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cause of our debts; it has become the sword of Damocles hanging over our heads,” said Francesco Fiordomo, Recanati’s mayor. Experts are not yet predicting cascading bankruptcies, but they warn that increasing problems in heavily indebted municipalities and provinces are creating finan- cial time bombs that could lead to defaults. Those concerns are al- ready raising cities’ borrowing costs on both sides of the Atlantic and contributing to budget woes, forcing many struggling jurisdic- tions to raise taxes and cut ser- vices.
Analysts are also warning that
national coffers could be further strained if heavily indebted coun- tries are forced to spend precious resources to rescue local juris- dictions. Portugal, under fire for allowing its cash-strapped region- al governments to assume more debt,was hit by a debt downgrade by Fitch Ratings last month. “We are only now beginning to understand the full scope of the global debt problem. This isn’t just about national governments; you’re talking about local govern- ments and municipalities,” said Eswar Prasad, an international economics expert at the Brook- ings Institution. “Many of them were engaged in risky invest- ments in the past, and now we are seeing those problems come to a head.”
Across Italy, budget problems
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have been severely compounded by growing liabilities on complex bets placed on interest rates dur- ing the credit boom of the past decade. Similar bad bets are well documented in the United States. Los Angeles, for instance, is losing $19 million a year off interest rate contracts; a wager by Jefferson County, Ala., has left it struggling
to avoid bankruptcy. But problems with these exotic
financial instruments are only now emerging in Europe, putting a fresh spotlight on the excesses of borrowers and the ethics of bankers who sold them.
Greece has come under scruti-
ny for using such deals to hide the extent of its debt. In Italy alone, an estimated 519 cities and towns are facing more than $1.3 billion in losses from derivatives deals, according to a report from the Bank of Italy.
Such deals were popularized as
a way for municipalities to shield themselves from the possibility of higher interest rates. In many cases, analysts say, they have done just that. In the Washington area, for instance, the largest user of in- terest-rate swaps has traditional- ly been the District, which now owns $262.2 million worth of such swaps. City officials say they have no complaints about them. But a minority of the deals, crit-
ics say, were put together by banks in ways that made it almost impossible for local jurisdictions to service their obligations in the long run without suffering losses. The growing number of problem- atic contracts has ignited a debate in European capitals and Wash- ington, and on Wall Street, over new oversight and curbs on de- rivative sales, as well as restric- tions on municipal borrowing. Bad deals in Italy are hitting small towns the hardest. Here in Recanati, a town of 22,000, more than a dozen swap contracts were signed between 2001 and 2004. Local officials said they were told they could not lose. The deal worked this way: To guard against sudden surges in interest rates, Recanati agreed to take out special contracts on the city’s $106 million in debt. It would pay banks a fixed annual interest rate of about 5 percent on the total. In return, the banks
would pay the city back an adjust- able rate tied to a key European interest rate index, theoretically ensuring that Recanati would not see wild swings in its interest pay- ments.
When European interest rates were high in the mid-2000s, the deal worked out well, allowing Recanati to pocket about $400,000 between 2001 and 2008. When interest rates fell to record lows in 2009, the tables turned dramatically. The city was forced to keep making fixed-rate interest payments to the banks averaging about 5 percent, while receiving adjustable-rate pay- ments of less than 1 percent in re- turn. The deals cost the city $420,000 in just one year and more than wiped its previous gains. With adjustable rates still at rock-bottom levels, Recanati of- ficials calculate that they are set to lose nearly $700,000 this year. City officials here and in other lo- calities across Italy said the possi- bility of such vast losses was never explained.
On top of that, the swap con-
tracts carried hidden fees of more than $650,000, according to Mar- co Fabio Delzio, a Rome-based partner at Martingale Risk, a firm hired to audit the town’s con- tracts. Given those fees, officials say, Recanati would very likely have lost money in the long run even if interest rates had re- mained high for years. Yet canceling the swap con-
tracts would cost $2.2 million more, money this town says it does not have. “We would have to sell our crown jewels, important buildings, more land,” said Anto- nio Bravi, financial adviser for Re- canati. “And we would have to cut services.”
Like many municipalities in
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Italy, Recanati is trying to negoti- ate a deal to close out the con- tracts. In the meantime, its fiscal problems are so bad that officials are considering scaling back the city’s internationally renowned festival marking the birth of Leo- pardi, the poet and essayist whose statue looms over the town square. Green spaces on the edge of town are being sold to in- vestors, and Recanati has sought to raise tax revenue by rezoning land for commercial use. At Recanati’s senior-care cen-
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ter, Aliandri Franco, 72, said the city’s financial problems have de- layed plans to build low-cost housing. Officials are also unable to meet their goal of expanding in-home care to some of Recana- ti’s neediest elderly residents. “It was a big mistake, getting
involved in all this nonsense,” Franco grumbled. “I hope they have learned their lesson.” In Italy, the troubles have
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raised the prospect that bankers may do jail time. Two weeks ago, an Italian court indicted 11 offi- cials at four global banks, includ- ing New York-based J.P. Morgan Chase and Germany’s Deutsche Bank, on fraud charges linked to the sale of interest rate swaps to the city of Milan. Those swaps, authorities say, have cost Italy’s fashion and financial capital $140 million since 2003 and were knowingly misrepresented to city officials. All four banks have de- nied the charges. “The way these deals were
structured, there was just no way any city could win,” said Alfredo Robledo, the chief prosecutor in the case. He called it another example of banks “taking advan- tage” during the 2000s.
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