezes in cash markets, magnifying the risk of adverse dynamics," he said. "They could increase systemic risk, by amplifying rather than dampening the movement in asset prices," he said. This is what happened as the banking crisis gathered pace. The CDS spreads measuring default risk on Bear Stearns debt rocketed from 246 to 792 in a single day on March 13 amid - untrue - rumours that the broker was preparing to invoke bankruptcy protection. Was it the spike in spreads that set off the panic run on Bear Stearns by New York insiders? Or are the CDS spreads merely serving as a barometer? In the old days it was hard for speculators to take "short" bets on bonds. Credit derivatives open up a whole new game. "It is now much easier to short credit, " said James Batterman, a derivatives expert at Fitch Ratings in New York. "CDS swaps can be used for speculation, and that can cause skittish markets to overshoot," he said. For now the meltdown panic has subsided. Yet the hottest document flying around the City last week was a paper by Barclays Capital probing what might happen in a counterparty default. It is not for bedtime reading. Direct losses from a CDS breakdown alone could be $80bn, but the potential risks are much greater. In theory, the contracts are matching. One sides loses, the other gains, operating through a neutral counterparty (ie Bear Stearns). But if the system seizes up, the mechanism is not neutral at all. It becomes viciously one-sided. "Upon the default of the counterparty, [traded] derivatives would be immediately repriced, with spreads widening dramatically," said the Barclays report. This is "gap risk", the stuff of trading nightmares. Fortunes can vanish in a moment. One side would suddenly be trapped with staggering losses on their books. Yet the winners would be unable to collect their prize from the insolvent bank in the middle. It would take years to unravel all the claims in court. By then the financial landscape would be a scene of carnage.

The goose is cooked

ARROYO GRANDE, Calif. (MarketWatch) -- "Charlie and I believe Berkshire should be a fortress of financial strength" wrote Warren Buffett. That was five years before the subprime-credit meltdown.

"We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

That warning was in Buffett's 2002 letter to Berkshire shareholders. He saw a future that many others chose to ignore. The Iraq war build-up was at a fever-pitch. The imagery of WMDs and a mushroom cloud fresh in his mind.

Also fresh on Buffett's mind: His acquisition of General Re four years earlier, about the time the Long-Term Capital Management hedge fund almost killed the global monetary system. How? This is crucial: LTCM nearly killed the system with a relatively small $5 billion trading loss. Peanuts compared with the hundreds of billions of dollars of subprime-credit write-offs now making Wall Street's big shots look like amateurs.

Buffett tried to sell off Gen Re's derivatives group. No buyers. Unwinding it was costly, but led to his warning that derivatives are a "financial weapon of mass destruction." That was 2002.

Derivatives bubble explodes five times bigger in five years

Wall Street didn't listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:

1. Sarbanes-Oxley increased corporate disclosures and government oversight
2. Federal Reserve's cheap money policies created the subprime-housing boom
3. War budgets burdened the U.S. Treasury and future entitlements programs
4. Trade deficits with China and others destroyed the value of the U.S. dollar
5. Oil and commodity rich nations demanding equity payments rather than debt

In short, despite Buffett's clear warnings, a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession.

Data on the five-fold growth of derivatives to $516 trillion in five years comes from the most recent survey by the Bank of International Settlements, the world's clearinghouse for central banks in Basel, Switzerland. The BIS is like the cashier's window at a racetrack or casino, where you'd place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:

• U.S. annual gross domestic product is about $15 trillion
• U.S. money supply is also about $15 trillion
• Current proposed U.S. federal budget is $3 trillion
• U.S. government's maximum legal debt is $9 trillion
• U.S. mutual fund companies manage about $12 trillion
• World's GDPs for all nations is approximately $50 trillion
• Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
• Total value of the world's real estate is estimated at about $75 trillion
• Total value of world's stock and bond markets is more than $100 trillion
• BIS valuation of world's derivatives back in 2002 was about $100 trillion
• BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion

Moreover, the folks at BIS tell me their estimate of $516 trillion only includes "transactions in which a major private dealer (bank) is involved on at least one side of the transaction," but doesn't include private deals between two "non-reporting entities." They did, however, add that their reporting central banks estimate that the coverage of the survey is around 95% on average.

Also, keep in mind that while the $516 trillion "notional" value (maximum in case of a meltdown) of the deals is a good measure of the market's size, the 2007 BIS study notes that the $11 trillion "gross market values provides a more accurate measure of the scale of financial risk transfer taking place in derivatives markets."

Bubbles, domino effects and the 'bad 2%'

However, while that may be true as far as the parties to an individual deal, there are broader risks to the world's economies. Remember back in 1998 when LTCM's little $5 billion loss nearly brought down the world's banking system. That "domino effect" is now repeating many times over, straining the world's monetary, economic and political system as the subprime housing mess metastasizes, taking the U.S. stock market and the world economy down with it.

This cascading "domino effect" was brilliantly described in "The $300 Trillion Time Bomb: If Buffett can't figure out derivatives, can anybody?" published early last year in Portfolio magazine, a couple months before the subprime meltdown. Columnist Jesse Eisinger's $300 trillion figure came from an earlier study of the derivatives market as it was growing from $100 trillion to $516 trillion over five years. Eisinger concluded:

"There's nothing intrinsically scary about derivatives, except when the bad 2% blow up." Unfortunately, that "bad 2%" did blow up a few months afterwards, even as Bernanke and Paulson were assuring America that the subprime mess was "contained."

Bottom line: Little things leverage a heck of a big wallop. It only takes a little spark from a "bad 2% deal" to ignite this $516 trillion weapon of mass destruction. Think of this entire unregulated derivatives market like an unsecured, unpredictable nuclear bomb in a Pakistan stockpile. It's only a matter of time.

World's newest and biggest 'black market'

The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco's bond fund king Bill Gross said "What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August." In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't "figure out" the world's $516 trillion derivatives.

Why? Gross says we are creating a new "shadow banking system." Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions.

BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic "shadow banking system" that has become the world's biggest "black market."

That's crucial, folks. Why? Because central banks require reserves like stock brokers require margins, something backing up the transaction. Derivatives don't. They're not "real money." They're paper promises closer to "Monopoly" money than real U.S. dollars.

And it takes place outside normal business channels, out there in the "free market." That's the wonderful world of derivatives, and it's creating a massive bubble that could soon implode.

Comments? Yes, we want to hear your thoughts. Tell us what you think about derivatives: as "financial weapons of mass destruction;" as a "shadow banking system;" as a "black market;" as the next big bubble dangerously exposing us to that unpredictable "bad 2%."

Kerviel: ‘I will not be made a scapegoat’

By Ben Hall in Paris

Published: February 5 2008 14:33 | Last updated: February 5 2008 14:33

Jérôme Kerviel, the trader accused of fake transactions costing Société Générale billions of euros, insisted on Tuesday he would not be used as a “scapegoat” by the bank.

In his first public comments since the scandal broke, Mr Kerviel told Agence France Presse he recognised his “share of the responsibility”, but he would not take all the blame.

”I was designated [as being solely responsible] by Société Générale. I accept my share of responsibility but I will not be made a scapegoat for Société Générale,” the 31-year-old former bank employee said in an interview at his lawyer’s office in Paris.

Mr Kerviel’s first public intervention came a day after he was questioned by two investigating magistrates who are examining the case. Judges Renaud van Ruymbeke and Françoise Desset grilled Mr Kerviel for eight hours on Monday, AFP reported.

Mr Kerviel was charged last month with ”breach of trust”, ”falsifying and using falsified documents” and ”breaching IT controls access codes” during his time as a trader on SocGen’s equity derivatives desk in Paris.

The bank said it incurred net losses of €4.9bn as a result of an unhedged futures exposure worth close to €50bn ($74bn) built up by its former trader.

"It's a form of institutionalized larceny..."

Feb. 1 (Bloomberg) -- James Barker saw no way out. In September 2003, the superintendent of the Erie City School District in Pennsylvania watched helplessly as his buildings began to crumble.

The 81-year-old Roosevelt Middle School was on the verge of being condemned. The district was running out of money to buy new textbooks. And the school board had determined that the 100,000-resident community 125 miles north of Pittsburgh couldn't afford a tax increase. Then JPMorgan Chase & Co., the second-largest bank in the U.S., made Barker an offer that seemed too good to be true.

David DiCarlo, an Erie-based JPMorgan Chase banker, told Barker and the school board on Sept. 4, 2003, that all they had to do was sign papers he said would benefit them if interest rates increased in the future, and the bank would give the district $750,000, a transcript of the board meeting shows.

``You have severe building needs; you have serious academic needs,'' Barker, 58, says. ``It's very hard to ignore the fact that the bank says it will give you cash.'' So Barker and the board members agreed to the deal.

What New York-based JPMorgan Chase didn't tell them, the transcript shows, was that the bank would get more in fees than the school district would get in cash: $1 million. The complex deal, which placed taxpayer money at risk, was linked to four variables involving interest rates. Three years later, as interest rate benchmarks went the wrong way for the school district, the Erie board paid $2.9 million to JPMorgan to get out of the deal, which officials now say they didn't understand.

``That was like a sucker punch,'' Barker says. ``It's not about the district and the superintendent. It's about resources being sucked out of the classroom. If it's happening here, it's happening in other places.''

$12 Billion in Deals

It is. During the past four years in Pennsylvania alone, banks have pitched at least 500 deals totaling $12 billion like the one JPMorgan Chase sold to Erie, according to records on file with the state Department of Community and Economic Development. Most of the transactions -- which occurred outside the state's largest cities of Philadelphia and Pittsburgh -- have been made without public bidding, which means that banks and advisers privately arranged the deals with small school districts, the records show.

JPMorgan's Chief Executive Officer Jamie Dimon declined to say if he thought the bank's fee disclosure was proper and whether the bank acted in a fair, responsible and moral manner in Erie.

Banker DiCarlo declined to comment. JPMorgan spokesman Brian Marchiony says the deal gave the school district immediate debt savings and protected it against unpredictable interest rate risk in the future. He declined to answer specific questions.

Overpaying Fees

The Pennsylvania transactions involve interest-rate swaps, which are derivatives. Derivatives are financial contracts whose value is based on other securities or indexes; interest-rate swaps are tied to future changes in lending rates.

The Pennsylvania deals show that school districts routinely lose when making derivative deals. They pay fees to banks that are as much as five times higher than typical rates and overpay advisers by as much as 10-fold. That means banks often underpay schools on upfront amounts, as JPMorgan Chase did in Erie, public records show. And school officials aren't always well served by their supposedly independent advisers, whose fees are paid by the banks selling the deals -- only if the sale is made.

`Getting Fleeced'

In 15 Pennsylvania school districts, officials entered into interest-rate-swap deals worth $28 million since 2003, according to data compiled by Bloomberg. Of that dollar amount, the schools took in $15 million, and banks and advisers got the rest as fees, Bloomberg data show.

``The school districts are getting fleeced,'' Pennsylvania Governor Edward Rendell says. The governor, 64, a Democrat who has been in office since 2003, says the state might in the future advise schools and municipalities on derivatives contracts before they sign with banks. Christopher Cox, chairman of the U.S. Securities and Exchange Commission, says he's concerned that municipalities are taking on more risk than in the past when they raised money primarily from bond sales.

``It's a serious issue, not only in Pennsylvania but across the country,'' says Cox, 55, who has headed the SEC since 2005. ``That is what we have seen repeatedly. More often than not, the municipalities aren't configured to have financial sophisticates in charge of these offerings -- and the result is that the firms are the only ones who know what's going on.''

Just five years ago, municipal derivative deals weren't sanctioned in Pennsylvania, the sixth-most-populous U.S. state. Then, in September 2003, the state Legislature adopted a law allowing schools and towns to use interest-rate swaps to lower borrowing costs and raise cash.

Exchanging Payments

In a swap, two parties agree to exchange payments over a period of time that can last as long as 30 years. Typically, one agrees to pay a fixed rate and the other to pay a variable rate that changes with a benchmark index or formula defined in the contract.

Public agencies can benefit by using derivatives to guard against swings in borrowing costs or to lock in current interest rates for bond sales they might not make for years. In many cases, school districts use swaps as a way to refinance bonds they've issued in the past.

Derivative deals can bring banks fees three times higher than the traditional selling of municipal bonds, public records show. School districts don't know whether they're getting fair market values with swaps because the contracts are private; they don't know how to compare their deals with those done by other districts.

`Profits Are Greater'

This lack of transparency is a boon for the banks, says Christopher ``Kit'' Taylor, executive director from 1978 to 2007 of the Municipal Securities Rulemaking Board, a panel that issues rules on municipal bond sales.

``Business moves from transparent and competitive markets to markets where there is less transparency and the profits are greater,'' he says. ``If you don't know how much you're paying, you're going to be paying too much.''

The Pennsylvania swap law was passed after lobbying by financial advisory firms that stood to profit from such deals.

The legislation made the state a member of an expanding club. Forty states give government bodies explicit authority to make derivative deals, up from none 20 years ago, says David Taub, a lawyer who specializes in derivatives and is a partner at McDermott Will & Emery in New York.

Derivatives aren't regulated by the SEC, the MSRB or by states. Pennsylvania offers a clear look at these deals because, by law, all the contract records must be publicly filed with the state.

Pennsylvania Adviser

One derivative advisory firm that backed the Pennsylvania swaps legislation is Investment Management Advisory Group Inc., or IMAGE. The Pottstown, Pennsylvania-based company was raided by the Federal Bureau of Investigation in November 2006 in connection with a criminal antitrust investigation of bid rigging of investment contracts that are sold to states and municipalities.

The U.S. Justice Department is also probing municipal derivative deals. IMAGE has said it's cooperating with the probe. No charges have been filed.

In some Pennsylvania transactions, banks bought from school districts rights to exercise options on an interest-rate swap, or swaptions. Banks can choose to exercise the option if they stand to make money or can let the option expire if interest rates aren't favorable to them.

Banks Hedge Risk

The banks that arrange these deals create the swap contracts before pitching them to schools. Using software programs designed for valuing swaps, they calculate prices for which they can sell them after a school signs a contract. That's how the banks make money. For example, if a bank agrees to pay a district $800,000 in a deal it valued at $2 million, it could reap $1.2 million for itself and middlemen.

``They load it off instantly,'' says Taylor, who's now on the advisory board of Rockwater Municipal Advisors LLC, an Irvine, California-based investment firm.

Banks hedge their risk in derivative deals by making trades to cover possible losses to school districts. The banks make their money from fees, regardless of interest rate movements.

The reason Erie and other districts don't know how much the bank makes from a deal is because banks don't tell them, the records show. The money isn't paid immediately out of school budgets. Fees are hidden from schools because banks include those costs in the contract by adjusting interest rates up or down.

SEC Disclosure Rules

While the SEC doesn't regulate derivatives, it has authority to oversee how banks conduct transactions. SEC Chairman Cox says all financial firms should tell clients what their fees are before signing any deals.

``Brokers and advisers should disclose their compensation and conflicts of interest to their customers, and to the extent that they are regulated by the SEC, they must,'' he says.

Cox also says school district officials have a responsibility to the public and to bond investors to ensure their advisers are actually independent and acting in the best interests of taxpayers. ``To the extent that municipalities are participating in transactions they are not qualified for, there is an obligation to get good independent advice,'' he says.

More than two dozen Pennsylvania school districts bought swaps that bet on the spread between two interest rates. Many bet wrong. Since 2006, at least 27 school districts gambled that the spread would widen between either the five- or 10-year London interbank offered rate on the one hand and weekly municipal bond yields or the one-month Libor on the other.

The opposite happened: Spreads narrowed as long-term interest rates fell. The schools had to pay banks, or they could pay a steep exit fee, as Erie did with its swaption to cancel the deal.

Historical Fluke

School district officials say their advisers have told them the contracting of the spreads was a historical fluke. In the Exeter Township School District, 55 miles (88.5 kilometers) northwest of Philadelphia, Financial S&lutions LLC told the schools their swap deals shouldn't have lost them money.

``They tell me that's never happened before,'' says Ernest Werstler, who was business manager of the district until November, when he retired. ``It's happening to us now.'' Financial S&lutions didn't respond to requests for comment. Deane Yang, head of research at financial advisory firm Andrew Kalotay Associates Inc. in New York, says local officials are putting too much stock in financial advisers who are paid by banks--and in many cases are referred to schools by banks.

``It's like trying to decide whether a used-car dealer is offering you a good price or not,'' says Yang, who doesn't work with school districts. ``There's a car appraiser down the street who tells you he will provide an independent evaluation. But he's paid only if there's a sale.''

`Pound Someone's Brains'

School board members usually have a poor understanding of derivatives, says Peter Egan, a financial adviser and former public finance banker at a unit of Cherry Hill, New Jersey-based Commerce Bancorp Inc.

``A derivative is a very powerful tool,'' says Egan, who's now managing director of Bordentown, New Jersey-based Phoenix Advisors LLC, which advises local governments on bond sales. ``It's like a hammer. You could use it to hammer in a nail with perfect precision. But you could also use it to pound someone's brains out.''

In many cases, the banks repeatedly sell more derivatives to replace old ones. In Bethlehem, Pennsylvania, JPMorgan and Morgan Stanley sold the school district eight swaps on just two bond issues, records show.

Outside Advice

``It sure looks a lot like churning,'' Yang says. Churning is a term used to describe how stockbrokers or insurance agents sometimes continually sell and resell the same or similar products to clients in order to make more in fees. ``Doing more than one swap against a single bond issuance definitely benefited the swap adviser and bank, but probably not the school district.''

In Pennsylvania, it's the financial advisers who are supposed to keep school district officials from getting fooled. That's why the 2003 law allowing for swaps requires districts to use independent advisers.

``There was a fear that these deals were being pushed on the unsuspecting, perhaps, without them getting any other advice,'' says Steve Nickol, a Republican member of the Pennsylvania House of Representatives who introduced the legislation.

Lobbyist Leads Change

Financial advisers -- especially IMAGE, which opened in 1992 -- backed the swaps bill from the beginning. At an Oct. 16, 2002, hearing in Harrisburg, the state capital, Rick Frimmer, a public finance attorney, and Martin Stallone, managing director of IMAGE, said swaps would save taxpayers money. Since 1998, IMAGE's founder, David Eckhart, has personally contributed $469,400 to Pennsylvania elected officials, political action committees and candidates for office, campaign records show.

IMAGE said in a written response to questions that the firm never lobbied for the law. It said Eckhart's contributions had no bearing on the 2003 legislation.

Nickol says he was first approached about approving swaps for school districts and municipalities in 2002 by Elmer Heinel, a public finance lobbyist whose clients have included bond underwriters Meridian Capital Markets Inc., Stallone's former employer, and Wheat First Securities Inc.

Authority to Buy

Heinel has contributed $141,245 since 2000 to state lawmakers, political action committees and candidates running for office. Heinel says the donations weren't tied to the legislation.

The law gave cities, counties and school districts the explicit authority to buy swaps.

Municipal derivatives had been gaining ground in other states, as well as in large cities such as Philadelphia and at agencies like the Pennsylvania Turnpike Commission, as a means to lower borrowing costs, Stallone told the legislature at the time. The law passed 197-0 in the House and 45-0 in the Senate.

``There could be huge cost savings for many of the local governments,'' Nickol said. Rendell signed the bill in September 2003. That same month, the Erie school district signed the swaption deal with JPMorgan.

Erie Buys In

Once an iron and steel center, Erie is now left with shuttered factories and an aging population. While General Electric Co.'s $4 billion transportation unit, which mainly builds locomotives, maintains its headquarters in Erie, much of the city's manufacturing base has disappeared.

Since 1970, the city's population has declined 30 percent. Seventy-six percent of students in the district are eligible for free or reduced-price lunches, according to the state Department of Education.

JPMorgan and IMAGE had pitched the swaption to the school board in June 2003. JPMorgan's DiCarlo and IMAGE's Mike Garner said at that meeting the district had locked in high interest rates in 2001, when it issued $38.7 million in bonds, according to an audiotape of the June 17, 2003, meeting.

In the two years after that, interest rates had declined. Using traditional bond financing, the district couldn't take advantage of the lower rates because tax law prohibited refinancing before 2011, Garner said.

Money Now

By agreeing to a swaption with JPMorgan, the district could cash in immediately, Garner told the board. The bank would make an upfront payment to Erie. In return, the school allowed the bank to enter a swap with Erie in the future, from 2011 to 2029.

The value of the swap hinged on four factors: the length of time before the option was exercised, credit market expectations of future interest rates, the relationship between a fixed rate to be paid by Erie and changing interest rates and volatility of lending rates.

The bank could choose to exercise or decline the option. The school district had no say in that decision.

JPMorgan had recommended IMAGE to the school district's law firm, Knox McLaughlin Gornall & Sennett PC, says Tim Sennett, a partner in the firm who worked with the school district on the derivatives deal. IMAGE's Garner told school board members he thought the district should make the deal.

'Risks Are Reasonable'

``Given your situation, the economics are very good for the district,'' Garner said, according to the tape of the meeting. ``The risks are reasonable. I believe everyone on the board has a good grasp of what the risks are.''

The board didn't make a decision that day. ``This was a new concept we'd never heard of,'' says Richard D'Andrea, the district's business administrator. ``Given the tight budget situations that we're always under, that's a very strong motivation to help balance the year's budget.''

On Sept. 4, 2003, as a new school year was starting, the board met again with DiCarlo, who said the district should sign the deal and the bank would give it $750,000. Board members asked DiCarlo how much the bank would make in fees.

DiCarlo said, ``Everybody has asked, and it's a reasonable question: What does JPMorgan, what do we get on this transaction? I can't quantify that to you,'' according to a transcript of the meeting.

$2 Million Asset

DiCarlo, who was a state representative from Erie from 1973 to 1980, didn't tell the board that the contract was worth $2 million in global derivative markets. Based on interest rates that day and terms of the deal, Bloomberg data show that was the value of the contract.

JPMorgan's gross markup on the swaption was 0.82 percentage point of the rate compared with a 0.16 percentage point charge Goldman Sachs Group Inc. collected from the Philadelphia School District on a comparable swaption the city had bid competitively in March 2004.

In a written response to questions, IMAGE disputed the amount of fees paid to JPMorgan. ``The numbers your analysis produces for the districts are clearly way off the mark,'' it wrote.

IMAGE said it didn't know the bank's fees, estimating they were $365,000-$495,000. IMAGE said it doesn't know who recommended the firm to Erie as an adviser. ``Regardless, there are no conflicts,'' IMAGE wrote. IMAGE said its fees were normal for the industry.

Two-Page Opinion

D'Andrea says he relied on assurances from IMAGE that the deal was right for the district. IMAGE wrote a two-page opinion saying the deal was fair. It didn't say how much the fees were, according to a copy obtained under a public records request.

``The net swaption premium to the district was adjusted to reflect the forward starting and option-adjusted nature of the swaption, a reasonable hedging spread in the Libor markets and a fee to JPMCB reflective of its time and effort dedicated to the district as well as the inherent credit, operational and market underwriting hedging risk of the transaction,'' it said. Board member Eva Tucker, a retired professor of geoscience at Penn State University's Erie campus, says the board didn't fully understand the deal and trusted IMAGE, which recommended the transaction.

``We're not financial experts,'' Tucker, 72, says. ``We relied on the best advice we thought we could get.''

James Herdzik, a school board member who works as a sales manager at a machine shop, says the district couldn't turn down the deal because it was desperate for money.

``We're scrambling for every penny we can get,'' Herdzik, 48, says. The board approved the deal in a 6-0 vote.

Paying to Cancel

JPMorgan actually gave Erie $785,000 -- $35,000 more than DiCarlo had promised. The bank paid IMAGE $60,000, gave bond insurer Financial Security Assurance Inc., known as FSA, $57,585, paid lawyers and other middlemen $106,000 and kept $1 million as its revenue, according to public records and Bloomberg data.

By June 2006, the swaption had left Erie's district with a $2.9 million liability because expectations of future short-term interest rates had risen, narrowing the difference between future costs to borrow for one year and for 30 years. In July 2006, the district paid JPMorgan $2.9 million to terminate the swaption.

The district got the cash from the proceeds of two new derivative deals it did with Pittsburgh-based PNC Financial Services Group Inc.'s PNC Capital Markets unit. The transactions paid Erie schools $732,000 up front. One deal was an interest- rate swap that so far has lost $32,000 for the district, according to local records.

Most In Need

Erie revised the terms of the swap in October 2006, betting that beginning in March 2008, long-term rates would rise faster than short-term rates. The other deal is a swaption; PNC hasn't exercised the option yet.

Herdzik says he can't see why banks would take advantage of struggling school districts.

``It's kind of like preying on the municipalities that are most in need of money,'' he says. ``It's like we got raped.''

Other Pennsylvania school districts are paying banks excessive fees. Bethlehem, 50 miles north of Philadelphia, is also a former steel-making center. With a population of 72,000, the city has maintained its historic buildings.

The Central Moravian Church is a symbol of the group that founded the city on Christmas Eve in 1741. In the industrial area of the city, Las Vegas Sands Corp. is converting an old steel mill into a casino.

Money-Making Plan

Bethlehem's school district has used derivatives to try to make money. At an April 2005 meeting, Les Bear, of advisory firm Arthurs Lestrange & Co. in Pittsburgh, told the school board by arranging two interest-rate swaps tied to $110 million in bond issues, the 15,350-student district could generate more than $11 million over 25 years.

School finance director Stan Majewski supported the plan.

``Mr. Majewski commented that we all try to surround ourselves with people who know more than we do,'' minutes of the meeting say. ``He believes Arthurs Lestrange is the best public financing department of any organization in this country.''

None of the board members asked Bear or Majewski how much the district would pay for the swaps, the minutes show.

A month later, Lestrange, working with a Lancaster, Pennsylvania, firm called Access Financial Markets, negotiated two swaps with JPMorgan and Morgan Stanley without competitive bidding.

$3 Million Fees

So far, the district has taken in about $900,000 from the deals, Bloomberg data show. That compares with $3 million in transaction fees. Lestrange and Access made $630,000 each for arranging the swaps, according to school district records. New York-based Morgan Stanley made $840,000 and JPMorgan received fees totaling $900,000, Bloomberg data show.

Lestrange and Access earned a fee 10 times more than the Easton Area School District, Bethlehem's neighbor, paid its adviser on a comparable interest-rate swap in 2004. In a memo to school board members, Majewski said the fees included annual interest rate monitoring that would cost the district hundreds of thousands of dollars.

Bear of Lestrange and Matthew Kirk of Access didn't respond to requests for comment.

The rates the banks charged Bethlehem were twice the average for comparable swaps deals. In this kind of swap, in which both sides pay floating interest rates, a bank calculates its fees by subtracting an amount from the rate it will pay.

In the average deal of this type, banks lower the rate by 0.06 percent, says Jeff Pearsall, a managing director of Philadelphia-based Public Financial Management, the largest municipal adviser in the U.S.

JPMorgan subtracted 0.13 percent in the Bethlehem deal, and Morgan Stanley lowered its rate by 0.11 percent. Morgan Stanley spokeswoman Jennifer Sala declined to comment.

`What's Going On?'

``It's obscene,'' says Peter Shapiro, managing director of South Orange, New Jersey-based adviser Swap Financial Group, who doesn't advise Pennsylvania school districts. ``What is going on in Pennsylvania?''

Bethlehem has paid Lestrange $1.6 million and Access $1.3 million for their work on eight of the district's 12 swaps, public records and Bloomberg data show. JPMorgan and Morgan Stanley made a total of $5 million on those transactions.

Board member Joseph Craig, who approved the deals, says he's not qualified to discuss the deals and doesn't know how much they cost.

``I really don't remember a whole lot of specifics about it,'' says Craig, 64, a retired special education teacher who's been on the board for 10 years.

School district business manager Majewski declined to answer questions about swaps and fees.

``They've worked very successfully for me,'' he says. ``Everything I've done is done publicly with my local taxpayers.''

Never Told Fees

The school district didn't know that it had overpaid the banks by about $870,000 because the banks and Lestrange never told them what the fees were, according to minutes of school board meetings.

Sometimes school districts have agreed to swaptions even when a local financial official warns against no-bid deals. In Butler County, a rural area dotted with working farms 40 miles north of Pittsburgh, County Controller Jack McMillin says the lack of competitive bidding for public finance has cost taxpayers.

``It's a form of institutionalized larceny under the guise of getting taxpayers a good deal,'' McMillin says. He wasn't involved in the school board decisions.

The board relied on an old friend, with the kind of connections that go far in western Pennsylvania: football and politics. The district put its trust in municipal finance firm Russell Rea Zappala & Gomulka Holdings Inc., known as RRZ.

Hall of Fame

Greg Zappala, head of JPMorgan's office in Cranberry Township just north of Pittsburgh, is the son of former Pennsylvania Supreme Court Chief Justice Stephen Zappala and the brother of Allegheny County District Attorney Stephen Zappala Jr. Greg Zappala, 46, played football for the University of Miami Hurricanes in the early 1980s.

He was a roommate of Jim Kelly, a Pittsburgh-born, Hall of Fame quarterback who led the Buffalo Bills to four Super Bowls. Zappala's uncle, Charles Zappala, was an RRZ executive.

In 1990, Greg Zappala became a broker with the firm. One of the founders was Andy Russell, formerly of the Pittsburgh Steelers.

In 2003, JPMorgan bought the firm's municipal unit: RRZ Public Markets Inc., which Zappala ran. The company had worked for the Butler Area School District since 1991. There was no competition when the former RRZ bankers paid $730,000 for an option to refinance, five years in the future, $39 million of bonds sold by the school district in 1998.

`No Secrets'

Russ Greer, 61, who served on the Butler school board at the time of the deal, says it provided much-needed cash and was approved at an open meeting.

``There were no secrets,'' he says.

Except one. Since the school district didn't know what JPMorgan made on the transaction, it didn't realize it had become another Pennsylvania municipality that was underpaid up front on a swaption deal.

``The school district has no knowledge of the specific fees made by JPMorgan,'' Superintendent Edward Fink said in a written response to questions.

The contract had a market value more than three times what the district was paid, Bloomberg data show. JPMorgan decided how much of the $2.2 million it would give the district, without ever telling the school board.

The bank paid $165,813 to bond insurer FSA, $40,000 to IMAGE, $147,500 to five law firms and $23,000 to the Butler County General Authority. JPMorgan kept the remaining $1.1 million as its own revenue.

The Board's Understanding

Controller McMillin, a Republican, says he doubts whether the elected school board had the skills needed to know whether it was getting enough for the option.

``I can't imagine how they could have understood that,'' he says.

Penelope Kingman, a former member of the school board, voted against the derivatives deal in 2003. She felt her colleagues had failed to grasp the risk they were taking in exchange for the money offered by JPMorgan.

``The financial guys would come in with a lot of stuff that nobody at the district understood,'' she says. ``Local governments are entering into these without fully understanding what they are doing.''

JPMorgan spokesman Marchiony says, ``the swaps used by Erie and Butler, which were vetted by independent financial advisers and voted on in publicly attended meetings, enabled both districts to realize immediate debt service savings, while protecting them against unpredictable interest rate risk over several years.''

`Beyond Angry'

Swap deals in Pennsylvania work out well for banks, advisers and lawyers who are paid for putting them together. Schools, parents and students see it differently.

In Erie, Rosena Wright says she's growing angry as her son, Desmond, 13, has been transferred from Roosevelt Middle School, which the city shut down in 2007 after the heating failed, the roof leaked and a ceiling tile fell on a student's head. Desmond is now in a temporary space the school district is leasing from a church. Wright, 44, a day-care worker, says no one told her about the deal that cost her schools $2 million.

``I'm beyond angry,'' she says. ``I really want to tar and feather somebody.''

Erie schools superintendent Barker says he had thought the 2003 derivatives deal would save some money for the district.

``We're always at the mercy of the experts that advise us,'' he says, adding that schools have to find a better way to raise money. One option would be to return to old-fashioned, publicly bid bond sales. He says he doesn't begrudge the banks or advisers their right to get paid.

``We expect people to make a profit,'' Barker says. ``But they don't have to put their interests over the kids'.''

To contact the reporters on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net ; William Selway in San Francisco at wselway@bloomberg.net