By Elisa Martinuzzi & Vernon Silver
Deutsche Bank has ranked among the top three underwriters of international bonds, excluding self-led deals, since at least 2002 and is first this year.
Deals totaling 2.5 billion euros ($3.3 billion) involving Italy’sBanca Monte dei Paschi di Siena SpA and Banco do Brasil SAreveal a technique that obscured Deutsche Bank’s lending reach when it sent cash to the banks, the documents show.
The company had talks about a similar loan to Dexia SA (DEXB) weeks before that firm was rescued, according to the documents, and it used the same accounting for other deals through 2011, two of the people with knowledge of the transactions said.
“We should be very concerned about the opacity and complexity of these transactions,” said Joshua Rosner, an analyst at research firm Graham Fisher & Co. in New York who warned in early 2007 that securities linked to subprime loans posed risks to the economy.
The loans are among 395.5 billion euros in assets that Deutsche Bank excludes from its balance sheet by offsetting them with equivalent liabilities, according to a person with direct knowledge of the practice. Deutsche Bank disclosed the amount for the first time in April under new international financial reporting standards. The total represents 19 percent of the company’s reported assets of 2.03 trillion euros.
Kathryn Hanes, a spokeswoman for Deutsche Bank, said the Frankfurt-based lender follows accounting rules “meticulously, conservatively and taking into account their intended spirit” and started reporting “these positions on a gross basis for even greater transparency.” She said the amount of any offset loans is “immaterial to our balance sheet and key ratios.”
Thomas Blees, a spokesman in Berlin for KPMG, which has audited the lender since 1990, declined to comment.
Deutsche Bank’s accounting for the loans, described in documents for some deals as “enhanced” repos, reduces reported lending as co-Chief Executive Officers Anshu Jain and Juergen Fitschen seek to convince investors the company has enough capital compared with assets to cushion against losses.
The bank profited from arranging side trades around the loans, including selling credit-default protection on government bonds later battered by Europe’s sovereign-debt crisis, according to documents describing the Monte Paschi and Banco do Brasil deals and three people with knowledge of the transactions who asked not to be identified because the loans are private.
The loan documents and other published information don’t show how the lender’s bets fared or whether regulators were aware of the accounting.
“They’re running a market risk,” said Theodore Krintas, managing director of Athens-based Attica Wealth Management, which oversees 100 million euros, including Deutsche Bank stock. “From an investor point of view, I’d like very much to know.”
Documents about the Monte Paschi and Banco do Brasil loans describing completed deals show they were structured to allow for the offsetting, or netting, of assets against liabilities. Deutsche Bank sought to use similar accounting for a 2009 loan to Verona, Italy-based Banco Popolare SC (BP), which like Monte Paschi was later bailed out, according to an internal Deutsche Bank e-mail and a person with knowledge of the deal.
Deutsche Bank also had long-term repo deals with three other lenders — National Bank of Greece SA (ETE), Athens-based Hellenic Postbank SA (TT) and Qatar’s Al Khaliji — according to four people with direct knowledge of the financings. The transactions involved netting, according to one of the people, who was briefed on how Deutsche Bank accounted for them. No documents about the three loans were made available to Bloomberg News.
By the third quarter of 2009, the amount of netting was expanding at a pace that led at least two senior executives to express concern that the bank’s assets would increase if they could no longer offset the loans, the person said.
Deutsche Bank’s Hanes said in a written response to questions about all six deals that “the information is inaccurate” and “includes references to purported transactions that never occurred, and in respect of companies for which we have never structured enhanced repurchase transactions.”
She wouldn’t specify what information might be in error or dispute specific deals.
“We do not comment on client transactions,” Hanes said.
Every billion euros Deutsche Bank kept off its balance sheet inflated measures of its financial health, including capital ratios, which otherwise might have compelled it to raise more money from investors, according to Thomas Selling, an emeritus accounting professor at the Thunderbird School of Global Management in Glendale, Arizona, and a former academic fellow at the U.S. Securities and Exchange Commission.
“Investors are relying on the financial statements for an unbiased view of the risk of the bank, and that view has been skewed,” said Selling, one of three accountants who examined deal documents at the request of Bloomberg News. “It makes their balance sheet look less risky than it really is.”
Deutsche Bank ranks last among global banks by at least one risk measure — the proportion of tangible capital to total assets, known as the leverage ratio — according to data as of Dec. 31 compiled by Thomas Hoenig, vice chairman of the U.S. Federal Deposit Insurance Corp., which handles bank failures and sets capital levels along with other bank regulators.
Kian Abouhossein, a JPMorgan Chase & Co. analyst in London, estimated in a July 4 note to clients that Deutsche Bank may face a capital shortfall of 12.3 billion euros under a proposal by the Basel Committee on Banking Supervision to include assets that are off banks’ books in leverage calculations.
Hanes said the company is “among the best-capitalized banks in the world in our global peer group” after improvements in its capital ratio and the sale of stock and subordinated debt this year. Chief Financial Officer Stefan Krause said in an interview with Boersen-Zeitung published July 6 that the firm would reduce its balance sheet and set aside profit as regulators implement stricter leverage rules.
Deutsche Bank has ranked among the top three underwriters of international bonds, excluding self-led deals, since at least 2002 and is first this year, data compiled by Bloomberg show. It also improved its standing among loan arrangers to third place this year in Europe, Middle Eastand Africa, up from eighth in 2008, the data show.
Deutsche Bank relied on what it called “no-balance-sheet usage” to keep loans off its books, documents for the Monte Paschi and Banco do Brasil deals show.
In a typical secured borrowing, a bank lends cash it already has, recording the outlay as an asset on its balance sheet. In exchange, it gets collateral that it holds until the loan is repaid.
In the no-balance-sheet transactions, Deutsche Bank received the collateral, sold it and used the cash to make the loan. By selling the collateral — government bonds, in the deals reviewed by Bloomberg News — Deutsche Bank created an obligation to return the securities, allowing it to net to essentially zero its assets and liabilities, the documents show.
The lender in effect created a short position on the bonds, according to deal memos and internal e-mails about the transactions. In a short sale, traders sell borrowed securities and expect to buy them back at a lower price before returning them to the owner.
Deutsche Bank was able to sell the collateral because it didn’t have to return the bonds under the terms of the agreement. Instead, the borrower agreed that Deutsche Bank could return the “cheapest-to-deliver” equivalent in the event of default, the documents show.
The German lender sold insurance against possible defaults of securities linked to the collateral, in effect moving the risk that the loan wouldn’t be repaid onto its trading book and away from public scrutiny, according to accountants who reviewed the documents for Bloomberg News.
Deutsche Bank is shielded from the deterioration of a government’s creditworthiness because its client would have to post additional collateral. It was on the hook if the country defaulted on its bonds, the accountants said.
“It goes against the spirit of any regulation,” said Arturo Bris, a finance professor at the IMD business school in Lausanne, Switzerland, who examined the Deutsche Bank documents. “Risks, like energy, get transformed but don’t disappear.”
The deals resembled repurchase agreements, or repos, in which a borrower sells securities to a lender, promising to buy them back at a future date at an agreed-upon price. Unlike typical repos, which are reported as loans and mature in as short a period as hours, the Deutsche Bank trades lasted five years or longer and weren’t recorded as assets, documents show.
To keep loans off the balance sheet, Deutsche Bank executives invoked International Financial Reporting Standards rule IAS 32, which requires certain financial instruments to cancel each other if obligations are settled simultaneously or net throughout the life of the deal, the documents show.
“Reporting on a net basis is an obligation, not an optional accounting treatment,” Deutsche Bank’s Hanes said.
By agreeing to accept the cheapest asset in the event of default, Monte Paschi and Banco do Brasil effectively insured the bonds they gave Deutsche Bank as collateral. They paid interest on the borrowed cash and kept earning the coupons on the bonds, which they accounted for as still owning because they were, in effect, due to receive them back, the documents show.
Deutsche Bank in turn earned a premium by acting as a broker on the default insurance by selling credit-default protection to investors, allowing the bank to record a profit at the outset. It reaped about 60 million euros that way at the start of the Monte Paschi deal, profit that was booked by the bank’s rates unit, the documents show.
The deal is described in internal Deutsche Bank memos as a “structured term” repo. In public filings, Monte Paschi labels the financing both as a long-term repo and as “total return swaps” in which the Italian lender receives cash for bonds.
Investors wouldn’t have known the netted-out deals existed because Deutsche Bank’s regulatory filings describe accounting practices that indicate it probably was showing the full loan amounts, two accountants who reviewed the deals said.
Since 2010, the company’s annual reports have included repos among the types of transactions it says it normally records in gross amounts, rather than net.
“Repurchase and reverse repurchase agreements are also presented gross, as they also do not settle net in the ordinary course of business,” Deutsche Bank said in the filings.
Still, the company continued to use netting to account for new long-term repos through at least 2011, according to two people with knowledge of the treatment. The pace of loans slowed as the European Central Bank stepped in with its own crisis lending, one person said.
“They cleverly found a way to exploit the law and followed the rules to the letter,” said Barry Epstein, a principal of forensic accounting and litigation consulting at Chicago-based Cendrowski Corporate Advisors, who reviewed deal documents.
The transactions were designed by the company’s investment bank, whose co-head at the time, Jain, helped build the lender into one of the world’s biggest securities firms. Jain, 50, was appointed co-CEO of Deutsche Bank last year.
The bank’s 2 billion-euro loan to Monte Paschi in 2008, first disclosed by Bloomberg News in January, is being investigated by Siena prosecutors because the Italian firm used the transaction to hide losses.
Deutsche Bank hasn’t been accused of wrongdoing in the matter. The deal “was subject to our rigorous internal approval processes and also received the requisite approvals of the client,” the firm has said. Jain declined to comment about the loans to banks.
The documents outlining Deutsche Bank’s design and bookkeeping of loans to Monte Paschi and Banco do Brasil provide a glimpse of the other side of such transactions and reveal their deployment beyond Italy.
When credit markets seized up in 2008, executives at Deutsche Bank’s global rates group in London, led at the time by Michele Faissola, along with bankers at other units, worked on long-term repo deals to help quench financial firms’ thirst for cash. Faissola, now the company’s global head of asset and wealth management, declined to comment.
The deals discussed in documents and cited by people with knowledge of the transactions involved some of the world’s most-troubled banks and economies at a perilous moment. They included the 2009 loan of 200 million euros to Banco Popolare, which like Monte Paschi took state aid from Italy.
Deutsche Bank executives approved a similar transaction with Dexia, the Franco-Belgian lender that was later bailed out, documents show. In a four-page memo that concludes with the words “Approved 8 August 2008,” the bank’s Accounting Technical Forum described the cash outlay as a loan.
“DB in effect has a financing transaction and books a loan to reflect this,” the accounting group said.
A one-page annex explained that Deutsche Bank would offset the loan with its obligation to return the value of the bonds to Brussels-based Dexia.
“No such trade was executed between Deutsche Bank and Dexia,” Hanes said.
Still, the planned financing provided a blueprint bankers proposed using for future deals, the documents show. A February 2009 memo from the accounting group explained that approval for an enhanced repo with Banco do Brasil was restricted because of a “limitation of Euro 5bn on the repo netting determined under the initial Dexia trade approval from 2008.”
Banco do Brasil, controlled by the Brazilian government, participated in a five-year deal with Deutsche Bank in 2009, in which it borrowed about $500 million, according to two people with knowledge of the financing.
Al Khaliji borrowed $42 million from Deutsche Bank in 2009 in a long-term repo backed by Qatari government bonds, according to an executive at the Doha-based lender who asked not to be named in line with company policy.
In Greece, which sparked Europe’s debt crisis by revealing in October 2009 that its budget deficit was more than double previous estimates, Hellenic Postbank borrowed at least 100 million euros from Deutsche Bank, according to two people with knowledge of the deal. National Bank of Greece, the country’s biggest lender, received 220 million euros, one person said.
“We cannot give any disclosure or information on that deal because it was a bilateral transaction between banks,” said Petros Christodoulou, deputy CEO of National Bank of Greece.
Harris Siganos, CEO of state-controlled Hellenic Postbank, declined to comment, as did spokesmen for Banco Popolare, Brasilia-based Banco do Brasil and Dexia.
The documents reviewed by Bloomberg don’t indicate whether regulators in Germany or elsewhere knew about the deals. Sven Gebauer, a spokesman for German financial watchdog Bafin, said confidentiality prohibits the regulator from commenting on specific companies or transactions.
Ute Bremers, a spokeswoman for Frankfurt-based Bundesbank, Germany’s central bank, declined to comment, as did John Nester at the SEC in Washington. A spokesman for the London-based International Accounting Standards Board, which sets rules, said the group doesn’t comment on how they are applied.
“The figures should be disclosed,” said Edgar Loew, an honorary professor at WHU-Otto Beisheim School of Management in Vallendar, Germany, who examined the Deutsche Bank documents for Bloomberg News. “This type of accounting was not intended by the rules.”
Loew, who previously held positions at KPMG and Deutsche Bank, said he wasn’t involved in preparing the bank’s public filings that would have addressed such deals.
By the end of 2009, the European debt crisis had set in, pummeling the bonds underlying some of the agreements and eroding the capital of banks, including Monte Paschi, which used a cash-for-bonds repurchase agreement with Deutsche Bank to conceal about 429 million euros of losses.
Siena prosecutors are scrutinizing the deal, dubbed Project Santorini, as part of probes into fraud, false bookkeeping and obstruction of regulatory supervision at the world’s oldest bank, court papers show. The Italian lender restated accounts and, as of March 31, had to post 939.1 million euros of margin, or guarantees on the Deutsche Bank transaction, which includes an interest-rate swap, Monte Paschi said on April 24.
By this year, even the off-balance-sheet lending couldn’t spare Deutsche Bank from the need to raise more money. It sold almost $3.9 billion of shares in April and about $1.5 billion of subordinated debt in anticipation of stricter capital rules.
Shareholders can be certain of a lender’s health only if they understand the activities a bank engages in, said Christopher Wheeler, an analyst at Mediobanca SpA in London.
“There’s been a lot of noise around the tools used by the bank to boost capital and reduce leverage since the crisis,” Wheeler said. “If this particular kind of mechanism were found to have been used, there would be grave concerns about whether its current capital and leverage ratios are a true reflection of the bank’s financial position.”