How shady actually was the Santander-Goldman deal?

With Matt Levine I share the fascination for the deal that featured in last week’s This American Life and in Propublica. I also wonder why actually this deal would be shady, as the Propublica story wants us to believe. Though Matt does a fair amount of explaining, the deal involves a simple transaction, recorded by two one journal entry. It is a very basic deal, once you figure out how it works.

Below is a graph that illustrates Matt’s story. These are T-accounts that represent simplified balance sheets – with fictional amounts. The upper set of accounts shows the holding that Santander has in its Brazilian Subsidiary: the long red dumbbell. That holding is funded by Qatar holding, the short red dumbbell.

Santander and GS


During the EBA recapitalisation exercise, many EU banks tried to get rid of hybrid capital, either through buybacks (on which I wrote), or through other creative solutions. For the deal at hand, Santander eliminated the hybrids by selling shares to Goldman.

Santander probably recorded these two journal entries:

  1. D: Cash 10
    • CR: Equity Santander Brazil 10
  2. D: Hybrid Capital 10
    • CR: Cash 10

The cash inflow in (1) cancels the cash outflow in (2). Therefore, the following journal entry is really the same:

  1. D: Hybrid Capital 10
    • CR: Equity Santander Brazil 10

Voilá: The second set of T-accounts shows the end-result: Santander eliminated the hybrids + a slice of Santander Brazil. In fact, the second row of T-accounts shows that Santander (the holding company) has become irrelevant. The new deal is one only between Goldman and Qatar.

It this shady? Probably not. The legal texts in force at the time are:

  • Article 60 of CRD II: the Spanish regulator may have chosen to deduct holdings in subsidiaries, such as the one in Santander Brazil from Santander’s Group regulatory capital. But I doubt it, given the size of the Santander stake. If that would be deducted, then Santander Spain would have kept a minimal majority stake instead of a stake of 83.6 percent, as this Bloomberg story shows. In addition, at the group level, Article 60 is probably irrelevant as intra-group holdings become invisible though the process of accounting consolidation.
  • The EBA’s hybrid guidelines. The guidelines assert that the issuer of the capital hybrids should have the flexibility to convert at any time, which Santander has. The guidelines also show that the Santander hybrids are probably high quality regulatory capital, almost as good as common shares.
  • More interesting is this one: The transaction makes Goldman (and later, Qatar) a minority shareholder in the Santanter group. The annual report of Santander 2012 confirms this: “Minority interests (placement of shares in Brazil, Mexico and Chile)” went up by a whopping 3.227bn euros (from 6.445bn Euros).
    The accounting for such minority interests is odd, as they are actually debt. However, accounting rules assume it is equity. Bank solvency rules assume it is bank capital,* though limits and conditions may apply, see for example, Article 65 of CRD II. If Santander Group structured the deal in such a way that it would respect these limits and conditions, then fine.

With these rules in mind, and probably little to worry about, Santander eliminated near-equity hybrid capital and converted it into equity capital in a fairly simple transaction, saved by the accounting and regulatory treatment for minority interests.

Or … is it? I actually miss some information that may be important. Suppose the hybrids traded way below par value, say at 5 cents per euro. That creates a 95 cent gain that Santander could add to capital without executing a transaction, under fair value accounting rules. However, I looked up some transactions in capital bonds executed by Santander around the EBA recapitalisation exercise, and these bonds traded at about 90 cent per euro. The potential 10% gain is probably too small to cover a 13bn capital shortage.

Verdict. Within the context of the EBA recapitalisation exercise, I think Santander’s transaction is acceptable, probably not as inefficient as the hybrid buybacks that were in fashion at that time.

* The regulatory treatment of minority interests and capital can best be analysed by way of using the COREP templates. You will notice that minority interests (item are part of  Eligible Reserves (item 1.1.2). Santander’s statement presenting its composition of capital, after the EBA 2011 capital exercise shows that this item is part of Common equity before deductions (item 1.1); which in just a couple of months rose to 46,640, from 40,048 million euro. At the same time hybrids went down to 4,083 from 12,763 million euro.