Credit derivatives blowup threatens Italian bank

By Ambrose Evans-Pritchard
The Telegraph, London
Wednesday, July 4, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/03/bcnita...

A derivative blow-up at the Italian bank Italease has sent tremors through Milan's banking fraternity and exposed the hidden dangers of exotic credit instruments.

The bank has paid off 610 million euros (£419 million) in recent days to counterparties in what amounts to a massive margin call after interest rate rises in Europe caused hedging and derivative losses by clients to mushroom out of control.

The share price has tumbled 9 percent so far this week, and is down 64 percent since the troubles first began to emerge in April.

"These derivatives were very complex and suddenly turned against us," said Pierantonio Arrighi, the bank's spokesman.

"They started moving in a non-linear way, so the losses were rising exponentially. We were afraid that in the worst case some of our clients would not be able to pay the contracts, so we stepped in to protect them, which means we took over the risk," he said.

The losses still looked manageable at 225 million euros in December. They then jumped to 400 million euros by March, and then 600 million euros by early June, in a classic derivatives spiral, at which point the bank faced the choice of cutting its losses or risking disaster.

It appears the derivatives team were caught off-guard as the European Central Bank stepped up the pace of interest rates rises, hitting credits swaps sold as hedges to clients.

While the debacle poses no systemic risk to the Italian banking system, it sheds light on the murky world of credit derivatives -- viewed by regulators as the most risky and untested of the $410 trillion derivatives market (seven times global GDP).

John Raymond, an expert on Italian banks at Credit Sights, said Italease had been seduced by the lure of extra yield.

"They're in a boring and safe business with low margins so they found a way to boost returns, but they did so by doing something too exotic. The potential losses are huge in relation to the bank's capital base of 1.5 billion euros, so this is pretty serious," he said.

Italease said it still had 120 million euros of derivatives positions still open, but markets are far from convinced that the crisis is over. The bank will not present its conolidated statement until September. Analysts in Milan say Italease may have to raise a fresh 300 million euros in capital to repair the damage.

The troubles in Italy came amid fresh problems for US hedge funds linked to the subprime property crash. United Capital Markets, which has funds of $620m, said it had suspended redemptions from its Horizon Strategy hedge funds after a sudden exodus by investors.

The funds are heavily exposed to collateralized debt obligations (CDOs), typically packages of mortgages sold as securities. The lead fund lost 5 percent of its value in April and May. It is unclear whether United Capital faces the same crunch as two Bear Stearns hedge funds, which came to grief as rising default rates on subprime property ate into the top A-rated tranches of this form of debt.

Michael Gregory, the group's spokesman, said the redemption halt was a "defensive move" to prevent a forced sale of assets into a depressed market, where prices for high-risk CDOs have already plummeted.

BBB-rated tranches of subprime debt from the worst hit 2006-vintage have crashed to a record low of 54.06 from near par of 97 in February, according to the ABX index. These bond-like assets have in effect lost half their value.

In a further sign that the investors are shunning risk in the capital markets, spreads on the iTraxxx Crossover index measuring a basket of 50 European junk bonds have ballooned to 245, the highest since the mini-rout in February.

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