Germany's attempts to manage the financial crisis in Europe to their benefit, by regulating every single financial product/bank/action, and claiming their banking superiority as a reason and example, is looking more and more like a sick joke...
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 “hidden 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 hidden 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 ...
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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 misstatements 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 ...
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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 ...
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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.”