Warren Buffett once referred to derivatives as "financial weapons of mass destruction" created by "madmen." Real WMD have rarely been used. However, derivatives are used quite a lot, a $600 trillion per year market dominated by a narrow oligopoly of mega-banks. It appears that Italy got hit by the derivatives WMD in January.
Last week, it was belatedly disclosed that the government of Italy paid Morgan Stanley $3.4 billion to terminate derivatives contracts that had been in place since the 1990s. For Italy, facing precarious finances and painful austerity, this is a damaging loss of cash. Italy has raised sales taxes by $7 billion for this year as part of a plan to put its house in order, so half will go to Morgan Stanley. Bloomberg reminded us that this is only part of the story. Italy is reported to owe over $31 billion in connection with derivatives overall. For perspective, Italy is struggling to implement an $80 billion austerity plan that cuts its $1 trillion budget and raises taxes.
This is nothing new. The Hellenic Republic of Greece entered into a similar € 2.8 billion swap with Goldman Sachs in 2001 that came back to haunt them as they faced down default. Local governments in the United Kingdom, Italy and Germany have all been burned by derivatives, some successfully claiming after the fact that the prior governments had no authority to enter into the obligation to avoid payments.