10 to €12 billion of structured loans exhibit a high potential risk!

According to Didier Migaud, the first President of the French revenue court, the investigation of his institution shows a widespread use of structured products, regardless of the category of communities, and their size.

He said the figures on the debt structure of local authorities remain opaque. Nevertheless, the Court finds that the local public debt, valued at 160 billion €, includes about 30 to € 35 billion of structured loans structured out of which 10 to 12 billion € exhibit a high potential risk.

“It sometimes happens that some governments find themselves already bound by debt or derivatives they cannot escape unless agreeing to pay a prohibitive interest rate or a cash payment regarding the financial resources they have”, says Didier Migaud.

“Fortunately, We did not yet suffered from the drawback of these risks, which is not surprising as these loans start with a period of lower interest rate. Another economic factor may have helped too: since fall of 2008, money market rates have collapsed. As part of floating rate loans benefiting from the decline, the gains have offset the additional cost of structured loans” argues Didier Migaud.

According to the Court, significant risks remain mainly for three reasons:
 The structure of these products, with the sequence of alternate period of low/high rates;
 The Duration, which is longer than fixed and floating conventional products
 The fact that they are indexed on highly volatile underlying, including exchange rates or spread on exchange rates.

“It sometimes happens that some local authorities find themselves already bound by debt or derivatives they cannot escape unless agreeing to pay a prohibitive interest rate or a cash payment they cannot afford to”, says Didier Migaud.

However, these issues seem to be concentrated on a small number of local authorities.The Court estimates at a few hundred the number of local authorities sustainably being at risk, while probably less than a hundred are severely exposed. “This confirms one of the findings of our annual report published in February 2009: the toxic loans contracted in recent years by local authorities are certainly able to significantly affect the communities bearing the highest level of risk, but they are not likely to deteriorate the financial situation of the entire local area” says Didier Migaud.

He believes that the State should draw the conclusions from the development of structured loans to prevent such a situation to happen in the future despite the low level of systemic risk on French public finances as a whole.

The Court recommends to implement measures likely to better improve the management of local debt and reflect its peculiarities in the accounts.

The principle of temporary and provisional interest rate subsidy should be reconsidered. Loans with interest rates linked to spreads out of the eurozone should be banned as well as those using leverage

Didier Migaud

While some initiatives had already been taken including a "charter of good conduct" initiated in 2009 by the Government with some banks and groups of elected officials, the Court suggests to go further.

“Until the 2008 financial crisis, the state had not taken sufficient measures to prevent the rapid growth of loan contracts with clauses based on leverage or linked to highly volatile indices. These loans have spread without reluctance since they were offered by major banks operating in the market for loans to local authorities. These banks, sometimes derived from former national public institutions, had the confidence of communities since they were long-term partners, "said Didier Migaud.

According to him, we should first assess the implementation of the charter of good conduct which, validates the use of loans with high volatility risk and the periods of self-subsidy that are not justified. Moreover, the Court held that The principle of temporary and provisional interest rate subsidy should be reconsidered. It also recommends a ban on loans with interest rate linked to spreads out of the euro zone as well as those using leverage. If needed, since the principle of free administration of local authorities applies under the conditions provided by law, the shortcomings of the Charter could be compensated by legislative measures.

The Court also recommends monitoring of highly volatile structured products that had been contracted before the financial crisis and are expected to remain much longer in the local authorities accounts.

More precisely, in order to address these high risk loans, the Court recommends the following:

1. to develop a statistical monitoring of the structure of local public debt;
2. to take into account these risks within an accounting framework by establishing a mandatory provisioning system that should at least offset the temporary gain induced by the existence of a interest-rate subsidy;
3. to clearly write, in the accounts of local authorities and their public institutions, all the payments that may be paid or received during redevelopment operations or early termination of hedging instruments
4. to strengthen the role of the deliberative assemblies by requiring the submission of an annual report on debt management as a basis for an annual debate on this issue coupled with the budget vote. It would be a kind of virtuous chaining of local public debt.

As for the idea of a bad bank that would take in charge for some local governments the riskier loans they have contracted to a significant degree, the Court considers it would not be justified or appropriate to proceed with this project. “Such an act would encourage the renewal of irresponsible practices”, concludes Didier Migaud.

As for the idea, often mentioned, of a bad bank that, on behalf of a very few local authorities, would handle the high risk loans they have contracted to a significant size, the Court considers it would not be justified or appropriate to proceed with this project. "It would otherwise encourage the renewal of irresponsible practices" concludes Didier Migaud.