Italy takes lead in investor derivative backlash

* 21 criminal probes in Italy into derivatives selling

* 600 municipalities sitting on 36 bln euros of derivatives

* About 100 cities seen suing banks over 2 years- consultant

MILAN, Feb 11 (Reuters) - Italian cities that gorged on opaque financial derivatives are leading a European backlash against the banks that sold them as the costs now threaten their already over-stretched public coffers -- and possibly national security.

Banks globally face a rising tide of claims from clients who bought sophisticated financial products that soured in the 2007-2009 crisis. But Italian civic authorities stand out for the enthusiasm with which they snapped them up during the credit boom -- and the extent to which they now rue their decision.

Municipalities failed to take into account the risks and the costs of complex deals and keen prosecutors in Italy are now investigating whether banks missold products to clients too unsophisticated to fully understand what they were buying.

"There are (such) cases all over Europe, including in Germany and Norway," said Dario Loiacono, a lawyer involved in the defence of a San Marino bank against Britain's Barclays BARC.L in a high-profile derivatives case in London. "But Italian municipalities are certainly the most stricken."

Twenty-one criminal investigations are underway in Italy over derivative contracts that have left local governments nursing potential losses put by conservative central bank’s figures at 1.2 billion euros ($1.64 billion).

But experts agree this is just the tip of the iceberg.

Before Italy’s Treasury banned investment in derivatives at the end of 2008, 600-plus Italian municipalities borrowed 36 billion euros and then tried to hedge -- or lower -- their interest payments through swap deals that sometimes actually masked new borrowing.

Marco Tedone, a consultant at Martingale Risk in Rome, expects the number of Italian municipalities launching legal suits to more than double to over 100 from a current ballpark figure of 40 over the next two.

“The number is rising sharply,” he said. “Although not every town can afford to hire a lawyer and a financial adviser.”


Among Italy’s 8,000 towns, even tiny ones have derivatives that threaten basic public services because the costs come on top of radical spending cuts imposed by Rome’s government.

“Local administrators are sometimes truly desperate,” Tedone said. “In one case, a city had to sell property to keep up with payments.”

Italy’s exposure to derivatives has even prompted the intelligence service to warn of a possible “systemic risk for the state’s economic and financial security” from such contracts in the latest issue of its online magazine Gnosis.

All eyes are on a test case in Italy's financial capital Milan, where Depfa Bank, Deutsche Bank DBKGn.DE, JPMorgan JPM.N and UBS UBSN.VX face fraud charges for their roles in a 1.7 billion euro financing package involving swap deals devised for the city in 2005.

Eleven bankers and two former city officials have also been sent to trial. The banks denied any wrongdoing. [ID:nLDE62G0OQ]

With a verdict still months away, Italian cities are taking heart from a Rimini case where a judge last October voided interest rate swaps between the city and UniCredit CRDI.MI.

Most cases in Italy revolve around alleged fees hidden in the pricing of contracts that allowed local governments to swap variable-rate payments on a loan with fixed-rate ones.

Rome’s Lazio Region sued 11 banks in December and is seeking almost 83 million euros in compensation for what it alleged were hidden costs in derivative contracts it signed.

Also in December, prosecutors in Florence seized 22 million euros at six banksas they probed fraud allegations over derivative deals which they claim allowed the banks to book “illicit profits”.

Joyce Frost, from U.S. consultancy firm Riverside Risk Advisors, says it is not often clear to a counterparty how much profit the dealer has built in when pricing a swap.

“That’s where the lack of transparency may be problematic,” she said. (Additional reporting by Kirstin Ridley in London)

Editing by Sophie Walker