The Monte dei Paschi di Siena saga is not just an Italian affair. Revelations that complex financial transactions used by the country's third largest bank had the effect of hiding losses are causing a political storm in Italy.
With a general election only weeks away, Silvio Berlusconi looks like the main winner from the political spat. The former prime minister's camp has attacked Pierluigi Bersani's Democratic Party, which is leading in the opinion polls, for being close to Monte dei Paschi (MPS). It has also criticised Mario Monti, the current prime minister, who agreed to increase MPS's bailout to €3.9-billion ($5.3-billion).
The scandal won't be enough to get Berlusconi back as prime minister. But it could prevent a Bersani-Monti coalition from running the country with a solid majority in both houses of parliament. If so, fears about Italian political risk could return to haunt the markets.
The still-murky saga has also put Mario Draghi under the spotlight because the ECB president ran the Bank of Italy when MPS was getting into such a mess. Giulio Tremonti, who was finance minister in Berlusconi's last government, tweeted that it was "stupefying" that Draghi had failed to discover or prevent the complex transactions.
The Italian central bank's defence is that, while some of its supervisors knew about the transactions, it did not know that they were linked to other loss-making operations because key documents were hidden from it. What's more, even though it was worried about MPS's weak risk management, it didn't have the power to fire bank directors, despite Draghi requesting the last Berlusconi government for such authority. Its moral suasion did, though, eventually help remove the old MPS management last year.
The Sienese bank's troubles began in November 2007 when it bought Antonveneta, another Italian bank, from Spain's Santander for €9-billion. This was a crazy price. The sub-prime crisis had already burst into the open and the price-tag was 60 per cent more than Santander had itself paid only a few months earlier when it helped carve up ABN Amro, the Dutch banking group, with the U.K.'s RBS and Belgium's Fortis. Italian prosecutors are now investigating why MPS paid so much.
Some people think the Bank of Italy should have stopped MPS buying Antonveneta. But its defence is that it didn't have the power to say a deal was over-priced. All it could do was insist on MPS raising more capital, which it did.
Even so, the Antonveneta deal left MPS with a weak balance sheet just as the financial crisis was about to go into overdrive. That's when two other investments – which have triggered the current turmoil – went bad: one nicknamed Santorini and the other called Alexandria.
The original Santorini deal was done with Deutsche Bank in 2002 to warehouse MPS's shares in yet another Italian bank, San Paolo di Torino. That transaction allowed MPS not to report losses on the stake provided it didn't fall below a certain level. However, in 2008, the value of the stake plummeted meaning that MPS was staring at a loss of about €360-million. That was unfortunate given that MPS's balance sheet was already stretched after the Antonveneta deal.
MPS engaged in two more transactions with Deutsche Bank which had the effect of mitigating its Santorini loss. One was structured so it was likely to generate a profit for MPS; the other so it was likely to generate a profit for the German bank. MPS rapidly unwound the first transaction, helping 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.
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.
The Alexandria transaction was somewhat similar. In this case, MPS's original bet was on risky credit derivatives called CDO squareds which, by 2009, were threatening it with a loss of about €220-million.
That's when MPS embarked on another series of side-deals – this time with Nomura. One transaction 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 was structured so Nomura would make a profit, but MPS didn't acknowledge the countervailing losses upfront.
Nomura says the deal was approved by the Italian bank's board and its then-chairman, Giuseppe Mussari, as well as being reviewed by MPS's auditors, KPMG. The Italian bank denies that its board approved it. KPMG says it never received the Alexandria documentation. Mussari denies any wrongdoing.
These complex transactions only came to light when an exchange of letters from Nomura to MPS was found in a hidden safe by the Italian bank's new management last October. It immediately told the Bank of Italy and the judicial authorities. Snippets of what happened have started to seep out into the press in the last two weeks – forcing MPS to acknowledge that it was sitting on mega-losses and triggering the political storm.
But the full facts have not come out. Until they do, it will be impossible to know for sure whether the Bank of Italy, Deutsche Bank and Nomura could have been more vigorous in pursuing hints that things weren't quite right or were well and truly hoodwinked by MPS.