The Latest Deutsche Bank Scandal Reeks On Enron: 103 “Enhanced Repo” Deals To Make Loans “Disappear”

deutsche bank

The Latest Deutsche Bank Scandal Reeks On Enron: 103 “Enhanced Repo” Deals To Make Loans “Disappear”:

Nearly four years after it was first revealed that Deutsche Bank had engaged in various shady deals at the height of the financial crisis designed to mask Monte Paschi’s financial woes, on October 1 Italy finally charged the German lender and 6 of its current and former managers, including the infamous Michele Faissola (much more on him soon), Michele Foresti and Ivor Dunbar, for colluding to falsify the accounts of Italy’s third-biggest bank, Monte Paschi, and manipulate the market. Two former executives at Nomura Holdings Inc. and five at Banca Monte dei Paschi di Siena were also charged.

As Bloomberg reported, prosecutors have been reconstructing how Monte Paschi’s former managers misrepresented the lender’s finances in the years through the two deals signed with Deutsche Bank in 2008 and Nomura in 2009.  The investigation revealed Monte Paschi arranged the transactions to hide billions in losses that led to false accounting between 2008 and 2012, according to a prosecutors’ statement released Jan. 14, when they completed the investigation.

To be sure, Deutsche Bank’s intimate relationship with Monte Paschi is not new, and had been public knowledge ever since it first emerged in January 2013 that the German bank, as part of its long-standing relationship with the just as scandalous insolvent Italian bank, had used a complex transaction, dubbed Santorini, to mask losses from an earlier derivative contract. The world’s oldest bank restated its accounts and has since been forced to tap investors to replenish capital amid a slump in its shares. It’s now attempting to convince investors to buy billions of bad loans before a fresh stock sale.

However, in a new development in the neverending saga chronicling Deutsche Bank’s illicit activities, earlier today Bloomberg reported that Deutsche Bank, indicted for colluding with Monte dei Paschi to conceal the Italian lender’s losses, “mismarked the transaction and dozens of others on its own books, according to an audit commissioned by Germany’s regulator.

In total, Deutsche Bankers arranged 103 similar deals with a total value of 10.5 billion euros ($11.8 billion) for 30 clients, according to the audit, Bloomberg writes citing the audit. In an attempt to “clean up balance sheets”, the Frankfurt-based lender, Germany’s largest, adjusted the accounting of 37 of those trades in 2013, in addition to Monte Paschi’s, changing them from loans that had been kept off the books to derivatives.

According to Bloomberg, “the widespread use of a transaction that’s now the subject of a criminal case highlights the lender’s appetite for complexity at a time when the bank was expanding its fixed-income empire. While Deutsche Bank has since cut risky assets and eliminated thousands of jobs to bolster capital, mounting legal costs have become a source of increasing concern to investors, driving shares to a record low.” The chronic recidivism may also explain the DOJ’s surprising high-ball ask in the ongoing RMBS settlement negotiation, which at $14 billion was about two times greater than DB’s litigation reserves.

According to the German audit, while Monte Paschi was the only client that used a transaction to “window dress” its books, Deutsche Bank didn’t correctly account for similar deals with banks from Italy to Indonesia made between 2008 and 2010. The report also said senior executives didn’t properly authorize the Monte Paschi trade, dubbed Santorini, or more importantly, adequately review the transaction after receiving a subpoena from the U.S. Federal Reserve in 2012.

In a flashback to Lehman Brother’s infamous “Repo 105” designed to make the Lehman balance sheet appear healthier than it was for quarter end purposes, often times by tens of billions of dollars, the deals structued by Deutsche Bank were known internally as “enhanced repos”, which had two components.

On one hand, the enhanced repos allowed clients to avoid using mark-to-market accounting, which would have forced them to immediately recognize changes in value, according to the audit. Instead, the deals were structured to be eligible for accrual accounting, allowing counterparties to book gains or losses as they occurred over a longer period of time.

On the other, the repos kept the loans off Deutsche Bank’s balance sheet by canceling them out with separate liabilities created in the transactions, according to deal documents reviewed by Bloomberg. Effectively, this mean that Deutsche Bank investors were unaware of the implicit risks carried on the bank’s books courtesy of off balance sheet transactions.

Deutsche Bank sold collateral the borrower had provided, such as government bonds, creating a new obligation for the bank to eventually return the bonds. In the original accounting, the loan was offset by that obligation, making it essentially disappear. A smaller balance sheet would make Deutsche Bank look healthier by boosting its capital ratios. Changing the repos to derivatives meant that the bank’s assets more accurately reflected the size of the deals.

It also brings up fond memories of Enron’s own Special Purpose Vehicle “accounting practices.”

Cited by Bloomberg, Mint’s Bill Blain said that “this is the kind of thing that banks used to do – complex investment banking where the more complex, the higher the fees. The world has changed. Successful banks are the ones that have adapted – at Deutsche Bank, we’ve seen very little buy-in.”

But perhaps what is more interesting is how the review of the transactions led to no consequences for DB: the audit said that Fed scrutiny of Deutsche Bank’s Monte Paschi deal in late 2011 led to a subpoena a few months later. Bafin expressed concerns to Deutsche Bank about “balance-sheet cosmetics” soon afterward. It appears that both concerns subsequently faded or were swept under the rug even though the review said that Deutsche Bank’s “risk management regarding the MPS/Santorini transaction as a complex structured financing transaction was materially inappropriate and ineffective,” given the reputational risks involved, according to the review. In retrospect, considering DB’s reputation as of this moment, the conclusion was spot on.

As expected, the bank itself found nothing wrong with the deals:

“Deutsche Bank reclassified how it accounted for a number of so-called enhanced repo transactions in September 2013, which had no impact on Deutsche Bank’s reported profit,” Adrian Cox, a London-based spokesman for the lender, said in an e-mail. “The fact that these transactions were enhanced repos does not justify inferring a connection between them and the particular case of Monte Paschi.”

And indeed, from DB’s standpoint nothing wrong happened: the bank was paid handsomely for the “complex services” it had provided – a consenting deal between two sophisticated financial entities –  and as Bill Blain correctly summarized, “this is the kind of thing that banks used to do – complex investment banking where the more complex, the higher the fees.”

Indeed, and as long as the market was rising and risks remained hidden, DB’s clients did not mind either, and in fact were quite delighted. However, once the bottom fell out, and such DB clients as Monte Paschi imploded, what until then was a welcome ruse to fool investors that the bank was healthier than it looked, immediately became fair game for seeking monetary damages, and perhaps criminal charges. DB learned that the hard way this weekend.

But while both DB and its clients can be excused for engaging in such a transaction, it was the regulators’ job to make sure such procyclical deals did not take place. And in the particular case they were criminally absent; in fact some may ask if it was Mario Draghi’s prerogative, formerly the head of the Bank of Italy when these deals were being arranged, to keep the “enhanced repos” brried as long as possible.

To be sure, it would all unwind in due course: in the July stress tests, the European Central Bank – which previously sternly ignored the DB deals – found Monte Paschi to be the weakest capitalized euro-region lender. The Siena-based bank, the world’s oldest, is now seeking to sell bad loans and raise fresh capital after tapping investors twice before. The bank, whose shares have lost 99 percent of their value since 2008, restated its accounts to change a repo to a derivative on a similar deal with Nomura Holdings Inc. in 2015. The Deutsche Bank trade was settled in December 2013.

Deutsche Bank in February said Bafin completed inquiries into multiple cases including Monte Paschi, pointing to changes already implemented and further measures it planned to take. An overhaul of the management board and the departure of some senior executives contributed to the regulator’s assessment that the company’s remedial actions were sufficient, a person with knowledge of the matter said at the time.

In short, everyone knew what was going on, and everyone kept their mouth shut. Just like in the case of Lehman’s infamous Repo 105, a financial instrument which successfully masked the bank’s woeful finances until it ultimately imploded, very much the same was as Monte Paschi has not once but three times.

As for Deutsche Bank and its other 102 such deals, we eagerly look forward to the discovery phase, and especially what a certain Michele Faissola, the architect behind all these deals, will say.

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We conclude with an excerpt from today’s letter by the above-quoted Bill Blain, who writes the following:

I am shocked, shocked, absolutely shocked, to read on Bloomberg this morning that Deutsche Bank has been indicted for colluding with Monte di Busti for concealing losses, mismarking books and the rest. And guess what? Germany’s premier bank has been doing much the same for a raft of other clients – arranging over 100 deals for 30 clients that allowed them to pass off loans as derivatives. In view of the questions around DB’s own derivatives book.. nope I won’t go there.

Are we surprised? Frankly we are not.

Those who wish to learn more about the underlying accounting can read the following 2013 article: “The Deutsche Bank, Monte Paschi Cover-Up: Tier 1 Capital and an Equity Swap

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