A court battle between the Portuguese government and Santander is shedding light on a crazy debt deal that almost sunk one of the country’s railway companies.
And, according to the ex-banker who fought Portugal's corner, it shows how investment banks “took advantage” of naive governments in the pre-financial crisis years.
Several debt-laden European governments signed deals with investment banks in the lead-up to the financial crisis, hoping to reduce debt repayments. But many of these complex deals have since gone spectacularly sour.
The dispute between Santander and the Portuguese government is a prime example of one such disaster, centering around a 'snowball' clause that left Portugal paying interest of 40.6% on a debt originally carrying a 4.79% repayment rate.
It started in 2005, when Metro do Porto, the state-backed organisation that runs Oporto's rail network, started looking at ways to reduce a 4.79% interest rate it was paying twice-yearly on a debt of €89 million.
Metro do Porto (MdP) entered into a bizarre and complicated debt swap deal with Santander in 2007 that cut the rate it was paying by 3% to 1.76%.
But there was a catch, the 1.76% rate would apply only as long as three-month Euribor, a benchmark banking industry interest rate, stayed above 2% and below 6%. The lower the interest rate went, the more it had to pay.
In short, Santander wasn't refinancing MdP in the more traditional sense, by offering a new loan at a better rate to pay off the old debt, but in fact making a bet with MdP that interest rates would swing one way or the other.
For two years, it worked out well for MdP. Euribor was within the range. Buy then in 2009 central banks lowered their base rates to near zero in response to the global financial crisis. Euribor followed central bank rates, falling hard and fast which meant MdP found itself having to a lot more.
For every quarter Euribor stayed below 2%, the difference was doubled and added on to the quarterly rate MdP had to pay.
So, if Euribor was at 1.66%, which it hit in March 2009, MdP had to add an extra 0.68% to its base repayment rate of 1.76%. That's because 0.68% is double 0.34%, the difference between the 2% cut off and the actual 1.66% rate.
But it gets much worse. Every quarter's interest rate addition was added on to the next quarter's – effectively compounding the coupon payments for MdP for as long as Euribor was on the floor.
In June 2009, Euribor was down to 1.28%. That's an extra 1.44% added to the interest (double the 0.72% gulf) and took the total interest to 2.12%.
By the next quarter, Euribor stood at 0.77%. So the cumulative rate became: 2.12% + double 1.23% = 4.58%. Remember, MdP entered into the deal to negotiate down its 4.79% rate.
The snowball rolled quickly downhill, getting bigger as it went. Coupon payments rapidly grew, reaching 40.6% before MdP stopped paying Santander in 2013.
By then, MdP owed a huge €459 million from the initial €89 million debt that formed the basis of the swap. According to calculations made by Risk magazine, the interest rate will hit 100% by 2018 if allowed to continue.
You can see this either as a case of spectacularly bad timing on the part of MdP or a financial hoodwinking, which is exactly what the current court case has to decide.
Santander is fighting the Portuguese government in the UK High Court for the money it believes the state, which took over management of the deal, owes.
MdP and Portugal's defense hinges on its ignorance, saying the deal should be void because the people that signed didn't understand the consequences of the sophisticated clause, even thought the deal was passed by government overseers including Maria Luis Albuquerque before she became finance minister.
A spokesman for the Santander's Portuguese arm declined to comment on the case, beyond saying he expects the case to finish this month, with the judgment coming in the first quarter of 2016.
The snowball debt swap is a striking example of the types of risky transactions European government agencies got mired in with investment banks before the sovereign debt crisis exploded in 2011.
Portuguese agencies made other, similarly complex deals, with banks such as Goldman Sachs and Nomura, but managed to settle their claims and get back some of the money.
The High Court case continues.
