In 1993 Mr Filotti [Ludovico Filotti, a trader at Barings] was on holiday in Italy. Reading the local newspaper, something caught his eye. An advertisement was encouraging companies to buy bonds issued by Italy's Post Office. These bonds were postal savings bonds, rather like Britain's national savings certificates, and carried the guarantee of the Italian state. Mr Filotti was curious: normally such bonds would only be for retail investors, so he wondered on what terms companies could invest. Back in Britain, he sent his Italian father the equivalent of £100 and asked him to nip down to a post office to buy a bond certificate so that he could study the small print on the bond.
What he found was encouraging. The postal bonds were “zero coupon”, that is, unlike most bonds, which pay annual interest instalments, they would pay nothing until they matured, so investors would have to wait a set period before pocketing their returns and recovering their original investment. The bonds promised a return of three times the initial investment after 12 years—a rate equivalent to 9.6% a year.
Back at his bank, Mr Filotti explained his discovery to a colleague, John Hunter, who realised that this highly attractive rate would be even more so if the equally juicy rates on Italian-government bonds were to fall. That would open a spread between Italy's ordinary borrowings and the postal bonds, just the kind of “arbitrage” opportunity traders love. But the most remarkable feature of the offer was that there was no upper limit on how much could be invested. Nor were there disadvantageous tax obligations for foreigners.
In fact, the arbitrage quickly disappeared when Italy's interest rates rose rather than fell. The trading idea sat on a shelf. But, towards the end of 1995, Italy's economy began its path towards convergence with those of the other countries hoping to join the euro. That meant its interest rates began to fall. And, in the summer of 1996, they started to fall dramatically. Suddenly, the Post Office trade was on. Mr Hunter persuaded his new employer, a big Japanese bank, to buy $50m of the postal bonds.
At this stage, his trade became one of the greatest ever. It also became amusing. Mr Filotti, who had also gone to work at the same Japanese bank, flew to Italy and, escorted by police, carried a banker's draft for the equivalent of $50m into a post office. Queuing up alongside pensioners claiming their modest weekly infusion, he exchanged the draft for a savings bond. Soon the certificate was safely lodged in London. With no limit on the amounts that could be invested, a huge and profitable arbitrage was there for the taking.
[...]
Mr Hunter, however, was unable to persuade his conservative masters to go further. No matter: he sold the idea for the trade, first to a single rival bank, then to several others. This set off a mad rush to buy the bonds before the opportunity disappeared. Bankers flew in droves to Italy, jostling to be in front of each other in the queue. In double-quick time UBS bought over $1 billion-worth of the bonds. CSFB bought the most, but, according to International Financing Review, a trade magazine, later gave back its profits when the Italian government threatened to withhold lucrative mandates for privatisations. Nomura made the biggest single purchase, plonking down $1.1 billion on the counter of a bemused clerk, who duly filled out a certificate for more than a trillion lire.
Of course, it could not last. After $3.6 billion of the bonds had been issued in the space of a few days, the Italian government suddenly put a ceiling on the amount that could be bought and made threats to the banks' future fee income.