SEC Vindicates Deutsche Bank Derivatives Whistleblowers Eric Ben-Artzi and Matthew Simpson

At the end of 2012, we wrote a couple of posts about how Deutsche Bank was charged by three separate whistleblowers with having greatly understated the risk of the biggest derivatives exposure in the entire bank, which meant it had artificially pumped up its capital level during the crisis. The second, longer post, Deutsche Bank’s $12 Billion in Hidden Losses: Why Whistleblower Charges Have Merit and Why They Matter was in response to a typical Matt Levine, “nothing to see here, move on” defense of financial services industry misconduct (Deutsche Bank Ignored Some “Losses” Until They Went Away). Deutsche settled the charges for $55 million, which says the agency concluded there was a real problem. However, the fine looks light given the seriousness of the misconduct.

Here’s the overview from our December 6, 2012 post:

Today, the Financial Times reported that three separate whistleblowers charged that Deutsche Bank had mismarked up to $12 billion in exposures to make it look healthier in 2008 and 2009 than it was, yet the agency had not acted on these allegations. And this level of window dressing most assuredly would make a difference. From the Financial Times article that discusses the charges in detail:

When Deutsche reported earnings at the start of 2009, its tier one capital ratio – the gauge of banks’ ability to absorb losses – was about 10 per cent, with €32.3bn of tier one capital against €316bn of risk-weighted assets. If the tier one capital had fallen by €8bn, below the upper end of the former employees’ estimates, its ratio would have fallen below the 8 per cent that German regulators were demanding at the time.

It is important to recognize that even now, Deutsche is thinly capitalized….

The line taken to minimize the significance of these charges is the trades were eventually unwound without impairing the bank. Yes, in no small measure because the financial system is still on life support, with central banks engaging in ZIRP to goose asset prices and flatter bank balance sheets (and that’s before we get to the ongoing high wire act in Europe to contend with French and German bank exposure to periphery country debt). So the idea that this all worked out well is a convenient fiction. It all worked out well for bankers, at considerable cost to ordinary citizens in their economies…. Again from the FT:

“If Lehman Brothers didn’t have to mark its books for six months it might still be in business,” says one of the men. “And if Deutsche had marked its books it might have been in the same position as Lehman.”

Our second post unpacked the so-called leveraged super senior trade and the Deutsche risk management omissions and exercises in creative accounting. The post is meaty and wonky, for those of you who miss that sort of thing at NC (we don’t have messy financial puzzles to pick apart these days). For instance:

To give a very brief and simplified overview (see this post by Lisa Pollack for more details), the so-called LSS trade involved the creation of a special purpose vehicle. The asset side of the SPV was a portfolio of corporate credit exposures, achieved through credit default swaps.* The SPV was leveraged because it was not fully funded.

Normally, in a CDO (and this structure was a CDO), even in a fully synthetic deal (all the assets are CDS) you have someone (usually multiple someones) lined up to take the losses if the thing blows up completely. And usually, the investors who take the riskiest exposures put up cash so that the SPV has collateral and does not have to chase investors to fund the CDS payouts until the losses exceed the level of the posted collateral. But in a LSS trade, the investors put up only 10% of the notional amount.** This was non-recourse***; if the deal lost more money than that, too bad for the protection buyers.**** Now these deals did have certain triggers that would allow them to be unwound to contain losses, but it’s not hard to imagine that if one LSS deal needed to be unwound, probably other did too, and the pressure of selling would exacerbate losses.

On top of that, there was a funding mismatch. The 10% collateral was provided not through the issuance of bonds or notes that matched the maturity of the credit default swaps (5 to 10 years) but commercial paper sold to Canadian investors that had to be rolled every 30 to 90 days.

Deutsche was the protection buyer in this deal. Even though it might turn around and lay that risk off to customers, it “faced” the SPV. It would not sell the CDS, it would enter into offsetting trades (and the offsets were often not exact, but that’s not germane to the regulatory discussion). So Deutsche was exposed if anything went wrong with this scheme.

It isn’t hard to see that the biggest risk in this trade is that the losses exceed the 10% that the investors ponied up. That risk was called the “gap option” or gap risk. That is also the risk that Deutsche undervalued significantly or simply failed to include at all in its financial reports (more on that shortly). Because this trade was $130 billion notional and was the largest exposure in the bank’s trading book during the 2007-2009 period, the undervaluation was significant, to the point where incorporating those costs would have raised questions about the bank’s stability during the crisis. Ben-Artzi pegged the value as $10.4 billion lower at the worst point of the crisis, when Deutsche’s equity was €32 billion ($44.5 billion) at the end of 2008.

The main argument of defenders of Deutsche’s case is that this trade was properly classified as a Level 3 asset. The Level 3 classification was called “mark to model” or “mark to make believe”, in that modelers could use “unobservable inputs” in coming up with their valuation. But as the filing details, Deutsche went far outside the permissible boundaries for Level 3, and not in one way, but several….

And let’s get to the basic issue. The LSS trade, if properly modeled and accounted for, would never have been done in the volume that it was and Canadian investors would have been spared at least some of the disruption and losses that they suffered. But the traders and their managers were able to pull out more in bonuses by booking the trade in a way that exaggerated its profits. This is looting, pure and simple. Tough accounting and controls won’t catch all bad or sloppy behavior, but it would have stopped this trade, and you can be sure it would have prevented others.

And to give you a sense of how egregious this strategy was, see these footnotes:

**** You can see why this is a dumbass trade. It’s hard to imagine it would make sense, with the risks properly estimated, in anything other than unusual circumstances, when risk pricing was out of whack.
***** This is pretty stunning. It’s one thing to kludge a trade or two because you’ve done something exotic and the customer was so dumb you are pretty confident you loaded enough margin into the pricing that you’ll be OK under most circumstances. It’s quite another to move a strategy into production without having sorted out how you will hedge the trade (the hedging strategy determines how you price it). And remarkably, they tried hedging a credit position with….equities! We’ll turn the mike over to Colin Lokey:

Even more astonishing is what the bank apparently did to hedge against this faulty hedge — yes, that’s right, this is yet another example of a hedge of a hedge gone wrong. From the Financial Times:

“A person close to Deutsche Bank says the bank hedged its exposure by betting that the S&P 500 stock index would drop.”

That’s it?! You have tens of billions in theoretical losses on a complex credit derivatives book to protect against and you bought yourself some S&P 500 puts?!

Here is the denouement, courtesy the Financial Times:

The Securities and Exchange Commission said on Tuesday that Deutsche Bank made material misstatements about a giant derivatives portfolio, inflating its value at the height of the financial crisis.*

The bank failed to account for a “material risk for potential losses estimated to be in the billions of dollars”, the SEC said…

An outside expert hired by the SEC said the positions were misstated by at least $1.5bn. Deutsche’s internal estimates put the gap at $1.5bn-$3.3bn, the SEC found.

Yves here. We’ve pointed out repeatedly that the SEC enforcement chief when the SEC was first given warning of the misreporting, and later when the story broke, was Robert Khuzami. Khuzami never pursued CDO risks seriously because he had been general counsel for Deutsche Bank for the Americas from 2004 to 2009. Any serious investigation of CDOs would have implicated Deustsche, and hence Khuzami, in a major way. And it is impossible for the head of enforcement to recuse himself effectively. Do you really think subordinates will pursue a line of inquiry seriously that will undermine their boss? So one has to wonder how the SEC found an expert who came up with an estimate of losses that looks to have consistent with Deutsche’s internal estimates, when (as we explained at length in our post), there were sound reasons to see higher loss estimates as credible.

And as is too often the case, alerting the SEC may not have been worth what it cost the whistleblowers:

One of the ex-employees said on Tuesday that he was satisfied with the result, which has come five years after complaints were made to the securities regulator that Deutsche was not correctly accounting for mark-to-market losses. Another expressed disappointment at the size of the settlement.

And as usual, the bank is paying a fine. None of the individual perps have suffered.

So while the SEC did at least obtain a decent-sized fine and provided a detailed description of Deutsche’s bad conduct, yet again, it looks like the bank got off easy, and was also sanctioned so long after the fact that it’s easy to see the crisis risks as from another era. And that sort of complacency is what will make the next one much worse than it needs to be.

Disclosure: We have made a private equity whistleblower filing to the SEC