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The Deutsche Bank, Monte Paschi Cover-Up: Tier 1 Capital and an Equity Swap

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At Deutsche Bank, the job title “risk manager” might be more appropriately characterized as “campaign manager.” That is, Deutsche Bank is no more concerned with the active mitigation of risk than the unscrupulous politician is with actively avoiding extra marital affairs. Like campaign mangers then, risk managers at Deutsche Bank must accept the fact that occasionally (or perhaps quite often) messes will be made and spin campaigns will need to be devised and deployed in order to keep public opinion from turning sour and in order to keep the few regulators who aren’t on the payroll from stirring up any trouble. In short, risk management at the firm seems to be more reactive than proactive and the combination of pliable mathematical models, questionable ethical standards, and a clueless public makes it possible for the firm’s quant spin doctors to disappear vast amounts of risk from the books without anyone getting wise.

Apparently however, even the mainstream media has gotten wise to the act. Recently, CNBC’s John Carney and DealBreaker’s Matt Levine observed that Deutsche Bank was able to report a higher Tier 1 capital ratio in its most recent quarter not by reducing the loans on its books or by increasing its earnings, but by changing the way it calculates its risk weighted assets. In other words, it manipulated its mathematical models to achieve more favorable results.

It is ironic that these commentators should be the ones calling out Deutsche Bank for crimes against mathematics. After all, a little over a month ago, these same two journalists (and many of their peers) trivialized the whistleblower claim filed against Deutsche Bank by a Mr. Eric Ben-Artzi, a PhD mathematician from the most prestigious school of applied mathematics in the country, NYU’s Courant Institute.

In any case, on January 17, Bloomberg reported that “Deutsche Bank 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.” The Bloomberg story set-off a wave of investigations which ultimately revealed that the world’s oldest bank made a series of bad derivatives bets that will ultimately cost it three quarters of a billion euros. The Bank of Italy has since approved a 3.9 billion euro taxpayer-sponsored bailout. The story has taken several decisive (albeit hilarious) turns for worst over the past two weeks and the whole thing now reads like a lost chapter of The Da Vinci Code, complete with treacherous characters, scandalous deal-making, and a secret contract locked away “in a concealed safe in a 14th century Tuscan palace.”

As intriguing as all of that is, it is the Deutsche Bank connection which is of particular interest. The firm’s role in helping Monet Paschi conceal losses speaks to the depravity of Deutsche’s corporate culture and to the firm’s willingness to share its expertise in the art of obfuscation with its clients. Here is Bloomberg’s description of what happened:

Monte Paschi was facing a 367 million-euro loss on a… 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…
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.

This is the first part of what would eventually become a multi-legged trade that spanned the better part of a decade. Although the mainstream media has done a decent job of describing the mechanics of the transaction, I wanted to know the details, so I contacted Bloomberg to see if they would be interested in sharing the 70 some odd pages of documents on which they based their original story. Not surprisingly, they informed me that they are not currently able to share the evidence. While they promised that I would be the first to know if the situation changed, I thought I might take a stab at explaining, in detail, what exactly went on between Deutsche and Monte Paschi in lieu of Bloomberg’s top-secret document stash.

I cannot, of course, be sure that this is entirely accurate without access to primary sources, but this should serve as a decent outline for those interested in learning how the largest bank in the world conspired with the oldest bank in the world to effectively hide hundreds of millions in losses from shareholders.

For our purposes, the story begins on page 310 of Monte Paschi’s 2002 annual report. Under “Acquisitions, Incorporations, and Sales,” the following passage appears:

Sale to Deutsche Bank AG London Branch of a 4.99-percent holding in San Paolo-IMI S.p.A. Along with this sale, the Bank invested EUR 329 million to purchase a 49-percent interest in the newly incorporated Santorini Investment Ltd. Partnership, a Scottish company that is 51- percent owned by Deutsche Bank AG. The aggregate price of the sale was EUR 785.4 million; the difference (EUR 425.3 million) between the sale price and the carrying value (EUR 1,210.7 million) was charged to the revaluation reserve set up in accordance with Law 342/2000. The residual amount was allocated to shareholders' equity through a bonus share capital increase authorized by a resolution of the extraordinary shareholders' meeting of 30 November 2002. (emphasis mine)

This is the genesis of the Deutsche Bank deal and while it may sound convoluted, the bank’s motives seem relatively clear in retrospect. First, consider the effect the transaction above had on Monte Paschi’s statement of shareholders’ equity:

First, the bank had to account for the 425 million-euro difference between the carrying value of its stake in San Paolo bank and the amount Deutsche Bank paid for those shares. This was effectively a loss, and as it turned out, Monte Paschi had held what it called an “extraordinary meeting” on November 30 of 2002 to get shareholder approval to use its entire 715 million-euro revaluation reserve (green arrow above) for an increase in the par value of the ordinary and savings shares and to absorb the loss on the sale of the San Paolo stake to Deutsche Bank (this is outlined on page 383 of the 2002 annual report).

Because revaluation reserves didn’t generally count towards Tier 1 capital, the bank was able to absorb the loss on the sale without affecting the area it was really concerned about: core capital. As an added benefit, Monte Paschi was able to use the remainder of the revaluation reserve (the 209 million left over after it absorbed the loss on the sale of the shares) to raise the par value of its own shares, resulting in an increase in its share capital (yellow arrow above). This of course, led to a concurrent increase in the bank’s Tier 1 capital ratio. Effectively then, Monte Paschi turned a 425 million euro loss on the sale of an equity stake into a .2% increase in its Tier 1 capital ratio (there were other components which contributed to the increase, but the point stands).  This is likely what Bloomberg was referring to when it said Monte Paschi was seeking “to bolster capital” by using its equity stake in San Paolo.

As noted above, Monte Paschi and Deutsche set up “Santorini Investment Ltd” after the completion of the equity sale. This is where the “equity swap” referenced by Bloomberg comes into play. From what I can tell, this was some derivation of a “total return equity swap.” Here, the deal began with the sale of the San Paolo stake to Deutsche Bank. “Santorini Investment Ltd” (the ”partnership” Deutsche and Monte Paschi set up after the sale) was essentially a special purpose vehicle (SPV) through which the swap was effectuated.

Santorini was majority owned (51%) by Deutsche Bank – Monte Paschi controlled 49%. A portion of the cash from the original sale of the San Paolo stake to Deutsche was effectively used to finance Monte Paschi’s stake in Santorini. Through the SPV, Monte Paschi was able to retain exposure to the share price fluctuations of its San Paolo stake. Typically in such a deal, there is either a floating rate or a fixed rate of interest paid over the life of the swap to the entity to which the shares were sold (in this case Deutsche) based on the notional amount of the shares traded (so 785 million euros here). When the swap matures, the original seller of the shares (Monte Paschi here) will receive the difference between the price of the shares when the swap was originated and the price of the shares at maturity.

Obviously, if the shares rise over time the original seller makes a profit on the swap (minus any interest payments made along the way). Of course the stock could go up or down over the life of the transaction so there is a very real possibility that the original seller of the shares will have to make a payment at maturity in addition to the interest payments made along the way. Note also that if the stock drops over the course of the deal, the original seller may be forced to post collateral to the buyer of the shares. Through Santorini then, Monte Paschi appears to have entered into a total return equity swap with Deutsche Bank referencing the 4.99% stake in San Paolo. Monte Paschi paid Deutsche interest on the deal and was on the hook for margin calls in the event the value of San Paolo’s shares dropped. The following graphic is a simplified diagram of the swap based on an unrelated total return swap diagram originally posted on Sober Look:

It is important to remember that one of the pitfalls of entering into such an agreement is that the seller of the shares may initially have to recognize a capital loss on the sale.  By using its revaluation reserve, Monte Paschi was able not only to effectively avoid this for the purposes of core capital, but was in fact able to boost its Tier 1 capital ratio while retaining exposure to the share price movements of the sold San Paolo stake through the swap deal with Deutsche.

The original term of the deal was 3 years but according to Monte Paschi’s 2004 annual report, the swap was extended to 2009:

“…with reference to the investments held in Santorini Investment Limited Partnership, the capital loss, due to the compliance with several accounting principle, is not deemed to be permanent in view of the assets underlying the financial contracts, which anyway increased in value in the last period; moreover, the contract was renewed for further 4 years (new expiry: 31 May 2009) while keeping the advance redemption right.”

On January 1 2007, San Paolo merged with Banka Intesa hence the following passage from the Bloomberg piece:

“Monte Paschi,… originally took the stake in one of Intesa’s predecessor companies… [and] entered into a swap with the [Deutsche] in 2002 to raise cash from [that]…while retaining exposure to Intesa’s stock-price moves.”

It appears then, that Monte Paschi effectively gained exposure to Intesa’s stock by default. Whatever the case, the collapse in the price of Intesa’s shares in 2008 resulted in a 367 million euro impairment to Monte Paschi’s Santorini investment. Desperate, the bank asked Deutsche Bank what could be done. Ultimately, it was determined that Deutsche and Monte Paschi would restructure Santorini and devise a replacement swap that would allow Monte Paschi to hide the losses on its original position.

The replacement swap will be the topic of a follow up piece. For now, consider that Deutsche Bank and Monte Paschi were able, via a stock purchase and a subsequent equity swap, to boost Monte Paschi’s 2002 Tier 1 capital (even though the stock purchase resulted in a nearly half billion euro capital loss for Monte Paschi), while ensuring that Monte Paschi retained exposure to the underlying shares. At the time, it undoubtedly seemed like a good idea – perhaps even a win-win situation. Of course, the near collapse of the worldwide financial system in 2008 would turn the deal into a nightmare for Monte Paschi, but as the Italian bank learned, when Deutsche Bank’s risk management department is involved, “losses” are just an illusion.

 

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Sat, 02/16/2013 - 17:41 | 3250130 enoch_root
enoch_root's picture

Vatican Bank- Monte di Paschi link

So where does this leave the timing of Pope's resignation, days after these rumours start surfacing?

 

Maybe he knows there is storm coming that he does not want to be a part of .... the ghost of Roberto Calvi never really left the Vatican.

Sat, 02/16/2013 - 15:58 | 3249949 Tic tock
Tic tock's picture

There's yet another trick in this;...imagine that the deal could have been structured the other way ...for Deutsche to pay MPS if IMI fell..and where Deutsche could also hold various short-positions on IMI. ..instead, Banks correctly guess that if either or, both suffer 'extreme risk' they can get- due to their size - a sort-of bridging loan from the free-money brigade. So a collection of Banks make a series of these Bank-buyout deals - and place the tip in German Banks, whose economy has the most to lose from a Bank collapse. ...meanwhile, because the banks are watching personal credit in the US they can tell the end is coming - so sovreign debt is ramped up and up inside the EU, and also with low i% in the US, so there is no way that countries can sustain their expenses or afford their expansion. ...that's only the half of it, because.. then the price of Gold and Silver is manipulated...why? 90% of industrial assets are at-least co-owned with the banks - that means payments in fiat are ensured, 90% of the population have no clue about the history of Gold and Silver, it is simply so irrelevant to the economy that it operates as a footnote - the one thing it does, the only thing, is to allow those ten percent who are intelligent but not connected to preserve their wealth - this is the placard that says NWO, because it isn't just a bank-scam, it's an attempt to make this  'limbo' carry on for so long, that by attrition, the entire western world will be enslaved under debt. 

This is a WAR being waged against the people, by their government, (strip-searches of white women on domestic US flights, possibly trained in Afghanistan.. really.! High-fructose corn syrup..!) and certainly, the americans, the people, can do nothing about it... they are lost to us. But look at the strategy, it isn't important how many people die or fall into hopeless poverty, it is only that 99.99% of all consumers use 'credit' - until that is achieved, anything will happen... this Central-bank assistance is... a bandage, solution-wise - four years and the real solution is not just nowhere in sight, it isn't even being discussed. There is only one solution...government debt is nominally bought by the / distributed to the people through bank accounts, peole get the interest, banks get the created deposit... no more welfare, no more uncapitalization, ...like Healthcare, what good is the solution when the problem makes money... the solution, is to read Lao Tze. soft-power, China will rise, and requesting that form of administration in a proper manner will prove to be an unstoppable force.      

Sat, 02/16/2013 - 09:10 | 3249153 GCT
GCT's picture

Did you expect any different result from the German banks.  Hell all the banksters are in this on a global scale.  The Europan bankers have been at it alot longer then the American banks.  They have theft down to a science.  Nothing will change until it has too and most likey with the next world war.

Sat, 02/16/2013 - 00:34 | 3248795 Decimus Lunius ...
Decimus Lunius Luvenalis's picture

Fiat contracts based in fiat currencies based in fiat electrons.....  CB intervention is like the weight-loss pill "alli": sure you might lose weight because you only considered fat absorption as the solution to all your problems, but now your ass leaks uncontrollably.  The problem is that your goal all along was to get laid with better looking people, but now you don't get laid at all because your ass leaks. 

Sat, 02/16/2013 - 00:34 | 3248794 Decimus Lunius ...
Decimus Lunius Luvenalis's picture

Fiat contracts based in fiat currencies based in fiat electrons.....  CB intervention is like the weight-loss pill "alli": sure you might lose weight because you only considered fat absorption as the solution to all your problems, but now your ass leaks uncontrollably.  The problem is that your goal all along was to get laid with better looking people, but now you don't get laid at all because your ass leaks. 

Fri, 02/15/2013 - 21:18 | 3248381 gimli
Fri, 02/15/2013 - 19:52 | 3248185 Downtoolong
Downtoolong's picture

How am I supposed to produce my majic show in Vegas when these bankers keep using up all the blue smoke and mirrors.

Fri, 02/15/2013 - 19:02 | 3248025 Number 156
Number 156's picture

Utterly futile. They are just prolonging the inevitable and they know it.

Not even nationalization will save them because the eurozone is a slow motion train wreck, and no matter that they do, they will never be able to get off the rails before the derailing locomotive wipes them out.

Good luck trying to tax your your way out of it you stupid euro technocrats, there wont be enough economic activity for them to have money to tax.

Fri, 02/15/2013 - 17:17 | 3247772 The Heart
The Heart's picture

Breaking news!!!

Not so associated CIA-press reports for the first time secretly recorded conversations in the vaults of the wully-bully banksters where they are hiding are now going viral.:

http://www.youtube.com/watch?v=3zZrLjcMFw4

Fri, 02/15/2013 - 16:36 | 3247629 hooligan2009
hooligan2009's picture

santorini was that mediterranean island that blew up in a piece of seismic activity that wiped Atlantis and half of Crete wasn't it? how apt!

Fri, 02/15/2013 - 22:10 | 3248518 disabledvet
disabledvet's picture

i'm sure they were laughing when they came up with the title as well. here's the video:
http://www.youtube.com/watch?v=kRW7pITY5Cg
with some musical accump...acccamp...accormpany...accor....aaaaahhh...here's the music
http://www.youtube.com/watch?v=_ul7X5js1vE

Fri, 02/15/2013 - 16:09 | 3247505 The Reich
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