ONE of the great advantages of financial innovation, it was often said, was that risk would end up going to those best qualified to hold it. In fact, much of it seems to have ended up in the hands of those least able to understand it. How some of it got there may soon be revealed in an Italian court.

On March 17th four big banks, 11 bankers and two former city officials were charged with fraud in connection with the sale of interest-rate derivatives to the city of Milan. The trial is due to start in May. The prosecution relates to a huge bet on interest rates that the four banks -- UBS, JPMorgan Chase, Deutsche Bank and Hypo Real Estate's DEPFA unit -- helped the city authorities to take in 2005. The banks helped arrange the sale of €1.7 billion ($2.3 billion) of bonds for the city and then also helped it swap the fixed interest rate it was paying on the bonds for a lower, floating rate. Part of the contract is thought to have involved a "collar", a way of limiting the range of outcomes on a bet, which protected Milan from rising rates but which also meant it would have to pay out if they fell.

The city claims that it was originally promised interest savings of about €60m on the deal but has now made big losses because interest rates have fallen, triggering payments to the banks. Bankers with knowledge of the transaction claim that, in fact, the city has benefited from offsetting gains as the interest rate it pays on the underlying debt has fallen too. The prosecution also claims that the banks charged more than €100m in fees that were built into the price of the swaps and were not properly disclosed to city officials. The banks all deny any wrongdoing.

The outcome of the case will be closely watched elsewhere. In Italy alone, local municipalities had derivatives exposures with a face value of €25 billion last year, according to the Bank of Italy. Some academics reckon that losses on these may go as high as €8 billion. In many of these cases local authorities swapped fixed rates for floating ones, only for collars incorporated into the deals to leave them with losses as interest rates fell. In other cases, losses may only start to show when rates move the other way. Had their bets paid off, however, it seems unlikely that any cities would be crying foul. (1)

In Germany scores of public authorities signed contracts that they seem not to have understood. In Leipzig the courts have been asked to rule in a dispute between the city and UBS. That case relates to a complex sale-and-leaseback agreement that the city signed for its local waterworks. Part of the deal reportedly entailed the city agreeing to insure a portfolio of loans against default through a collateralised-debt obligation (CDO). Making good on those loans may bankrupt the city.

In all, about 100 German local authorities are thought to have entered into sale-and-leaseback agreements with American investors over the past decade in a bid to take advantage of loopholes in tax laws. In many of these deals local municipalities unwittingly agreed to take on credit risks for various counterparties, exposing them to demands for collateral as the ratings of institutions such as AIG, an American insurer, fell. (1)

"Hundreds of U.S. municipalities are losing money on interest-rate bets they made during the bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities. Now some are criticizing Wall Street and trying to exit the contracts. .. Government agencies that saw the transactions as a cushion against fiscal surprises now are being squeezed by the arrangements. The supply of municipal derivatives swelled to more than $500 billion before falling in the past two years, estimates Matt Fabian, managing director at research firm Municipal Market Advisors. Moody's Investors Service says the surge was fueled by Wall Street marketing efforts, demand from state and local governments and "relatively permissive" statutes on the use of swaps in Pennsylvania and Tennessee, both of which are taking steps to tighten rules.

Many of the deals generated higher fees for securities firms than traditional fixed-rate debt. Government officials, for their part, entered the deals in hopes of reducing borrowing costs. The swaps were introduced in many cases along with floating-rate debt that municipalities issued because it was cheaper than traditional fixed-rate debt. Lower interest rates have served them well on this; their borrowing got cheaper.

But municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving payments from banks that vary with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.5%. Government budgets are stretched thin, prompting officials to look for dollars wherever they can. The clashes over the swaps come amid growing scrutiny of the municipal-bond market, where the U.S. government is investigating whether there was bid rigging in certain cases." (7)

"The Service Employees International Union said Chicago, Denver, Kansas City, Philadelphia, Massachusetts, New Jersey, New York and Oregon all are in the hole on swaps agreements they made with financial firms. The required payments range from a few million dollars to more than $100 million a year, the union said. Such deals are deepening the misery faced by state and local governments throughout the U.S., already facing their worst financial squeeze in decades because of shrinking tax revenue and stubbornly high pensions and other costs."(7)

Study by the Service Employees International Union - Detailed Spreadsheet List,

The "Stop the Swaps" Campaign by the Service Employees International Union (SEIU) (15)

Watch
VIDEO: WSJ Takes On Interest Rate Swaps

In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap with J.P Morgan Chase & Co., according to state auditor general Jack Wagner. J.P. Morgan declined to comment. State lawmakers have proposed restrictions on municipalities' ability to use swaps. "It's gambling with the public's money," Mr. Wagner said. "Elected officials are simply no match for the investment banker that's selling the deal." (7)

While the investigation focused on the Bethlehem Area School District, Wagner called his report a "case study" of the use of swaps by all local governments in Pennsylvania. The Department of Community and Economic Development's records indicate that 626 swap filings were made in Pennsylvania between October 2003 and June 2009, which related to $14.9 billion in debt. The precise number of different swaps and the precise amount of debt cannot be determined because the DCED data may include some double-counting. During this time period, 107 of Pennsylvania's 500 school districts, or 21.4 percent, and 86 other local governments reported to DCED that they entered into swap agreements. At least 13 investment firms, including Citibank, Goldman Sachs, J.P. Morgan, and Morgan Stanley, have entered into swap agreements with Pennsylvania school districts and other local governments. (8)

Municipalities in America are also grappling with derivative contracts they barely understand. The city of Los Angeles is pressing Bank of New York Mellon to soften the terms of an interest-rate swap on $443m of bonds that is costing the city money because rates fell. (1)

The Los Angeles city council approved a measure this month instructing city officials to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city's wastewater system, currently is costing the city about $20 million a year. The banks declined to say how they would respond to a request to renegotiate.(7)

Jefferson County in Alabama is teetering on the edge of bankruptcy after it entered into swaps that were worth more than $5.4 billion at their peak. (1)

"Jefferson County in Alabama is on the brink of bankruptcy after sinking 100 percent of its $5 million sewer system financing into swaps. JP Morgan and CDR were also involved there."(3)

They were touted as a state-of-the-art financing tool that would help New Mexico stretch its highway improvement dollars. Nearly five years later, state officials are trying to keep the $420 million in fancy financing from turning sour. In the last six months, one of the banks involved in the so-called interest rate swaps has gone bankrupt and the state has had to post about $16 million in collateral because the value of the investments dropped. That's in addition to major political fallout. The swaps and how a California company was selected to handle them are at the center of a federal grand jury investigation that derailed Gov. Bill Richardson's nomination as commerce secretary. (2)(3)

Escaping isn't cheap or easy. Under a transaction between Oakland, Calif., and a Goldman Sachs Group-backed venture, Goldman paid the city $15 million in 1997 and $6 million in 2003, according to Oakland financial reports. But now, the city stands to lose about $5 million this year. That money "is coming out of taxpayers' pockets and could be used for other things," said Rebecca Kaplan, a city council member. She wants the city to renegotiate. But the city faces a $19 million termination payment. Oakland officials didn't respond to requests for comment. (7)

Last August, a unit of bond insurer Ambac Financial Group sued the Bay Area Toll Authority for payments it said it was owed under various swap agreements. The authority paid Ambac $104.6 million to terminate the swaps after the insurer's credit ratings were downgraded and bonds associated with the swaps were retired. Ambac claims it is owed $156.6 million under the agreements. The toll authority, which is fighting the claim, said it made the payment, and Ambac sued for the other part of what it says it is owed. An Ambac lawyer couldn't be reached for comment.(7)

Richmond, Calif., is expected to restructure a $65 million agreement with Royal Bank of Canada that could cost the struggling city an estimated $3.5 million a year, based on current interest rates. Under the revised deal, Richmond would make smaller, more regular payments to the bank over time. In November, RBC and city officials rejiggered a separate transaction that would have cost Richmond about $2.5 million. An RBC spokesman said bank officials are working with the city to "restructure the underlying bonds in a way that best serves the city's interests and those of its residents." The "goal of the original transaction was to lower borrowing costs for the city," the bank spokesman said, adding that the bonds didn't perform s anticipated because of downgrades at bond insurers that backed them. Richmond's vice mayor, Jeff Ritterman, said he still is reviewing next month's proposed restructuring. Financial woes have forced Richmond to cut its budget and lay off employees. (7)

New York State provides a good example. An Oct. 30, 2009, filing describing its swaps shows that for the most recent fiscal year, April 2008 to March 2009, the state paid $103 million to terminate roughly $2 billion worth of swaps -- more than a quarter of which resulted from the Lehman bankruptcy in September 2008. (2)(5)

DPS (Denver Public Schools) entered into negotiations with JP Morgan and CitiGroup, agreeing to issue fixed-rate bonds secured by DPS school buildings and other properties. DPS then began discussion to enter into an interest-rate swap agreement with JP Morgan, Bank of America and the Royal Bank of Canada. We believe that following ensued: DPS entered into a swap transaction, believing that interest rates would stay high. As recent financial news tells us, interest rates fell. We are concerned that this may have translated to a loss of taxpayer dollars. (2)

Eight California municipalities, including Los Angeles, Fresno and San Diego County, filed civil class-action, or group lawsuits. The suits, most of which were consolidated with others in U.S. District Court in New York City, allege that banks colluded by deliberately losing bids in exchange for winning one in the future, providing so-called courtesy bids, secretly compensating losing bidders and allowing banks to see other bids.

Brokers participated in the collusion by facilitating communication among banks and sharing in illegal profits, the civil class-action suits allege. (2)(4)