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Deutsche Bank Derivative Helped Monte Paschi Mask Losses

By Elisa Martinuzzi and Nicholas Dunbar
January 17, 2013 3:28 PM EST 28 Comments
A woman walks over a Monte dei Paschi di Siena bank logo at one of the bank's branches in Milan, Italy.
Photographer: Giuseppe Aresu/Bloomberg
A woman walks over a Monte dei Paschi di Siena bank logo at one of the bank's branches in Milan, Italy.

Deutsche Bank AG (DBK) designed a derivative for Banca Monte dei Paschi di Siena SpA at the height of the financial crisis that obscured losses at the world’s oldest lender before it sought a taxpayer bailout.

Germany’s largest bank loaned Monte Paschi (BMPS) about 1.5 billion euros ($2 billion) in December 2008 through the transaction, dubbed Project Santorini, according to more than 70 pages of documents outlining the deal and obtained by Bloomberg News. The trade helped Monte Paschi mitigate a 367 million-euro loss from an older derivative contract with Deutsche Bank. As part of the arrangement, the Italian lender made a losing bet on the value of the country’s government bonds, said six derivatives specialists who reviewed the files.

“I can’t understand why any financial institution would engage in a trade like this for legitimate objectives,” said Frank Partnoy, a professor of law and finance at the University of San Diego who structured derivatives at Morgan Stanley and has read the files. “They shouldn’t ever be doing that.”

After Bloomberg News reported on the transaction, Monte Paschi said it will conduct a “thorough” review of several structured deals to determine their effect on previous years’ accounts as well as any future impact. The bank didn’t identify the trades involved.

“Any potential action will be carried out under the utmost transparency toward the market and regulatory authorities,” the company said today in a stock-exchange statement.

Opaque Products

The Santorini transaction shows how investment banks devised opaque products that years later are leaving companies and taxpayers with losses. From the Greek government to the Italian town of Cassino, borrowers have lost money on bets that were skewed in banks’ favor. In December, an Italian judge convicted bankers at four firms, including Deutsche Bank, of fraud in arranging an interest-rate swap for the city of Milan.

The Frankfurt-based lender’s investment-banking unit, run by Anshu Jain until his appointment as co-chief executive officer in June, also is being probed over alleged interest-rate rigging and has been criticized by German lawmakers.

Monte Paschi, founded in 1472, sought a 1.9 billion-euro bailout from the Italian government in 2009 and last year requested more funds after it became the nation’s only lender to fail the minimum capital requirement set by European regulators. CEO Fabrizio Viola, 55, requested an additional 500 million euros, bringing the total cost of the bailout to 3.9 billion euros, after the lender said in November that structured financings linked to government securities had soured.

Police Probe

Monte Paschi never disclosed the effect of the 2008 deal in its annual reports. Kathryn Hanes, a spokeswoman for Deutsche Bank in London, wrote in an e-mail that “the transaction was subject to our rigorous internal approval processes and also received the requisite approvals of the client who was independently advised.”

Italy’s finance police and prosecutors are probing the Siena-based bank for alleged market manipulation and obstruction of regulatory activities. A police official, who declined to be identified in line with policy, wouldn’t say whether the Deutsche Bank transaction forms part of the probe. A Monte Paschi spokeswoman in May said the bank would cooperate with the investigation.

Jain, Fan

The Deutsche Bank documents include a review of the trade by the risk profit-and-loss control group at the bank’s global rates division, as well as a trade-approval request addressed to the firm’s risk committee that identifies Dario Schiraldi as the senior banker responsible for the deal.

Schiraldi, who joined Deutsche Bank in 2004 after stints at Lehman Brothers Holdings Inc. and Merrill Lynch & Co., was moved four months ago from the firm’s investment-banking unit, where he oversaw the institutional client group for Europe, to the asset-and-wealth-management division, where he’s head of distribution. He didn’t respond to an e-mail seeking comment.

Deutsche Bank’s Global Markets Risk Assessment Committee approved the transaction, according to a summary of the deal by the risk profit-and-loss control group. Jain, 50, and investment banking co-head Colin Fan, who then ran the credit-trading business, had ultimate responsibility for the businesses that devised the Santorini transaction.

‘Without Merit’

Jain and other Deutsche Bank executives are grappling with escalating regulatory probes and litigation stretching from the alleged manipulation of interbank lending rates to claims the bank misrepresented products tied to U.S. mortgages. German lawmakers are calling on Deutsche Bank and the country’s finance regulator to publish the findings of the lender’s probe into allegations of rate-rigging.

The bank has said it’s cooperating with regulators in their rate-manipulation probes, and an internal investigation cleared current and former management board members of any wrongdoing. A limited number of employees had “engaged in conduct that falls short of the bank’s standards,” it said in July. Amanda Williams, a spokeswoman for the bank, said in an e-mail in December that the mortgage litigation “is without merit.”

Jain and Fan declined to comment through a bank spokeswoman. A spokesman for Bafin, the German financial regulator, also declined to comment, as did a spokeswoman for the Rome-based Bank of Italy.

Intesa Derivative

As Lehman Brothers teetered toward collapse in September 2008, stocks around the world began to plunge. Monte Paschi’s earnings came under strain following then Chairman Giuseppe Mussari’s decision the previous year to spend more than the lender’s market value to acquire Padua, Italy-based competitor Banca Antonveneta SpA, just as bank stocks hit their peak.

Monte Paschi shares tumbled 49 percent in 2008 and profit fell 47 percent in the fourth quarter of that year, the company reported, prompting the bank to seek aid the following March.

Adding to the pressure, Monte Paschi was facing a 367 million-euro loss on an earlier Deutsche Bank derivative linked to its stake in Intesa Sanpaolo SpA (ISP), Italy’s second-biggest bank, according to two documents drafted by executives at the German lender in November and December 2008.

Derivatives are financial instruments used to hedge risks or for speculation. They’re linked to specific events such as interest rates or are derived from stocks, bonds, loans, currencies and commodities.

‘Way Around’

Monte Paschi, which originally took the stake in one of Intesa’s predecessor companies more than a decade earlier, had entered into a swap with the German bank in 2002 to raise cash from the holding to bolster capital while retaining exposure to Intesa’s stock-price moves, the documents show.

Intesa shares fell more than 50 percent in the 11 months through November 2008, and the decline would have forced Monte Paschi to post a fair-value loss on the swap at the end of the quarter, threatening the bank’s capital and earnings, the derivatives specialists who examined the documents said.

“Monte Paschi was facing a loss on its equity position and may have needed to find a way around it,” Satyajit Das, a former Citigroup Inc. (C) banker and author of half a dozen books on risk management and derivatives, said after reviewing the files.

In an equity swap, the owner of shares borrows against the holding in return for paying interest. Monte Paschi had also agreed to post collateral on the agreement, the files show.

Volcanic Island

Instead of booking a loss, Monte Paschi decided to replace the swap. Marco Morelli, chief financial officer at the time, was one of at least three Monte Paschi executives involved in discussing the replacement swap, the Deutsche Bank documents show. Morelli, now Bank of America Corp.’s most senior executive in Italy, declined to comment.

Mussari, now chairman of Italy’s banking association, ABI, didn’t return a request seeking comment through a spokesman for the group.

Deutsche Bank and Monte Paschi chose to restructure Santorini Investments LP, an Edinburgh-based limited partnership they set up in 2002 for the original equity swap.

The venture takes its name from the Greek volcanic island known for its black sandy beaches. Monte Paschi had bought out Deutsche Bank’s stake in Santorini in 2006, according to the Italian lender’s annual report. The firm said at the time the purchase would have no impact on its “riskiness,” without elaborating, the report shows.

Digital Options

Under the 2008 plan, Deutsche Bank entered into two trades with Monte Paschi designed so that one would create a positive value for the Italian lender and the other a positive value for the investment bank, the documents show.

“It was more likely that one of the trades will trigger in DB’s favour and the other in the client’s favour,” according to an undated memo drafted by the independent valuation group at Deutsche Bank’s global rates unit.

Deutsche Bank entered into short-term bets on interest rates with Monte Paschi, including so-called digital options linked to euro interest rates, the documents show. In a digital option, each trade results in either a gain or a loss depending on whether a specified rate crosses an agreed-upon threshold. Each party gained on one part and lost on the other.

One of those bets created an immediate mark-to-market gain and was unwound within days, the documents show, generating a payment of an unspecified amount for Monte Paschi. The files also show Deutsche Bank reaped about 60 million euros in profit in the first two weeks of December 2008 from the loan, which matures no earlier than 2018, according to the documents.

‘Banks Gambling’

“You have two banks gambling on regulatory action in late 2008, at a time of supposed crisis, and they are using overly complex and opaque derivatives to do it,” said Partnoy, the University of San Diego professor. “Deutsche Bank made a fortune for facilitating the trade. You can’t tell any of this from looking at their financial statements.”

The documents also show that in the second part of the restructuring, Monte Paschi agreed to make a long-term bet that the 1.5 billion euros of Italian government bonds it pledged to Deutsche Bank wouldn’t go down in price, leaving it exposed to losses if the value of the bonds plunged.

Deutsche Bank sold Italian government bonds and credit- default swaps tied to the securities. Monte Paschi, effectively, agreed to be the issuer of that protection against default, according to the risk managers who examined the transaction.

The yield on the benchmark 10-year Italian government bond jumped to as much as 7.48 percent in November 2011 from an average of 4.66 percent in 2008 as Europe’s sovereign-debt crisis engulfed Italy.

‘Complex Structuring’

Credit-default swaps tied to Italian 10-year government bonds hit a record of 569.6 basis points on Nov. 15, 2011, compared with the 148.3 basis points at the end of November 2008, before the Deutsche Bank transaction, according to data compiled by Bloomberg. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The increase in credit-default prices probably is exacerbating Monte Paschi’s potential losses on the trade, said Michael Dempster, founder of the University of Cambridge’s Centre for Financial Research, who also reviewed the documents.

Santorini “exemplifies the complex structuring, questionable internal decisions and lax external supervision rampant in the lead-up to the crisis and beyond,” Dempster said. “The accumulated losses to the borrower at maturity have yet to play out.”

‘Other Skeletons’

Monte Paschi shareholders haven’t been in a position to know about the bank’s derivative bets because its filings didn’t provide sufficient information on Santorini and its liquidation, according to two accountants in Italy who reviewed the documents and asked not to be identified because they aren’t authorized to speak publicly.

In its annual reports, Monte Paschi said Santorini’s fair- value loss narrowed to about 62 million euros at the end of 2008 from 87 million euros in 2007. In June 2009, Monte Paschi liquidated Santorini. The liquidation generated 224.4 million euros for the Italian bank, the filings show.

The lender didn’t provide further details about Santorini. It refers to the unit as Santorini, Santorini Investment, Santorini Ltd. and Santorini Investment Ltd. SA in its annual reports, without providing details about its assets.

One of the accountants said Monte Paschi should have disclosed the existence of the 2008 contract that enabled the bank to raise cash by liquidating Santorini and how the asset was sold. A spokesman in Milan for KPMG, the accounting firm that audited Monte Paschi in 2009 and 2008, declined to comment, citing client confidentiality.

“This transaction shows the complexity of banks’ balance sheets,” said Mark Williams, a former bank examiner for the Federal Reserve and now a lecturer at Boston University’s School of Management, who also reviewed the documents. “It leaves one wondering what other skeletons are in the closet.”

To contact the reporters on this story: Elisa Martinuzzi in Milan at emartinuzzi@bloomberg.net; Nicholas Dunbar in London at ndunbar1@bloomberg.net

To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net

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