Portuguese Train Company Was Run over by a Snowball

5/4/2014

Portuguese Train Company Was Run Over by a Snowball - Bloomberg View

W A LL S TRE E T

Portuguese Train Company Was Run Over by a Snowball

M A Y 2 , 2 0 1 4 2 :3 6 P M E D T

By Matt Levine Risk magazine have a great one.1 The story is that "Portuguese state-backed rail operator Metro do

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One service that I like to provide is pointing my readers to ridiculous derivatives trades, and oh boy does Porto (MdP)" had some floating-rate debt outstanding that it had swapped to fixed at 4.76 percent. In 2005, government auditors "urged it to find a way of reducing" that rate. One option was I guess to swap it back to floating but that was obviously dumb, so MdP decided to do something obscurely and wonderfully dumb instead. In 2007, it entered into a lunatic swap with Santander, in which Santander agreed to pay it 3 percent a year, and MdP agreed to pay Santander back a calculated "spread" for 14 years (the time left on the debt).2 The spread was zero for the first two years, so MdP succeeded in reducing its interest payments by 3 percentage points a year. After the first two years, the spread each quarter would be: the previous quarter's spread, plus "two times the difference between three-month Euribor and 2 percent for every quarter the rate is below that level, or two times the difference between three-month Euribor and 6 percent for every quarter the rate is above it," or minus 0.50 percent, if Euribor was between 2 and 6 percent (but never bringing the spread below zero). This worked great for a while -- Euribor was between 2 and 6 percent, so the spread stayed at zero and Santander kept paying MdP 3 percent. And then it stopped working: On the March 2009 reference date, Euribor was 1.66 percent, so the spread was 0.68 percent (2 x [2% - 1.66%]). Then it snowballed: But the formula also dictates the spread payable for that quarter be added to the spread for the...