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Leipzig entangled in web of financial products

Leipzig has been dragged before a London court by Swiss bank UBS, suing the small German town for huge damages. The town's waterworks believed in the bank's promise of jackpot returns from new financial products.

The story of the Leipzig Waterworks reads like a scene from Don DeLillo's "Cosmopolis." The novel describes the self-destructive irrationality of modern financial capitalism and how people perish in a system they have created but no longer understand.

The protagonist in this story is the town of Leipzig in the eastern German state of Saxony. Wanting to make a fast buck, town officials offered the publicly-owned waterworks in a deal with an American investor.

The waterworks were sold for a certain amount of time, with the city cashing in the money while at the same time leasing back the waterworks - a model known as cross-border leasing, or CBL. From the late 1990s until the mid-2000s, such speculative deals were popular with German cities and municipalities.

Meanwhile, such deals have been outlawed, the catch being that the Americans, due to an ambiguity in US tax law, were able to deduct the purchases from their taxes and pass along some of the savings to their partners in Germany. That loophole has now been closed.

Since the financial crisis, local authorities looking to exploit loose tax laws in America are paying the price for the dubious deals. Leipzig paid dearly for its foray into the complex world of risky financial instruments.

UBS bank building

UBS bank, based in idyllic Switzerland, has successfully exploited financial market deregulation in the EU. Its newfangled financial products have reaped huge profits, but these investments often mean risky business for clients.

Toxic assets

The risky deal was supposed to have been buffered with another financial instrument, namely a CDS, or credit default swap - a common insurance against credit loss. This insurance was in turn financed with another, rather unique product: CDOs, or collateralized debt obligations, from the Swiss bank UBS.

Largely unknown to the average layperson, these products, referred to by experts as "toxic assets," were highly risky and complex.

UBS, however, paid a premium of some 40 million euros at the time to transfer the entire risk to the waterworks, but the deal went sour. By the end of 2009, the waterworks owed UBS 29 million euros. The bank wanted its money back and sued in a London court.

Watch video 01:25

UBS risk-taking costs lenders dearly

However, Norbert Menke, head of Leipzig's LVV utility holding considers the contracts invalid.

"This business has been driven by criminal energy on both sides - both from the responsible manager at the time and, in our opinion, from the perspective of the bank," Menke said.

In fact, the managing director of the waterworks at the time as well as two financial advisors who negotiated the transaction with UBS were charged with corruption and bribery and given prison sentences by a German court.

German business publications Handelsblatt and Wirtschaftswoche also suggested that a "high-ranking UBS manager" had known about the nature in which the contracts had been forged. UBS has so far refused to comment on the issue and has disclosed only on request that it believes in the validity of the contracts with Leipzig's waterworks.

Both parties' lawyers made their closing arguments before London's High Court of Justice last Friday (01.08.2014), and a verdict is expected in late September at the earliest. Regardless of how the case concludes, an air of gloom is hanging over Leipzig - and many other German cities too.

Menke has declined to comment on any of this finance business, although many still depend on the same kind of "instruments" to protect investments in municipal infrastructure. The appetite for risk, however, is long gone.

The entrepreneurial city

Leipzig town hall

If found liable, Leipzig would have to drastically cut expenditures to meet its debt obligations.

Not everyone believes there has been a fundamental change of heart at the municipal level.

In a 2012 study, a researcher at the University of Frankfurt named Conny Petzold studied the impact of such financial transactions on local communities. Self-awareness on the local level, she said, had been replaced with "entrepreneurial city politics."

For decades, stretched revenues have been unable to cover expenses, and the political will at the federal level has been lacking to fill in the budgetary gaps. Thus the municipalities' debts continued to grow despite spending cuts, which in turn increased their need for credit.

Even after the financial crisis, highly indebted communities in particular would gamble on precarious financial products to reduce their debt burden, according to Petzold. Due to these transactions being so complicated and the consequences often unforeseeable for municipal finance directors, the pros and cons are hardly ever addressed in political debates.

This is "a problem for local democracy," said Petzold.

Business at eye level

Ines Zenker, a lawyer specializing in administrative law and an expert on derivatives trading, told DW she saw financial products as a sensible and effective way for cash-strapped cities and municipalities to replenish their budgets.

However, the often lengthy contracts have to be accurately read, understood and evaluated - something that the European Union's "Financial Instruments Directive," or MiFID, is now enforcing.

New regulations prevent banks from treating communities as equals in the future. Now they must be explicitly clear about the complexities of the financial instruments they are selling, as they would do with private investors.

For banks, that means more transparency, which also increases their risk of liability, according to Zenker.

"That's a good thing because, as we have seen, treasurers and managers are not on par with investment bankers in terms of complex products," Zenker said.

The novel "Cosmopolis" tells the story of a highly intelligent and educated broker who embodies the irrationality and madness of financial capitalism. To the victor go the spoils of an unregulated market that has begun infringing upon other areas of life that were once considered unmarketable - such as the cities' basic needs.

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