Should an investment bank worry about a client’s motives when it engages in a complex and potentially suspicious transaction?
Banca Monte dei Paschi di Siena of Italy has been just such a client. The Italian bank, which has just been rescued by the state, engaged in a series of complex deals with Deutsche Bank, JPMorgan Chase and Nomura that had the effect of giving a misleading picture of its finances.
One issue relates to how Monte dei Paschi di Siena, or M.P.S., paid for its acquisition of Antonveneta, another Italian bank, in 2008. JPMorgan helped finance part of the deal by selling €1 billion, or about $1.34 billion at current exchange rates, worth of so-called Fresh notes, a type of bond that could be converted into M.P.S. equity. But the Bank of Italy objected that they were not sufficiently loss-absorbing and insisted that M.P.S. not pay money to JPMorgan to forward onto the investors unless it made a profit.
The snag was that by the time the central bank objected the notes had already been sold and some of the investors were not happy with a change in the terms. M.P.S. then gave indemnities to JPMorgan and Bank of New York Mellon, which was an intermediary between JPMorgan and the Fresh investors.
It is not clear what these indemnities were. But the Siena prosecutors say that M.P.S. concealed the JPMorgan indemnity from the Bank of Italy and did not communicate the Bank of New York’s indemnity to the central bank either, according to a document reviewed by Reuters.
The question for JPMorgan and the Bank of New York is whether they knew that the Italian central bank had not been in the picture at the outset. If so, they should not have touched the deal. JPMorgan and the Bank of New York declined to comment.
Now look at the Deutsche Bank transaction. What happened here was that in 2002, M.P.S. had invested in yet another Italian bank, Sanpaolo Imi. The investment was stuck in a special-purpose vehicle called Santorini, which the German bank had helped establish. The value of this vehicle plummeted after Lehman Brothers went bust in 2008.
M.P.S. then engaged in two more transactions with Deutsche Bank, which mitigated its Santorini losses. Each deal involved M.P.S. pledging €2 billion worth of Italian bonds to Deutsche Bank in return for a same-sized loan. One of these transactions was with Santorini; the other with M.P.S. itself. But there was a curious quirk: The interest rate on the Santorini leg was less than the market rate, while that on the M.P.S. leg was more expensive.
M.P.S. rapidly unwound the first transaction, creating a gain that helped it counter the loss on the original Santorini deal. But it hung on to the second investment and did not report any immediate loss from it.
Last week, M.P.S.’s new management said that the value of the investment had been incorrectly listed on its balance sheet. It should have incurred a loss of €429 million.
Deutsche Bank’s defense for being involved in the transaction is that it asked for and received representations from M.P.S.’s senior management that its auditors and regulators had been informed of the transaction’s details. But the Bank of Italy said that when it examined the transaction in 2010, it was worried that the operation did not show fair value on M.P.S.’s balance sheet.
What is more, it would be revealing of the German bank’s culture at the time if it did not ask what possible motive M.P.S. could have had for doing these deals. Deutsche says its standards have evolved since 2008 and continue to do so in light of its own experience and the market’s. That, at least, suggests it is learning some lessons.
The same does not seem to be so for Nomura. In this case, M.P.S.’s original bet — nicknamed Alexandria — was on risky credit derivatives called “C.D.O. squareds,” a type of collateralized debt obligations, which, by 2009, were threatened with big losses. That is when M.P.S. embarked on two new deals. One involved the Japanese investment bank buying the C.D.O. squareds from M.P.S. at above their market price, with the result that the Italian bank avoided booking a loss.
The other involved M.P.S.’s pledging Italian government bonds with its Japanese counterpart in return for a loan. The oddity was that, although Nomura kept the fixed coupon on the bonds, it paid back to M.P.S. an unusually low floating interest rate. At the time, M.P.S. did not recognize any loss on this part of the transaction. But last week its new management said it should have booked a €309 million liability.
There was also a side-letter between Nomura and M.P.S. linking the two new deals. But this was not revealed to the Bank of Italy until October, after the new management found it. The central bank says that letter clarified the real purpose of the operation.
Nomura said the deal was approved by the Italian bank’s board and its auditors, KPMG — although M.P.S. said its board had not approved the deal, and KPMG said it had never received the Alexandria documentation.
It would be sad if Nomura did not investigate what possible purpose M.P.S. could have had for all this financial engineering. The Japanese bank said it had acted fairly and reasonably while a spokesman denied it had acted unethically.
This really will not do. An important lesson of the M.P.S. story is that, when banks are presented with a client who wants to do something that seems suspicious, they should check its motives deeply. And if they do not get a satisfactory answer, they should refuse to do business with it.
Hugo Dixon is editor at large of Reuters News.
Article source: http://www.nytimes.com/2013/02/11/business/global/11iht-dixon11.html?partner=rss&emc=rss