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Banks Help Sovereigns Cook Their Books

From Zero Hedge, we find a must read on how Italy had cooked their books in order to meet certain fiscal requirements for admittance into the EU, and its ramifications.

In this 2001 report produced in collaboration with the Council on Foreign Relations, Professor Gustavo Piga of the University of Rome whose life was threatened for his findings addressed the following:

…a real-world example of how sovereign borrowers can use derivatives to window-dress public accounts as a means of achieving short-term political goals. It is by no means a theoretical example, but a real swap transaction undertaken by one of the sovereign borrowers cited in this book, which now belongs to the European monetary union.

Briefly, the crux of the Italy issue according to the CFR was that:

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.

The main conclusions from Piga’s report were:

“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.”

Why is this old report so significant?  In many ways, the mechanics of this deceptive if not illegal swap seem analogous to the deals that banks did with Greece to help them with their debt.

I have long held that the relationship between banks and governments is an incestuous and probably inherently corrupt one as government’s trade an implicit and now explicit backing of financial institutions through cartelization under the central bank for the bank’s underwriting and making markets in government debt.  Banks help states manage their budgets with various financial products and allow states to stealthily tax through inflation and deficit spending, while states back up their most important banking counterparties.

If banks have helped government’s mask their true fiscal standing, is it any wonder that the whole banking system would have been saved by the taxpayer at the point of the government’s gun during this financial crisis?  Further, what will be the fallout if rumors and/or direct evidence breaks out that many nations are cooking their books?  We already know that the finances of many nations are imperiled, but could this type of revelation be the tipping point that collapses not just the PIIGS but other sovereigns, causing mass financial chaos and currency collapses?

Stay tuned…

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