Risky Finance 13 May 2009

With its plume-helmeted soldiers and a ban on outsiders marrying elderly citizens for money, there is something of a comic opera quality about San Marino, the micro-state located on a hilltop near the Italian town of Rimini. Yet for Italian authorities, there is nothing comic about San Marino, whose website proudly talks up the principality’s banks as being beyond the reach of jealous Italian taxmen.

Last week, the Italian authorities struck back. Prosecutors in Bologna arrested the chairman, chief executive and other senior management of San Marino’s biggest bank, CRSM. Meanwhile, the Bank of Italy seized control of CRSM’s Bologna-based subsidiary Delta, which is one of Italy’s top dozen consumer finance companies.

While the Bank of Italy press release accompanying the seizure talks about flaws in San Marino’s money laundering controls, the ostensible reason for taking control of Delta was that CRSM had used hidden stakes to enjoy 100 percent ownership of Delta – which the Bank of Italy had expressly forbidden in the light of its money laundering concerns.

However, what the Bank of Italy release did not mention was how CRSM obtained financing for Delta’s €4.5 billion balance sheet, which grew sixfold between 2003 and 2007. An ongoing dispute in London’s High Court has shed light on how credit derivatives were used to achieve this, out of sight of the Italian and San Marino regulators, with about €700 million of the financing provided by Barclays Capital.

In 2003, CRSM was doing fine accumulating deposits within San Marino’s tax-friendly confines, but there were few places to invest this money on a tiny hilltop. Thriving Italian cities like Rimini and Bologna were in spitting distance, but CRSM was unable to lend the money out to Italian consumers via Delta, due to what it complained were ‘risk concentration limits prescribed by the Central Bank of San Marino’.

As recent events suggest, CRSM had good reasons for staying out of the Bank of Italy’s sights as well, which ruled out funding Delta via an Italian bank. So to avoid regulatory oversight, CRSM apparently came to London, looking for financing secured on the consumer loans that Delta would make. Unfortunately, investment banks like Barclays had no great interest in taking on Italian consumer lending risk, even if backed by segregated collateral.

However, for a price they were prepared to advance the required cash on condition that CRSM retained most of the credit risk, via a credit default swap (CDS), wrapped up in a structured note that CRSM invested in. Economically, this amounted to breaching regulatory credit concentration limits, but in a legal, off-balance sheet way. Regulators would see Barclays lending Delta money on the one hand, while CRSM bought a structured note on the other, without realising that the two were connected via the international bank’s credit derivative desk.

And the deal that the UK bank signed with CRSM in mid-2004 turned out to be even more complicated. As a condition for Barclays agreeing to provide €700 million to Delta, CRSM was required to invest €450 million a series of structured notes: €200 million of these notes were CDS protecting Barclays from a default by Delta, while the remaining €250 million was an investment in four separate Barclays synthetic CDO-squared transactions.

It was the CDO-squareds that would lead to the London courts. In its July 2008 claim, CRSM argues that they were ‘needlessly complex financing’, and were grossly mispriced when measured against fair value. After taking subsequent restructuring into account, CRSM estimates that Barclays made a risk-free profit at its expense of €75 million on the CDOs. It claims damages under UK law for ‘misrepresentation’.

While contesting most of CRSM’s allegations, Barclays concedes in its defence statement that made a smaller, but still substantial profit of €37 million on the €250 million of CDOs. Pointing out that CRSM had done a similar (albeit smaller and less complex) CDO-based financing with Deutsche Bank, Barclays maintains that CRSM should have understood what it was getting into. The UK bank is itself suing CRSM for breaking the terms of a waiver in which it promised not to sue Barclays.

The recent interventions by Italian authorities would seem to tilt the case heavily in Barclays’ favour. After all, having to explain to a High Court judge that the chief executive who signed CRSM’s claim is unable to appear as a witness because he is in Italian police custody might be a challenge even for the best London QC.

However, Barclays would be wrong to draw too much comfort from this turn of events. First of all, there is a question of conduct. Assuming that the Italian authorities’ evidence of wrongdoing is grave enough to justify the arrests, shouldn’t Barclays have known that there was something fishy about CRSM and Delta? Interestingly, Barclays’ defence statement, filed in January, makes the same charge that the Bank of Italy does in May: that CRSM was lying about the size of its stake in Delta.

Sources familiar with the situation dismiss any suggestion that Barclays employees were aware of any illegality, or that Barclays was even aware of the Bank of Italy’s investigations. Yet all the same, given the detailed discussions that it had with CRSM over the years, observers – including the FSA – might expect Barclays’ highly paid compliance staff to have done their homework more thoroughly.

Secondly, there is the question of suitability. Taking together CRSM’s claim and Barclays’ defence, one is reminded of the remarks by the FSA’s chairman Lord Turner about ‘rent extraction’ in structured credit and his quip that losing the formula for CDO-squareds would not harm human welfare. Aside from ‘extracting’ a minimum ‘rent’ of €37 million for Barclays (and possibly more), what was the point of the four CDO-squareds that it sold CRSM?

While Barclays spokesmen stick to the boilerplate language of the case being ‘without merit’, the bank’s High Court defence document does little to answer this question, at least for a non-legally trained observer. A charitable answer might be that CRSM was mad enough to buy such a product out of desperation to evade regulations, and was unknowingly abetted by Barclays.

And this leads to the ultimate question, whether the City of London is capable of coming up with socially useful financial innovation. A report on financial competitiveness commissioned by the Treasury and authored by ex-Citi banker (and now chairman of Lloyds Banking Group) Sir Win Bischoff recently tried to defend UK financial innovation and seemed to take a swipe at Lord Turner for daring to criticise it. But the CRSM case suggests that it is Turner who is making the most sense.

This article originally appeared on www.breakingviews.com.  If you wish to take out a free trial to breakingviews, click here.

Copyright © breakingviews 2009