It is not often that one finds smoking gun reports which refute all claims, such as those by EuroStat and Angela Merkel, in which the offended parties plead ignorance of the fiscal inferno raging around them, kindled by lies, deceit, and blatant mutually-endorsed fraud, and instead, now facing themselves in the spotlight of public fury, put the blame solely on related party participants, such as, in a recent case, Greece and Goldman Sachs. Yet a 2001 report prepared by Gustavo Piga, in collaboration with the Council on Foreign Relations and the International Securities Market Association, not only fits that particular smoking gun description, but the report itself was damning enough of another country, a country which used precisely the same off-market swap arrangement to end up with an interest expense of LIBOR minus 16.77% (in essence the counteparty was paying Italy 16.77% of notional each year as a function of the swap mechanics), in that long ago year of 1995. The country - Italy (for confidentiality reasons referred to in the report as Country M), was at the time panned as the Enron of the European Union due to precisely this kind of off-balance sheet arrangement by the Counsel of Foreign Relations. The counterparty bank: unknown (at least in theory, since the swap was highly confidential, and was referred to as Counterpart N), but considering the critical similarities in the structuring of the swap contract to that used by Greece in 2001, and that ISMA cancelled Piga's press conference discussing his findings out of fear for the academic's life, we can easily venture some guesses as to which banks value their recurring counterparty arrangements more than human life.
And only an idiot (here's looking at you, EuroStat) would miss this striking revelation in the ISMA report made almost 10 years ago, envisioning not only Italy but Greece, which joined the euro on January 1, 2001: "Piga has unearthed some rather striking documentary evidence: an actual swap contract, indicating that one EMU entrant (who, owing to an agreement with the source of the documentation, will remain anonymous) used swaps to mislead other EU governments and institutions as to the size of its budget deficit, so as to falsely suggest compliance with the Maastricht Treaty." Once all is said and done, and both the euro and the eurozone are forgotten history, it will be amusing to observe just how prevalent lies and deceit were in the Eurozone, where apparently it was a daily and thoroughly accepted occurrence to lie, both to others and to oneself, about the real state of financial affairs. Oh, and the "US-zone" which is doing precisely the same complete cover up of its true economic state, is certainly not too far behind.
Disclosures made in this report forced the Council on Foreign Relations to make an explicit comparison between Italy and the greatest corporate fraud of the early 2000's: Enron.
The parallel with the Enron transactions is uncanny. Like Enron, Italy took on debt but chose to represent it as a hedge for a yen bond it had issued in May 1995, which matured in September 1998. As with Enron, the hedge explanation was clearly misleading. If it had been a hedge, the exchange rate used would simply have been the market rate at the time the swap transaction was entered into. Off-market rate swaps were clearly selected for the purpose of producing interest revenue in 1997, with euro entry as the goal.
The Treasury does not deny this. It justifies it, however, using an explanation that is in part irrelevant and that in part implicates it clearly.
The irrelevant part of the explanation is that the Treasury was concerned that a yen appreciation could increase Italy's debt, thus jeopardising the country's hopes of entering the eurozone. So the swaps were structured to protect against its debt rising over the course of 1997. But Italy's debt was 110 per cent of gross domestic product in 1997, well beyond the 60 per cent Maastricht barrier. The European Union never intended to enforce the debt limitation, only the annual deficit limitation. Italy's deficit was forecast to be within striking distance of the 3 per cent barrier and the swaps legally affected only the deficit. The debt argument is a red herring.
The damning part of the explanation is the admission that Italy was taking a cash advance in 1997 against an expected foreign exchange profit in 1998. Under accounting rules, this is simply impermissible. Borrowers cannot use loans to anticipate capital gains on a bond.
In other words, cooking the public debt books in the EU started not with Greece and Goldman in 2001, but with Italy and Counteparty N in 1995; we are fully confident that many more examples will emerge shortly.
How widespread is this sort of financial chicanery among sovereign borrowers? It is very difficult to know, since these deals are done over the counter with no public paper trail. Gustavo Piga, author of the ISMA/ CFR report, uncovered the Italian transaction quite accidentally. But there are powerful reasons for concern.
First, governments have clear incentives to cook the books. The EU continues to impose fiscal expenditure restrictions on eurozone governments, violation of which can result in censure and fines. The International Monetary Fund imposes fiscal conditionality on its client governments, which naturally have a strong incentive to keep the Fund from closing the money spigot. Derivatives can be used to shuffle cash flows through time in ways that current accounting rules do not prevent.
Second, banks are only too willing to market derivatives tricks to their big client governments, particularly when it puts them at the front of the queue for future bond issues and privatisations.
Third, if the integrity of government financial data is fatally undermined, the damage to stock and bond markets will dwarf the "Enron effect" that has recently pummelled the Dow.
We urge everyone to reread the last sentence as many times as needed, until the truth sinks in.
Before we get into the implications, here are the "revelations" (even though these have been part of the public record for nearly ten years) about Italy, which is now certain to attract everyone's attention as the source of potential near-term eurozone destabilization.
Below we present the critical section from Piga's report, a must read for all those who are still unsure how governments used banks such as Goldman Sachs to create borderline legal, off-balance sheet swaps to hide their debt: