How to rip off a bank, Espí­rito Santo style

How to rip off a bank, Espí­rito Santo style

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I have been going through Banco Espírito Santo's half-year 2014 results. They make pretty grim reading. No, actually it's worse than that. They read like an instruction manual on how to rip off a bank.

I can't work out if the BES management at the time was stupid, naïve, complacent or criminal. Probably all four. No matter – it has now been entirely replaced. Well, I say “no matter” - but actually such abysmal management DOES matter. Those responsible for audit, risk and compliance have been guilty of incompetence so gross it borders on the criminal. And the former CEO and vice-chairman, Ricardo Espírito Santo Salgardo – a member of the Espírito Santo family – has been arrested on suspicion of money laundering and tax evasion. But I suspect he has done more than that: he was also chairman of ESFG, which – as will become apparent shortly – systematically drained the bank and its other subsidiaries. If he didn't know what was going on, he was incompetent: if he did, then he was a party to corruption and, perhaps, fraud on a simply massive scale. Exactly how massive is not yet clear. But I think we are talking billions of Euros.

Here is the exposure of BES to other entities in the group:

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I've outlined in red the largest exposures of BES to other entities in the Espírito Santo Group. Each of those entities has failed, one way or another. And each exposure tells a story.

Exhibit 1: exposure to Rioforte

On July 28th, to enable Rioforte to meet payment obligations on commercial paper, BES lent it E190m in exchange for securities. The securities never arrived. But Rioforte was already known to be in trouble: there were rumours circulating three weeks before that it was on the verge of bankruptcy. How, in God's name, could any responsible bank management possibly have lent this money without demanding delivery of the securities up front? I mean, delivery versus payment is normal practice in the commercial world. Why on earth was it suspended for a distressed intra-group transaction?

But in fact BES had been lending to Rioforte against securities throughout this period – securities that Rioforte may now be unable to deliver. Exposure increased from E101m to E270m between December 2013 and July 2014. New provisions against this are E144m.

Exhibit 2: exposure to ESFG and subsidiaries

The subsidiaries to which BES has the largest exposure are Espírito Santo Financière and Espírito Santo Panama.

ES Panama hasn't actually “failed”, but only because of pre-emptive action by a very perceptive regulator. ES Panama was seized by the Panamanian regulator on 18th July – well in advance of any actual failures in the ES group - because of fears about illiquidity and insolvency. Its securities trading licence was revoked on 21st July. If only the Portuguese and Luxembourg regulators had acted so promptly....!

In fact the inaction of the European regulators beggars belief. Someone should have been paying attention to the build-up of intra-group leverage. The increase in exposure to Rioforte was bad enough, but that to ESFG and subsidiaries was far worse: in the second quarter of 2014 alone it rose from E416m to E927m, most of it unsecured. And In June, someone bypassed BES approval procedures to lend ESFG E120m without the knowledge of executive management, apparently. I wonder who that was.

ES Financière filed for creditor protection on 1st August, along with ES Financial Portugal. ESFG itself had already filed for creditor protection a few days before, along with its parents Rioforte and Espírito Santo International (ESI). The web of interconnections between these entities meant that when one failed, they all did. And BES was caught in the middle – not as the spider, but as the mother of all flies. When the web broke, everything rebounded to BES.

BES may even have been deliberately misled by ESFG. This paragraph is telling (my emphasis):

The increase in the direct exposure to ESFG in 2Q14 occurred, initially, through drawings on the credit granted within the scope of the existing commercial relations between these institutions, reaching EUR 533 million. From the beginning of May, following a resolution taken by the Related Parties Committee and ratified by the Board of Directors, it was decided and accepted by ESFG to reduce the non collateralised exposure to a maximum of EUR 400 million until June 30th, 2014 and that any new credits should be secured by collateral. In accordance with this new policy, new lending operations in the amount of EUR 200 million were approved. However, to this date the commitments undertaken by ESFG and its subsidiaries to reduce their non collateralised exposure and to collateralise their exposures to BES have not been fully met and may in part be undermined by ESFG having filed for creditors protection.

So BES continued to lend to ESFG on the understanding that the lending would be collateralised, but the collateral never appeared. Just like Rioforte's undelivered securities.

But there was an even bigger problem. BES had sold debt issued by ESI and Rioforte to its own retail customers through its branches. This debt was subject to a guarantee by ESFG, in return for which BES provided ESFG with a credit line. The credit line was collateralised with shares in ESFG's insurance arm Tranquilidade. (See , I told you this was complex....)

When ESFG filed for creditor protection, the credit line was cancelled. BES was left not only with unpaid debts from ESFG, but was also forced to bear the guarantee to its retail clients that ESFG was no longer able to honour. After all, Rioforte and ESI were in no position to provide guarantees: they were already bust too. And worse, it transpired that ESFG had dumped E150m of debt into Tranquilidade, destroying the value of the shares BES had relied on as collateral. BES is not the only subsidiary ESFG wrecked in order to prop itself up.

Provisioning against ESFG's unpaid debts and the retail guarantees has cost BES E823m. But it may not be enough. The extent of ESFG's losses, and those of Rioforte and ESI for which BES will have to compensate its retail customers, is not yet known.

Exhibit 3: ESCOM

Three years ago, Rioforte commenced proceedings to sell ESCOM to an Angolan company, Sonangol. Part way through the negotiations, the Angolan government got involved: the money for the purchase was to come from the Angolan sovereign wealth fund. Except that it hasn't. Angola has the company, but there is still a debt of E297 on BES's books representing the amount that Angola hasn't yet got round to paying. This is no way to do business. Rioforte would have done better to have kept the company and dug up the diamonds themselves.

But if you think this is all of BES's problems, you couldn't be more wrong. The worst is yet to come.

Exhibit 4: BES client exposure to ES Group debt

Here is a chart showing BES's exposure to debt securities from other parts of the ES Group that it has sold through its branches:

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But the Board has no idea how great the losses from this might actually be:

Considering that the Espírito Santo Group’s restructuring plan is not yet available, it is not possible to, as of the date of approval of the 1H14 accounts, determine with the necessary accuracy the non recoverable amounts of the subscribed debt.......

And then there is the little matter of two letters in favour of ESI clients apparently issued by BES without the knowledge or approval of management and not accounted for in the June 2014 accounts.

So the new provisions of E856m are a complete stab in the dark, and as the chart above shows, the possible losses could be far larger. BES's total exposure is over 3bn Euros.

That's the Group's debt. But then there is BES's. And at this point, I start to doubt Hanlon's Razor. Thus far, stupidity and complacency on the part of BES management could adequately explain its losses. But what comes next is hard to explain as anything but corruption.

Exhibit 5: BES debt securities and the mysterious SPEs

During 2014 BES Group issued bonds at a discount which are carried on the balance sheet at amortised cost. These bonds were purchased by retail clients through financial intermediaries and were packaged in several products, for an amount higher than the respective issuance value. Considering that these are long-term bonds and that the liquidity expectations raised may force the Group to repurchase them from the clients, the Board of Directors decided to adjust the value of these issues, recognising a EUR 767 million loss.

So, BES accounted for discount bonds on an amortised basis but actually sold them to retail investors at a higher price. This probably complies with accounting standards, just, but it's hardly prudent accounting. It understates the real value of BES's debt in issuance.

But it gets worse. FAR worse.

In July three Special Purpose Entities (SPEs) were identified whose assets mainly consisted of the aforementioned bonds issued by the [BES] Group. Taking into account the characteristics and purposes of these SPEs, it was concluded that they should be included in BES Group’s consolidated accounts....

The current members of the Board of Directors who were in office as of June 30th, 2014 were not aware of the transactions referred to above carried out through financial intermediaries, or of the creation and operation of the SPEs, nor of the existence of a fourth SPE whose assets’ value is estimated at around EUR 77 million. As of the date of approval of the 1H14 accounts there was no available information concerning this fourth SPE. With regard to these matters, the Board of Directors has decided to take the action set out in point 1.7 below.

It seems that far more BES debt had been issued than anyone knew about, and it had been taken off balance sheet into these “special purpose entities” with the explicit intention of hiding it – giving the impression that BES was far less leveraged than it actually was. Why so much debt was issued we can only surmise, but the new Board seems to be in no doubt as to the reason. Here's point 1.7:

The Board of Directors is committed to assessing all the facts that led to the need to create this additional set of provisions, and intends to take all measures within its reach to recover the maximum amount of the credits now provisioned and to ensure that the Bank is reimbursed for the losses caused as a result of any potential illegal behaviour that is identified, whether committed by individuals or entities, through the various means and methods to which it can resort for the purpose.

That's about as close to an allegation of fraud as you are ever likely to see in a company report.

The cost of taking the SPEs on to the balance sheet, revaluing the debt securities and provisioning against contingent exposures is an eyewatering E1.25bn. But even that may not be enough. The Board warns that if BES is forced to repurchase short-term debt securities due to loss of liquidity arising from this crisis, there could be up to another E505m of losses.

Exhibit 6: Other losses

I should point out that BES would have made a substantial loss anyway even if the Espírito Santo Group had not got itself into such a mess. The Angolan subsidiary BESA hit it with a sizeable loss on unrecoverable interest income, and BES was also forced to write down the value of its Libyan investments due to political risk there. BES also had to increase general provisions against a deteriorating loan portfolio. And of course there is also the question of that E3bn loan from BES to BESA, and the reliability of the Angolan government guarantees on BESA's lending. If that all unravels, then BES's losses would increase still more.

So BES's declared loss of E3.7 bn may not be the end of the matter. Potential losses could be as high as E10bn, though personally I think they are likely to be around E6bn.

And where does this leave BES? In a word, bust. This table shows the damage that has been done to its regulatory capital:

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The Portuguese regulator sets a minimum Common Equity Tier1 (CET1) capital requirement of 7% of risk weighted assets (RWAs). Despite the fall in RWAs, BES's CET1 capital now falls well below the minimum. BES's losses have wiped out HALF of shareholders' funds, and there may be further losses still to come. This is regulatory insolvency.

And this raises an interesting question. BES was recapitalised in May with a rights issue, which was fully subscribed. But the results show that Espírito Santo Group was already in deep trouble by then. And perhaps more importantly, the discovery of the SPEs shows that BES's own financial position was nowhere near as strong as it appeared. Did management know? If they did, then the shareholders may be able to sue for compensation. It does look as if they were deliberately misled. But it might be hard to prove: RBS's shareholders have tried twice to sue in American courts and lost both times.

It also raises another question. What to do with BES? It either has to be recapitalised, or it has to be wound up. The Bank of Portugal has indicated that it would prefer a private sector recapitalisation, but with the uncertainty over the extent of losses and the possibility of litigation, private sector investors are understandably nervous. Bailing in junior bondholders is virtually certain: bailing in senior bondholders as well is not impossible. And there is also the possibility that the Portuguese government will cough up some money. Personally, I hope it doesn't: as I've said before, this amounts to bailout of the parent conglomerate, and it legitimises the returns from fraud. But I fear I am doomed to disappointment. As I write, there are already rumours of sovereign bailout....

Fear of bank failure is now deeply entrenched. We have not fixed “too big to fail”. On the contrary, we are more terrified than ever of the consequences of bank failure.  BES will not be allowed to fail: it will be bailed out by the Portuguese sovereign, and the people of Portugal will suffer yet more austerity to pay for it. And the criminals who caused this disaster will walk away with the proceeds. It's an outrage.

Related reading:

Banco Espírito Santo: a Portuguese disaster, not a European crisis

Espírito Santo: complexity, opacity and moral hazard


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