Deutsche Bank's Monte Dei Paschi derivative shows why banks must disclose current exposure details

As Bloomberg reports, Deutsche Bank designed and sold a derivative to Monte dei Paschi so the large Italian bank could hide losses that it had already incurred.

The very fact that a bank could engage in a trade to hide its losses confirms the need for banks to provide ultra transparency.

By requiring banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, it eliminates the ability of banks to hide their losses.

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.”...

Which is why banks should not operate behind a veil of opacity, but rather should have their entire business exposed to the best disinfectant of bad behavior: sunlight.

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....

Under the FDR Framework, government regulators are given responsibility for ensuring transparency.

Had banks been required to disclose the details of these opaque products, they probably wouldn't have sold them and the buyers probably wouldn't have purchased them.

“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.”...

As your humble blogger has been saying since the beginning of the financial crisis, so long as banks are opaque "black boxes", bankers will engage in gambling.

Current disclosure rules for banks are not up to the task of preventing or exposing this gambling.  A point Professor Partnoy makes.

The only way to expose what is happening so that market participants have the information they need to assess each bank is to require ultra transparency and disclosure of each bank's exposure details.

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 only way to prevent this from recurring in the future is by restoring transparency to all the opaque corners of the financial system.  This includes bank balance sheets.

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....

Please re-read the previous paragraph because if shareholders aren't in a position to know about derivative bets, they aren't in a position to exert market discipline to prevent these bets in the first place.

“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.”

The only way to know what skeletons are in each bank's closet is to have them provide ultra transparency and disclose their current global exposure details.

ABC's Alan Kohler on casino banking: banks create risk and gamble on it

ABC's Alan Kohler makes the case for requiring banks to provide transparency when he talks about casino banking and how banks create risk that they subsequently gamble on.

Almost all financial derivatives trading adds nothing but risk to the world and should be banned. It won't be, but that doesn't mean the debate is academic. 

Regulators are attempting to bring derivatives into the light through mandatory exchange execution and clearing and "Legal Entity Identification" rules, but progress is slow and fragile. It can be filed under "B" for believe it when we see it.

Please note that derivatives could easily be brought into the light if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Disclosing their exposure details would disclose their derivative positions.

But is there any reason to allow financial derivatives at all? 

New York hedge fund manager James Rickards says they should simply be banned because the benefits are illusory and the effect is that risk is created out of thin air and then multiplied....

Most derivatives trading involves swaps or contracts for difference, where two people bet on movements in an underlying asset or income flow without actually trading in it. It's a bit like betting on flies crawling up a wall, without having to buy the flies.... 

Credit default swaps are bets on whether a country or company will go broke; interest rates swaps are bets on movements in interest rates; contracts for difference are bets on movements in a share price or other asset; and so on....

In fact, derivatives caused the 2008 global financial crisis because banks and investment banks vastly multiplied the leverage on their balance sheets by betting through derivatives and then losing control. 

I wouldn't say that derivatives caused the 2008 global financial crisis.  Derivatives clearly contributed to the magnitude of the crisis.

Since then, the amount of derivatives outstanding has actually grown, and now stands at more than $700 trillion....

Requiring the banks to disclose their derivative positions would have an immediate impact on restraining growth in the amount of derivatives outstanding and would give banks an incentive to shrink their derivative exposures.

Disclosure of their derivative books means that banks are subject to having their cost of funds linked to the risk they are taking.  The more risk in their derivative book, the higher their cost of funds.

This form of market discipline restrains growth in derivative exposures and provides an incentive to reduce the risk of the derivative exposures.

Nevertheless, regulators are grinding their way through consultation and report production with a view to eventually dragging OTC derivatives trading into the open, where the players at least have to say who they are.

The US Dodd-Frank legislation, passed in 2010, requires non-US banks to register as swap dealers with US regulators from next year if they want to trade derivatives there. 

Guess what? Reuters reported last week that Asian banks are cutting their relationships with US banks so they don't have to register, and US banks themselves are restructuring so they can keep going. 

Proving that complex rules and regulatory oversight are not a substitute for transparency and market discipline.

Let's be clear: basically, we're talking about a casino where the gamblers are banks. And banks aren't just any old punters: they also take deposits and lend money, underpinning the financial system on which society rests. 

As with all casinos, someone always loses their shirt occasionally - LTCM in 1998 (US$4.6 billion), UBS in 2011 ($2 billion), AIG 2008 ($18 billion), Barings in 1995 ($1.2 billion), Societe Generale in 2008 ($7.2 billion), and so on. 

The losses of shirts don't always cause a general financial crisis, but there's always a wobble, and in 2008, the combination of AIG, Merrill Lynch and Lehman Brothers and a few others did cause a global recession and is still causing widespread misery....

The only way to restrain bankers' desire to gamble is by requiring they disclose their exposure details.

As Jamie Dimon and JP Morgan showed with the London Whale trade, if banks are forced to disclose their positions, fear of the market trading against them will cause them to exit the position as soon as possible.

Surprise! Derivatives involved in Monte Paschi's ill-fated acquisition

In an attempt to escape blame for not taking prompt action on the Monte Paschi derivatives it knew about, the Bank of Italy is trying to change the topic by saying they were lied to about a derivative involved in Monte Paschi's ill-fated acquisition.

This latest disclosure reaffirms why all banks must be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Had this been the case, the counter-parties for the acquisition derivative would have noticed the Monte Paschi had not disclosed the derivative and would have alerted everyone to the omission.

Why?

Because the counter-parties want the derivative disclosed so they can get the benefit of the derivative.

As reported by Reuters,

Monte dei Paschi misled the Bank of Italy over a 1-billion euro hybrid instrument it used to partly fund its acquisition of rival bank Antonveneta, Siena prosecutors alleged in a document reviewed by Reuters on Wednesday. 

As part of their ongoing probe, prosecutors alleged in the document, dated February 1, that the Tuscan bank struck a deal which violated requirements set by the central bank over the hybrid financial instrument, known as FRESH 2008. 

Monte dei Paschi is being investigated for alleged wrongdoing relating to its 2008 acquisition of Antonveneta, a smaller rival. If proved correct, the allegations by prosecutors that Monte dei Paschi misled the Bank of Italy over the true nature of part of the financing it raised would undermine the basis on which the deal was approved....

Prosecutors alleged that the indemnity documents violated requirements set by the Bank of Italy by making the FRESH 2008 work like a bond rather than an hybrid equity instrument. Monte dei Paschi needed to show the Bank of Italy that it had sufficient equity capital in place to win approval for Antonveneta takeover. 

Based on the information officially received from the bank, the regulator allowed Monte dei Paschi to calculate those notes as core Tier 1 capital, a measure of a bank's financial strength which is closely monitored by regulators, boosting its financial base and allowing it to demonstrate it had sufficient capital to absorb the Antonveneta deal.

At best, this seems to confirm that Tier 1 capital is doesn't say much about a bank's financial strength.  At worse, this seems to confirm that Tier 1 capital is meaningless.

Italian bank involved in derivatives scandal seeks outside investor

Reuters reports that the Italian bank involved in the derivatives scandal is looking for an outside investor.

One might ask the question of could someone invest in that bank.  After all, the definition of investing involves being able to complete three steps:

• Independently assess the risk and value the investment.  To do this, the investor needs access to all the useful, relevant information in an appropriate, timely manner.
• Compare the independent valuation to the price being shown by Wall Street.
• Make a buy, hold or sell decision based on the difference between the independent valuation and the price shown by Wall Street.

In the case of the Italian bank, no investor can complete the first step because the bank does not disclose all of its global asset, liability and off-balance sheet exposure details.

In fact, it took the bank several days to disclose the existence of $1 billion in losses on three derivative contracts.

Who knows what else is lurking on or off the bank's balance sheet.

This is not to say that someone might not be willing to place a bet on the contents of the 'black box' that is the Italian bank.  This is a gamble and not an investment.

The Italian bank highlights the simple fact that all banks are 'black boxes' and that it is impossible to invest in them.  One might gamble, but that is it.  The only way this will change is when banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Monte dei Paschi di Siena said on Sunday it was seeking a financial investor as the political storm over a derivatives scandal at the ailing bank intensified ahead of next month's Italian election. 

Italy's third-biggest lender, which needs state loans to stay afloat, this week revealed opaque derivatives trades, conducted between 2006 and 2009, that could cost it some 720 million euros. 

The scandal has turned the spotlight on Monte Paschi's close political ties with the centre left and on possible oversight failings by the Bank of Italy (BOI), then led by current European Central Bank chief Mario Draghi. 

"I would like to have a long-term financial investor," Monte Paschi Chairman Alessandro Profumo told Italian business daily Il Sole 24 Ore on Sunday. "Nationality is not a problem. The important thing is that it believes in our project"....

In fact, placing a bet on the Italian bank is entirely a question of belief as there are no facts available on which to make an informed decision.

Corriere della Sera daily on Sunday published excerpts from the minutes of Monte Paschi meetings in 2011 showing several board members expressing concern about the bank's portfolio, overladen with long-term Italian government bonds. 

"The situation is no longer sustainable, we must take steps to reduce these positions," said former vice chairman Francesco Caltagirone in September 2011 as Italian government bond yields soared during the apex of the euro zone debt crisis.... 

Monte Paschi's new management have said the main loss-making derivatives it uncovered involved Japanese bank Nomura and Deutsche Bank.