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Financial magic round-about

6 January 2004

Parmalat’s appetite for tangled financial schemes seems to have known no bounds. UBS devised a particularly complex one – a sort of financial equivalent of a magic round-about. It looks pretty dubious.

In a nutshell, the UBS scheme allowed Parmalat to borrow money at low rates at a time when it was finding it difficult to raise money on the capital markets. But in order to avail itself of this attractive deal, the Italian dairy group put itself in double jeopardy: in the event that it went belly-up, it would do so spectacularly.

Meanwhile, UBS covered its own back extremely cleverly. Indeed, it protected itself against more than 100% of the downside. The Swiss bank could even profit from the disaster – provided its transaction turns out to be legally bullet-proof. Clever old UBS, one might think. The snag is that its profit would come at the expense of higher losses for other creditors.

Look at the money go-round in a little more detail. Last July the Swiss bank lent Parmalat E420m. The Italian dairy group only kept E130m. It invested the remaining E290m in the Cayman Islands subsidiary of Totta e Acores, the Portuguese bank. It did so to take advantage of an obscure tax advantage that investors get from putting money into Portuguese companies in certain offshore jurisdictions.

So far, so simple. The snag is that Parmalat also agreed to forfeit the E290m it had invested in Totta if it went bust. That’s where its double jeopardy comes in.

But why would Parmalat engage in such a foolhardy deal – apart, of course, from the fact that this is the sort of thing it habitually did? Well, the answer is that it had no choice if it wanted the money. Totta had done its own back-to-back deal with UBS promising to give the Swiss bank E290m if Parmalat went down. Totta needed the dairy group to forfeit the E290m so it could make good on its deal with UBS.

So UBS had covered its back. But, in fact, it had done more. Because, in the event of Parmalat collapsing, it wouldn’t just get E290m back from Totta; Parmalat would still owe it the cash. Even nowadays, with Parmalat bonds trading at about 20 cents on the euro, that residual claim is worth about E60m.

But what about the remaining E130m? Wasn’t UBS still on the line for that? Not for most of it. It had also protected itself by buying credit protection in the market against pretty much the full E130m.

UBS claims it has about broken even – mainly it didn’t hedge all of its exposure and because some of the hedges it did put on were very expensive. But it could still make a profit on the deal.

UBS may have been smart. But the deal does raise the question of whether it was fair to leapfrog up the line of creditors and, in the process, prejudice the position of others.

True, the transaction took place a few months before the group’s problems really tumbled out of the woodwork. But it came after the company was forced to pull a public bond issue in the spring because of disquiet about its finances.

UBS says it conducted due diligence but had not found anything that would “give rise to any concerns about Parmalat’s financial position”. According to a UBS spokesman, “Parmalat presented itself as a financially-sound company with the objective of seeking the most competitive funding rates. For such companies, structures of this type are not unusual and in no way inappropriate.”

The Swiss bank will certainly be hoping that such arguments hold up. Because, although it has been clever, it has not covered off every single avenue. Parmalat’s special administrator, Enrico Bondi, has the power under Italian law to revoke transactions entered into two years before Parmalat went bust. It is not clear whether, or if so how, he plans to utilise that power. But it would not be surprising if he looked at this deal. And, in that event, UBS might never get its E290m – or, if the Swiss bank already has it, it might have to hand it back.


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