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Know your client

11 February 2013 By Hugo Dixon

Should an investment bank worry about a client’s motive when it engages in a complex and potentially suspicious transaction?

Monte dei Paschi di Siena (MPS) has been just such a client. The Italian bank, which has just been rescued by the state, engaged in a series of fiendishly complex deals with Deutsche Bank, JPMorgan and Nomura which had the effect of giving a misleading picture of its finances.

One controversy relates to how MPS paid for its acquisition of Antonveneta, another Italian bank, in 2008. JPMorgan helped finance part of the deal by selling 1 billion euros in so-called FRESH notes, a type of bond convertible into MPS equity. But the Bank of Italy objected that they were not sufficiently loss-absorbing and insisted that MPS only pay money to JPMorgan to forward onto the investors if it made a profit.

The snag was that, by the time the BoI objected, the notes had already been sold and some of the investors were not happy with a change in the terms. MPS then gave indemnities to JPMorgan and Bank of New York (BNY), which was in turn an intermediary between JPMorgan and the FRESH investors.

It is not clear what these indemnities were. But the Siena prosecutors allege that MPS concealed the JPMorgan indemnity from the BoI and didn’t communicate the BNY indemnity to the central bank either, according to a document reviewed by Reuters.

The question for JPMorgan and BNY is whether they knew that the BoI was not in the picture at the outset. If so, they shouldn’t have touched the deal with a barge-pole. JPMorgan and BNY declined to comment.

Now look at the Deutsche Bank transaction. What happened here was that MPS had invested in yet another Italian bank called Sanpaolo Imi in 2002. 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.

MPS then engaged in two more transactions with Deutsche Bank which had the effect of mitigating its Santorini loss. Each deal involved the Sienese bank pledging 2 billion euros of Italian bonds to its German counterpart in return for a same-sized loan. One of these transactions was with Santorini; the other with MPS itself. But there was a curious quirk: the interest rate on the Santorini leg was cheaper than the market rate, while that on the MPS leg was more expensive.

MPS rapidly unwound the first transaction, creating a gain that helped it counter the loss on the original Santorini deal. But it hung onto the second investment and didn’t report any immediate loss from that.

Last week, MPS’s new management said that the value of the investment had been incorrectly put into its balance sheet. It should have incurred a loss at the time of 429 million euros.

Deutsche Bank’s defence for being involved in the transaction is that it asked for and received representations from MPS’s senior management that its auditors and regulators had been informed of the transaction’s details. But the Bank of Italy itself says that when it examined the transaction in 2010, it was worried that the operation did not show fair value on MPS’s balance sheet.

What’s more, it would be revealing of the German bank’s then culture if it didn’t ask what possible motive MPS could have had for doing these deals. Deutsche says that its standards have evolved since 2008 and continue to do so in light of its own and the market’s experience. That, at least, suggests it is learning some lessons.

The same doesn’t seem to be so for Nomura. In this case, MPS’s original bet – nicknamed Alexandria – was on risky credit derivatives called CDO squareds which, by 2009, were threatened with big losses. That’s when MPS embarked on two new deals. One involved the Japanese investment bank buying the CDO squareds from MPS at above their market price, with the result that the Italian bank avoided booking a loss.

The other involved MPS pledging Italian government bonds with its Japanese counterpart in return for a loan. The oddity was that, while Nomura kept the fixed coupon on the bonds, it paid back to MPS an unusually low floating interest rate. At the time, MPS didn’t recognise any loss on this part of the transaction. But last week its new management said it should have booked a 309 million euro liability.

There was also a side-letter between Nomura and MPS linking the two new deals. But this wasn’t revealed to the BoI until last October, after the new management found it. The central bank says it was that letter which clarified the real purpose of the operation.

Nomura says the deal was approved by the Italian bank’s board and MPS’s auditors, KPMG – although MPS denies its board approved it and KPMG says it never received the Alexandria documentation.

What’s more, it would be sad if Nomura didn’t probe what possible purpose MPS could have had for all this financial engineering. The Japanese bank says it acted fairly and reasonably while a spokesman denied it had acted unethically.

This really won’t do. An important lesson of the MPS story is that, when banks are presented with a client who wants to do something that seems suspicious, they should probe its motives deeply. And if they don’t get a satisfactory answer, they should refuse to do business with it.


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