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ABN deals left RBS exposed to Madoff

More pain for RBS from its decision to buy Dutch bank

By Sean Farrell and Mathieu Robbins
Wednesday, 17 December 2008

Royal Bank of Scotland's potential £400m loss from the world's biggest alleged investment fraud came from the investment banking business it bought from ABN Amro.

The exposure to loans used to leverage the investments of its clients in Bernard Madoff's giant $50bn (£33bn) pyramid scheme is the latest blow delivered to RBS from its purchase of ABN last year, a deal which accounted for about a third of RBS's £5.9bn of first-half write-downs. Investor anger at the takeover, which left RBS in a weak capital position, helped prompt the departure of the bank's chief executive, Sir Fred Goodwin, last month.

RBS said on Monday that if it recovered nothing from its lending to hedge funds of funds the losses would be about £400m. Hedge fund industry sources said the business would have come from the equity derivatives operation that RBS took on as part of the ABN deal.

"ABN had an equity derivatives team activity. That team would do a number of things, one of which is lending or providing leverage. They would issue a derivative instrument that an investor would put money into," one source said.

RBS declined to comment but a source familiar with the bank said that a fraud on the scale of the one alleged in the Madoff affair could not be blamed on the ABN transaction.

RBS and HSBC are believed to have used derivative contracts to protect more than £1bn of loans to clients wanting to increase their returns from Bernard Madoff's unspectacular but apparently reliable investment yields. The stable returns of about 10 per cent a year were more reassuring to many investors than the higher but more volatile performance of hedge funds.

HSBC's loans were made by its markets business. The so-called leverage allowed investors to borrow against its investments in the funds to boost returns on their own capital after paying the financing costs of the loans.

The contracts, which varied between transactions, were intended to protect the banks from the downside of the collateral on which the loans were made. No heads were said to have rolled at the banks over the potential losses.

HSBC declined to comment beyond its Monday statement, which put its maximum exposure at about £1bn from loans to funds of funds that invested in Madoff Investment Securities.

Both of the bank's estimates are worst-case scenarios that assume nothing is recovered.

Industry sources said banks' lending to funds of funds to leverage their investments was relatively small – and tiny compared with prime brokerage operations, which provide leverage direct to hedge funds.

In some cases, banks may be able to get nothing back because the loans were secured on specific collateral, though they may be able to question whether their clients visited Madoff or ran other checks on the business.

Mr Madoff was arrested last week after reportedly telling his sons his investment firm was "a giant Ponzi scheme". Bankers are turning the blame on the Securities and Exchange Commission, which had reportedly not inspected Mr Madoff's business since he registered it with the regulator more than two years ago.

Mr Madoff is reported to have said that there were no assets left in the scheme, holding out little hope for investors. The Securities Investor Protection Corp said yesterday that Mr Madoff's financial records were "utterly unreliable" and would take six months to go through.

"There are some assets but I have no idea what the relationships of the assets available are to the claims against them," Stephen Harbeck, the president of the corporation, said. "The records are utterly unreliable on this case."His organisation had found "two sets of books in complete disarray".

Bank Medici of Austria became the latest European bank to reveal a loss from Mr Madoff's alleged fraud, revealing that two funds at the Viennese bank invested $2.1bn entirely in his fund.

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