Risk Comes Home to Roost

  • Why it matters

    Why it matters

    Although 800 local authorities in Germany have used swaps to hedge against a rise in borrowing costs, this is the first time a case has gone to court.

  • Facts


    • The transactions in question took place between 2006 and 2008 and were advised by JP Morgan Chase.
    • The lion’s share of losses were recovered through previous settlements; this trial relates to the costs and fees incurred by the transactions, totaling €14.3 million.
    • One of the key legal issues is whether the councilors breached a ban on speculation by local authorities.
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Prozess um Millionenverluste
The former mayor of Pforzheim, Christel Augenstein, and her lawyer, Jürgen Leibold, meeting Tuesday in a Mannheim court. Source: DPA

It’s not often that the victims of bad financial advice and their advisers both find themselves as defendants in the same courtroom. But that’s exactly what’s happening in Germany this week. A trial has begun in Mannheim against former councillors of the city of Pforzheim, who conducted interest-rate swaps between 2006 and 2008, and two of the bankers who advised them.

Former mayor Christel Augenstein, her former finance officer Susanne Weishaar and the latter’s then deputy, Konrad Weber, have been charged with breach of trust. The two bankers from JP Morgan Chase, the US bank that advised on the deals, are accused of aiding and abetting. The city lost around €57 million ($67 million) due to the transactions.

There are shades of the subprime mortgage crisis of 2008, triggered after investors had swarmed into risky, high-yield instruments they didn’t understand. The case has also cast a spotlight on a little-known fact: that many German local authorities used such swap transactions to hedge against rising borrowing costs. It also raises ticklish issues of liability. Are local authorities allowed to use highly speculative financial instruments to improve their budgetary situation? And who is liable if things go wrong – solely the taxpayers, or the decision-makers as well?

Ms. Weishaar did what so many of Germany's cash-strapped local authorities have been doing since the 1990s: She bought swaps.

The trial may be local, but it’s attracted some high-profile national attention. Wolfgang Kubicki, one of the ex-mayor’s lawyers, is deputy leader of the pro-business Free Democratic party. Before the trial began, he told the court that of the 800 local authorities in Germany that have concluded such deals, this is the only case in which criminal charges have been filed. At the start of the trial, Judge Andreas Lindenthal promised confessions would be rewarded with particular lenience.

The charges filed by the public prosecutor, Uwe Siegrist, focus on Ms. Weishaar, the ex-finance officer of Pforzheim. In an attempt to improve the city’s finances, Ms. Weishaar did what so many of Germany’s cash-strapped local authorities have been doing since the 1990s: She hedged the city’s considerable debt against rising interest rates by purchasing so-called swaps.

The initial transactions were straightforward. The city agreed to pay banks a fixed rate on public debt, while the banks promised to pay the difference between that rate and the actual interest incurred by a variable rate. (In these “swap” deals, if the variable rate rises above the fixed rate, the local authority wins; if it’s lower, the bank wins.)

Interest-rate swaps flourished at a time when local governments felt they were paying too much in fixed interest payments as euro interest rates were falling. They essentially converted loans with a variable interest rate (which may be linked to the Libor benchmark rate, for example) into fixed-interest loans, giving local authorities greater certainty when planning their finances.

From 2004 onwards, however, Ms. Weishaar is alleged to have concluded much more complex swap deals with JP Morgan and Germany’s Deutsche Bank. These did not merely hedge interest-rate risk, but also aimed – according to the prosecutor – to generate profits. Municipal law in the German state of Baden-Württemberg, where Pforzheim is located, prohibits local authorities from engaging in speculation. In the months ahead, the court will determine whether the three former councilors breached this ban.

Typically, the variable rate on spread ladder swaps is determined by a hideously complex formula.

According to the public prosecutor’s office, Ms. Augenstein and Ms. Weishaar exceeded their authority, as the derivatives concerned included so-called “spread-ladder swaps,” which are regarded as highly speculative. The finance officer used these to bet on the relationship between short-term and long-term interest rates. She speculated that long-term rates would rise faster than short-term rates, but got it wrong, and at one point faced losses of €20 million.

Yet the ordeal was far from over. To avert these losses, Ms. Weishaar concluded “mirror” transactions that were similar, but worked the opposite way around together with JP Morgan Chase – this time in agreement with the mayor. This merely increased the losses, which ultimately came to around €57 million.

On the second day of the trial on Thursday, Ms. Weishaar said that she had no experience of trades when she first concluded these “spread-ladder swaps” in 2004, and that her only previous experience of derivatives transactions had been as an auditor.

Typically, the variable rate on spread ladder swaps is determined by a hideously complex formula. Starting over a decade ago, it wasn’t just public authorities that stumbled while using these instruments. In 2007, a Berlin court ruled that Deutsche Bank bore half the blame for swap advice it gave to Bleck, a medium-sized building firm. Shortly thereafter, the city of Hagen sued Deutsche Bank for losses, coincidentally also €57 million, on an investment of €170 million.

The former mayor says she authorized the finance officer "to decide for herself on the conclusion of interest-rate derivatives."

Ms. Augenstein, the former mayor, denied any deeper knowledge of the transactions. She described the state of Pforzheim’s finances as terrible when she took up office, and confirmed that she authorized the finance officer “to decide for herself on the conclusion of interest-rate derivatives.” She said she had no cause for suspicion and had not known anything about the risks.

The fact that the transactions went wrong was also due to advisory errors made by the banks, as the court has established. The city of Pforzheim has been able to get most of the money back in settlements: JP Morgan Chase paid back around €37 million in 2014, while Deutsche Bank repaid €7.7 million in 2016.

The latest proceedings are not about the outstanding losses, but the costs and fees caused by the transactions, which come to €14.3 million. The public prosecutor’s office argues that this has caused financial losses for the municipality that justify the accusation of breach of trust. Ms. Weishaar’s lawyer said that a financial mistake had been made, but that no crime had been committed.

The next date in the hearing is scheduled for Tuesday, August 15.

Kevin Knitterstedt reported this story from Pforzheim for Handelsblatt. 

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