Poste Italiane Could Be the First European Victim of Fair-Value Derivatives Accounting

Cover story l Lost in the post Poste Italiane could be the first European victim of fair-value derivatives accounting. But what trades were behind the €104 million of derivatives losses? Nicholas Dunbar reports air-value derivatives accounting has from PwC’s scrutiny of the company’s de- bution in their calculations. arrived with a bang in Europe, with rivatives portfolio. As Catasta was placed The only debt that the rating agencies Fthe discovery of significant mark-to- under investigation for possible false ac- do acknowledge is that owed by Poste market derivatives losses in the corporate counting, Poste Italiane managing direc- Italiane’s treasury. This division finances treasury of Italian state-owned postal and tor Massimo Sarmi was quoted making operations in mail and logistics through retail financial services giant Poste Italiane. dramatic threats against unnamed invest- debt of approximately €2 billion. Some The reported €104 million losses, ment banks that had carried out debt man- €750 million of this is in the form of a 10- which resulted in the suspension of Poste agement operations on the company’s year bond issue co-led by Deutsche Bank Italiane’s Rome-based finance director, behalf. “We shall decide what steps to take and JP Morgan Chase in 2002, while the Massimo Catasta, has led to an ongoing to defend the company and obtain com- remainder comes from bank facilities. investigation by public prosecutors and a pensation for the damage caused,” he told On the asset side, Poste Italiane main- debate in Italy’s parliament. the Corriere Della Sera newspaper. tains a so-called fiduciary deposit in order The losses have raised concerns over Meanwhile, under pressure from its sole to maintain its AA–/Aa2 credit rating. This the effect of mandatory fair-value deriva- shareholder, Italy’s economy ministry, consists of a fund with over €600 million tives accounting on Italian companies, Poste Italiane appointed former Alitalia invested in highly rated bonds and fi- many of which routinely use exotic de- chief executive officer Francesco Mengozzi nancial instruments that is audited at rivatives for speculative purposes. to oversee the company’s finance division three-month intervals. And, six months after Risk broke the and Banco Posta subsidiary. Poste Italiane emerged in its current story of Gruppo Editoriale L’Espresso’s Sarmi’s expressions of dismay have form in 1998, when Italy’s then-socialist losses from JP Morgan Chase-originated been met with coolness in banking cir- government appointed a management structured derivatives transactions, the giant derivatives dealer is now linked to A single JP Morgan Chase exotic swap accounts for a substantial proportion of Poste Ital- iane’s losses. €44 million of the €104 million reported According to a senior Poste Italiane official who has spoken to Risk, JP Morgan mark-to-market loss Chase is the company’s biggest derivatives counterparty. Although Poste Ital- cles. After all, the company’s Banco Posta team charged to cut costs and increase ef- iane has derivatives exposure to subsidiary, which accounted for 43% of ficiency in the state-owned behemoth, at numerous investment banks, a single JP the group’s €8.1 billion revenues in 2003, the time deeply unprofitable. Perhaps un- Morgan Chase exotic swap accounted at has long been known as a packager of derstandably, the senior management year-end 2003 for €44.4 million of the structured retail products, both for sav- gave Catasta considerable leeway in his €104 million reported mark-to-market ings and life insurance customers. So management of the group’s financial as- loss. Moreover, Risk can reveal that this competitive is Banco Posta’s public ten- sets and liabilities. swap was entered into in July 2003 to re- ders for equity derivatives products that While a treasury team reporting to Cat- structure an earlier, loss-making exotic sophisticated institutions often decline to asta would manage day-to-day operations transaction with JP Morgan Chase that cost bid, fearing a so-called ‘winners’ curse’. from its small dealing room in Rome, Cat- Poste Italiane €50 million. But some sceptics believe Poste Ital- asta made the big decisions himself. As a According to Italian press reports at the iane’s apparent sophistication may only be senior Poste Italiane official comments: “A end of February, an audit of Poste Ital- skin-deep. Take Banco Posta, which is ar- lot of deals – the most important deals – iane’s accounts by Pricewaterhouse- guably not a real bank at all. Prevented by were closed directly by Massimo Catasta.” Coopers (PwC) uncovered a ‘hole’ of law from lending money, Banco Posta acts Like many Italian corporate finance di- €104 million relating to the company’s purely as a broker or intermediary for its rectors, Catasta showed an appetite for debt management operations – opera- customers and up to now has transferred exotic interest rate derivatives, which tions that were understood to involve all deposits to the Cassa Depositi e Presti- happen to be a lucrative area for the long-dated derivatives positions. ti, the Rome-based public financing body. banks. Investment bank derivatives sales- PwC had been appointed by Poste Ital- For its fast-growing retail structured people flocked to Rome seeking Catasta’s iane to replace the firm’s previous auditor, products business, Banco Posta depends business – among them JP Morgan’s team, Ernst & Young, in accordance with Italian on the international derivatives houses led by then head of Italian corporate de- law requiring rotation of auditors at four- for ideas, although it does play these rivatives sales Antonio Polverino. year intervals. While PwC is not com- firms off against each other. The precise And in the highly competitive tussle menting, sources say the auditor was asked nature of Banco Posta’s obligations to for Poste Italiane’s exotic derivatives by Poste Italiane’s management to apply customers is a grey area. Thus, while trades, JP Morgan came out on top. This IAS hedge accounting rules in order to pre- Poste Italiane’s own 2002 accounts show was noticed by rivals, who saw a clear pare the company for future privatisation. debts totalling €42.8 billion, the rating change in Poste Italiane’s attitude from Poste Italiane’s management seemed agencies Standard & Poor’s and Moody’s 1999 to 2000. unprepared for the furore that resulted refuse to include the Banco Posta contri- For example, in 1999, UBS executed a 40 RISK APRIL 2004 ● WWW.RISK.NET so-called ‘top-side’ exotic swap transac- formation with him about exotic trades decision-making to his treasury desk, tion with Poste Italiane. This contract, with JP Morgan competitors, but was also which farmed out trades to numerous which had a maturity of five years, in- out-performing UBS in unwind costs – banks, always in small size. volved Poste Italiane paying a low fixed perhaps as a sort of ‘loss leader’ to ce- Poste Italiane’s list of counterparties rate of interest that could jump to a much ment the relationship between the firms. (aside from JP Morgan Chase) reads like higher rate if floating rates hit a barrier. Regardless of the explanation, there is an industry directory. According to a se- Since the barrier was set at a high level, no doubt that from 2000 onwards, JP Mor- nior official at the company: “At the end this contract is not believed to have lost gan excepted, the large derivatives deal- of 2003 we had three deals with Lehman, Poste Italiane any money. But in mid- ers only managed to trade exotics with but also deals with ABN Amro, SocGen, 2000, UBS learned that the swap – which Poste Italiane infrequently, and only in CSFB, BBVA, Bank of America, Barclays, had not been subject to an International relatively small amounts. Bear Stearns, Citibank, Deutsche Bank, Swaps and Derivatives Association mas- But JP Morgan began reaping rewards Morgan Stanley, Nomura, Merrill Lynch, ter agreement – had been reassigned by by trading in large size, combining a bar- Unicredito and Royal Bank of Scotland.” Poste Italiane to JP Morgan. rier with a quanto component. According By the time of going to press, Risk to a senior Poste Italiane official, the ex- had contacted all the major dealers in Fault otic swap of this type that would be re- this group. Each confirmed that their po- Although JP Morgan Chase declined to structured in 2003 at a cost to the company sitions with Poste Italiane were €5 mil- comment for this article, it could be ar- of €50 million dates from this time: “You lion or less. gued that in a highly competitive market, have to consider that the quanto knock- By 2002, Catasta was also pioneering UBS was at fault for failing to use Isda in component had been in existence since the use of credit default swaps in man- master agreements in its dealings with 2000,” he says. aging the asset side of Poste Italiane’s fi- Poste Italiane. At the level of plain vanilla swaps and nance division, specifically for ‘yield But most bankers dismiss this argu- semi-exotic derivatives such as standard enhancement’, according to the source. ment as a red herring. Isda agreements, quantos, Poste Italiane Poste Italiane sells credit protection on which contain carefully framed netting spread business European bank names – particularly those clauses and credit risk provisions, are es- around. Catas- with which it deposits cash. This way, it sential for interbank trading and other ta delegated gets paid for any risks it high-volume activity. But while banks much of takes. The prefer them, Isda’s agreements are not the considered essential for creditworthy corporate customers that trade infrequently.

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