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Bombshell: Deutsche Bank Hid $12 Billion In Losses To Avoid A Government Bail-Out | ZeroHedge
Financial Times
December 5, 2012 9:39 pm
Deutsche Bank: show of strength or a fiction ByTom Braithwaite, Michael Mackenzie and Kara Scannell
Three former employees have told US regulators that trades were valued in a way that hid billions in losses.
Josef Ackermann was bullish. Even as the global financial industry was
reeling, the Deutsche Bank chief executive began 2009 by boldly
declaring that his bank had plenty of capital and would return to profit
that year.
In an investor call that February, Mr Ackermann said he would provide
“as much clarity as we can on all the positions” to refute the
suggestion that banks such as his had “****** losses, and one day that
will pop up, and then . . . we need more capital and the only way to go –
to ask for capital – is to see the governments”.
During the public relations campaign waged by Deutsche, its share price
recovered from €16 in January to €39 at the end of April 2009, when it
reported pre-tax profit of €1.8bn for the first quarter.
But three of the bank’s former employees say the show of strength was
based on a fiction. In a series of complaints to US regulators, two risk
managers and one trader have told officials that Deutsche had in effect
****** billions of dollars of losses.
“By doing so, the bank was able to maintain its carefully crafted image
that it was weathering the crisis better than its competitors, many of
which required government bailouts and experienced significant
deterioration in their stock prices,” says Jordan Thomas, a former US
Securities and Exchange Commission enforcement lawyer, who represents
Eric Ben-Artzi, one of the complainants.
Also unknown to the public until now is the assistance – entirely proper
– provided to Deutsche by billionaire investor Warren Buffett’s
Berkshire Hathaway group.
In complaints to the SEC made in 2010-11, the employees allege that the
main source of overstatement was in a $130bn portfolio of “leveraged
super senior” trades.
In 2005 these were seen as the next big thing in the rapidly evolving
world of credit derivatives. They were designed to behave like the most
senior tranche of a typical collateralised debt obligation, where assets
such as mortgages or credit default swaps are pooled to give investors
varying degrees of risk exposure.
Deutsche became the biggest operator in this market, which involved
banks buying insurance against the possibility of default by some of the
safest companies.
Working with Deutsche, investors – many of them Canadian pension funds
in search of yield – sold insurance to the bank, posting a small amount
of collateral. In return, they received a stream of income from Deutsche
as an insurance premium. On a typical deal with a notional value of
$1bn, the investors would post just $100m in collateral – a fraction of
what would normally be posted by an investor writing an insurance
contract.
The small amount of collateral did not matter, the product’s creators
said. The chance of several safe companies, such as Dow Chemical or
Walmart, all going bankrupt at the same time was infinitesimally small.
It might require a nuclear war. The chance of the investors having to
pay out on the insurance appeared impossibly remote. The chance of their collateral being used up was inconsequential.
Having bought protection from Canadian investors, Deutsche went out and
sold protection to other investors in the US via the benchmark credit
index known as CDX. It would earn a spread of a few basis points between
the two positions, perhaps 0.03 per cent.
That does not sound like much. But as it amassed ever greater positions,
eventually representing 65 per cent of all leveraged super senior
trades, it accumulated a portfolio of $130bn in notional value. Over the
seven-year life of the trade, the few basis points were worth about
$270m.
There was a problem, though, which traders either did not foresee or did
not care about when they booked hundreds of millions of dollars of
upfront profits. A severe financial shock, well short of nuclear
warfare, could also produce disastrous results.
In 2007, credit spreads widened as investors grew nervous about
companies’ prospects and liquidity dried up. But spreads on super senior
tranches of derivatives structures, representing the safest portion of
the capital structure, did not just rise by two or three times – they
exploded.
An academic arrives
Mr Ben-Artzi joined Deutsche in 2010, well after the worst of the
financial crisis. A mathematician with a PhD from New York University,
he had worked at other banks, including Goldman Sachs, on the wonkier
end of the derivatives machine.
He was attracted to Deutsche partly because the job of modelling risks
was quasi-academic, with a better work-life balance than his job at
Goldman.
Mr Ben-Artzi became interested in the leveraged super senior trades and
how Deutsche accounted for the “gap option” – the chance that the
counterparty’s collateral would be wiped out and the investors would
walk away.
Coming from Goldman, where the bank had modelled this risk, Mr Ben-Artzi
believed this element of the trade was not inconsequential at all.
Based on the model used at Goldman, he calculated it could have been
worth as much as 8 per cent of the notional value of the trade during
the crisis, or $10.4bn. When credit spreads deteriorate, he knew, banks
should not just book the mark-to-market profit from the increased value
of their protection but also the gap option: the mark-to-market losses
associated with the counterparty walking away.
For several months, Mr Ben-Artzi quizzed colleagues at Deutsche on how
it modelled the gap option. He alleges he was told by superiors that the
bank had at one point used a model but found it came up with
“economically unfeasible” outcomes. Instead, it used two other measures.
First, a 15 per cent “haircut” on the value of the trades, a writedown
amounting to millions of dollars, but well short of the billions that Mr
Ben-Artzi estimated as the exposure.
Indeed, in an internal presentation in 2006, reviewed by the Financial
Times, a Deutsche financial engineer says that “the present reliance on
the [haircut] does not seem adequate in order to accommodate all
possible spread shock scenarios”.
In 2008, during the crisis, instead of increasing the haircut, the bank
scrapped it. The gap risk was now supposed to be covered by a reserve.
The complainants say that the total of reserves held by the credit
correlation desk was just $1bn-$2bn, which was supposed to cover all
risks, not just the gap option. Deutsche refused to say how big its
reserve was but a person familiar with the matter says it was
sufficient, and a more appropriate option for the market conditions of
the time.
Then, in October 2008, Deutsche chose another path. A person familiar
with the situation acknowledges that from this point until the end of
2009, Deutsche stopped any attempt to model, haircut or reserve for the
gap option but says that the company took that action because of market
disruption during the financial crisis. This was signed off by KPMG, the
external auditor, the person said.
At this time, to account for the gap risk, the bank hedged it by buying
S&P “put” options. The idea was that if the stock market fell
further, indicating broader financial stress, the value of those options
would increase, offsetting increased gap risk.
One of the former employees says that using equities to hedge credit
risk is not ideal. “It’s not a good hedge. It’s two completely different
markets. But no matter what kind of hedge you put against the gap
option, you separately still have to value the option correctly.”
Mr Ben-Artzi says he was not told of all Deutsche’s changes to the
valuation during the financial crisis despite persistent efforts to
understand them. He says his concerns were dismissed by superiors based
in London and he was told that the issue had been decided “at the tip of
the pyramid” of the bank.
In November 2011, after he says Deutsche continued to refuse to explain
the valuation, he was fired. Three days earlier, he had filed a
whistleblower complaint with the SEC. He later filed a separate
complaint – assisted by the Government Accountability Project, a
Washington non-profit organisation that advises whistleblowers –
alleging that his dismissal was retaliation.
While reporting his complaints, Mr Ben-Artzi did not realise he was not
the first to do so. But the FT has established that two other former
Deutsche employees had raised the same allegations with the SEC.
Matthew Simpson had been at Deutsche for 10 years when he was promoted
to a senior role on the credit correlation desk in New York in 2008. Mr
Simpson, who through his lawyer declined to comment, eventually raised a
number of concerns about the activity of the desk internally and,
ultimately, to the SEC. His was a much longer list of concerns about
securities and accounting procedures, but contained the gap option
concerns later raised by Mr Ben-Artzi.
He also alleged that traders were not simply understating the gap option
but actively mismarking the value of their trades. According to Mr
Simpson’s complaint, the protection bought from investors would be given
an artificially high value, while the protection sold would be given a
lower value. Both marks, he said, swelled the upfront profits and
traders’ bonuses. Deutsche says it has thoroughly investigated the
allegations of financial mis-statements from Mr Ben-Artzi and Mr Simpson
and found them to be “wholly unfounded”.
Mr Simpson also contended that if Deutsche had properly accounted for
its positions, it would have booked a multibillion-dollar loss in the
depths of the crisis and might have required government support to
survive.
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.
Mr Simpson did not know that there was another complainant whose
warnings predated his. This third individual, who has requested
anonymity, had an even broader raft of allegations against Deutsche. But
like the two men who followed, he complained of the gap option
violations – and, like Mr Simpson, he alleged widespread mismarking.
‘Crazy mismatches’
Even outside Deutsche, some experts were urging banks to examine their
treatment of the gap option back then. Among them was Jon Gregory, a
partner at the Solum Financial consultancy, who published a paper
warning of the gap option in 2008 when he worked at Barclays, the UK
bank. He says ignoring the gap option or accounting for it with a
reserve, as Deutsche did, was unacceptable.
“You can’t value it as if the whole thing is unleveraged, where you
would be buying protection from an investor who gives you the full
amount of notional, say $1bn,” he says now. “It’s leveraged. They
haven’t given me $1bn. They’ve only given me $100m. I have to account
for the difference between the two. The difference is the gap option,
and I should value this consistently with the underlying super senior
tranche.”
In 2008, Mr Gregory was concerned about valuations across the market and
did not single out Deutsche’s behaviour. But two other banks with large
leveraged super senior positions told the FT they modelled the gap
option. And if others did not model the trade, no other bank was subject
to potential losses as large as Deutsche’s. Nor have there emerged such
wide-ranging allegations of mismarking against any other bank.
“The valuations and financial reporting were proper, as demonstrated by
our subsequent orderly sale of these positions,” Deutsche says.
Some banks did share one problem, though: there was a mismatch in the
initial trade and the offsetting trade. Deutsche was buying protection
on a customised range of companies, which included diverse names from
around the world. It was then selling protection on a range of companies
in the CDX index of US-only companies. This was the same series of
indices that JPMorgan Chase used in its infamous “London Whale” trades,
which this year racked up more than $6bn in losses. It was an imperfect
hedge. Credit spreads in one portfolio could deteriorate while the other
portfolio could improve.
“You now have a huge name mismatch,” says one of the three former
employees. “Because the one that you bought protection on isn’t really
worth very much and the one you sold protection on might have had
Washington Mutual in it [the US bank that failed in 2008] or other
really toxic names. You had these really crazy mismatches.”
Adding to the risk, many of the counterparties were Canadian – meaning
the protection Deutsche bought was priced in Canadian dollars. But the
protection it sold to offset the trades was priced in US dollars. If the
currencies moved apart, losses could be accentuated.
At first Deutsche priced this risk of currency movements intertwined
with credit risk – known as “quanto risk” – at zero, two of the former
employees alleged. They allege that this alone should have added
hundreds of millions of dollars to Deutsche’s mark-to-market losses.
A person familiar with the matter denies this, and says that the bank
set up a reserve to deal with the quanto risk. But with market
volatility during the crisis, the bank realised it had to do more.
Eventually, Deutsche reached for a saviour that had helped many
institutions during the financial crisis: Mr Buffett. While his support
for Goldman and Bank of America was announced during the crisis, his
intervention in Deutsche has not been widely known until now.
Berkshire wrote insurance on the quanto risk for Deutsche at a cost of
$75m in 2009. Deutsche then accounted for this as full protection on the
risk. But the contract agreeing the trade, reviewed by the FT, caps the
payout in the event of losses at $3bn, while Deutsche was claiming
protection on tens of billions of dollars. Once again, the former
employees allege, the bank was accounting as if it had fully insured
itself against loss while in reality insuring itself against only a
small portion.
A person familiar with the situation says external auditors approved the
treatment. Berkshire Hathaway did not respond to a request for comment.
Lessons to be learnt
Amid the turmoil, one big event was helping Deutsche. In the darkest
days of 2008, it was working with other banks and their Canadian
counterparties to head off an implosion in leveraged super senior
trades, a risk heightened in part by a freeze in the Canadians’ funding
mechanism – the asset-backed commercial paper market. Eventually, they
came to an agreement known as the Montreal accord, finalised in January
2009, with both sides adding more collateral to the mix to minimise the
chance of losses.
Deutsche set great store by the accord. Even before it was in place, the
bank was accounting for its positions as if the restructuring had
already happened and its gap risk had been lowered. A person familiar
with the situation says that treatment was appropriate since
negotiations were advanced.
But despite the accord, in an internal document from May 2009 reviewed
by the FT, Deutsche was still identifying the leveraged super seniors as
“the largest risk in the trading book”. “Quality of additional
collateral posted after the restructuring is questionable,” the same
document warned.
By 2012, many of the trades have matured or have been unwound. With
credit markets back to more normal levels, Deutsche’s dalliance with
exotic derivatives is no longer life-threatening. A person familiar with
the matter says that for all the sturm und drang over gap risk, at no
time was the collateral jeopardised.
But the three former employees told the SEC that this outcome does not
mean the allegations should be forgotten. “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.”
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