The Deutsche allegations

By Felix Salmon
December 6, 2012

Tom Braithwaite, Michael Mackenzie and Kara Scannell of the FT have one of the wonkiest articles I can ever remember reading in any newspaper, trying to explain the mechanics behind the complaints that various former Deutsche Bank employees have taken to the SEC. Matthew Goldstein first reported on the whistleblower complaints last year, in pretty vague terms; the FT has now added a huge amount of detail.

I have sympathy with all three of the sides in this story: Deutsche Bank, the SEC, and the whistleblowers. The main whistleblower in the FT story is Eric Ben-Artzi, who joined Deutsche in 2010, when the actions in question were already in the past. An alumnus of Goldman Sachs, he was assiduous about finding and defining all the various exotic risks that can crop up in derivatives portfolios, and he ultimately came to the conclusion that during the crisis, Deutsche hadn’t been marking those risks properly to market.

Ben-Artzi, along with at least two other Deutsche whistleblowers, took his complaints to the SEC, which in turn heard them out but has not (as yet) accused the bank of any wrongdoing in the matter. These things are highly complex, and very hard to get a prosecution on, and frankly the SEC probably has more important things to do. Here’s how the FT story concludes:

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.”

The “gap risk” here needs a little bit of explanation. Simplifying a bit, let’s say that Deutsche Bank bought $130 billion of protection from some Canadians, but the Canadians, in turn, only put up $1.3 billion of collateral. Deutsche never actually called on that collateral — but there was a risk that something catastrophic would happen, and that it would demand much more than $100 million. In that event, the Canadians would probably have just walked away, leaving their $1.3 billion behind, but also leaving Deutsche on the hook for potentially enormous losses.

The question then becomes: what is the value of the protection that Deutsche bought from the Canadians? And the answer depends in part on what Deutsche did to hedge the risk that the Canadians would walk away. Deutsche hedged that risk — the “gap risk” in various ways at various times — first it applied a “haircut” to the valuation of the trades, then it used a reserve account, and finally it bought put options from Warren Buffett.

None of these hedges was remotely perfect, however, and Ben-Artzi, who came from a bank which was notoriously aggressive in such matters, came to the conclusion that the $130 billion of protection had actually been worth roughly $10 billion less than that, if you marked its value to, um, “market”. One problem with this, of course, is that at the height of the financial crisis, the ability of Deutsche Bank to sell $130 billion of leveraged super-senior derivatives was exactly zero. There was no real liquid market to mark to, and what Ben-Artzi was really doing here was “marking to model”.

In the end, what the whistleblowers seem to be complaining about here was that Deutsche didn’t aggressively write down its assets so far that “it might have been in the same position as Lehman.” And why on earth should it have done such a thing? Well, an equally aggressive SEC could surely try to make the case that US GAAP required them to. But let’s take a step back here.

The whole point of banks is that they lend money for the long term, “through the cycle”, and make money over the long terms as well. Sometimes defaults spike, but if you can get through those tough periods, then banking can be a profitable business overall. Now that’s not the way that Goldman Sachs thinks. At Goldman, everything is marked to market every day, and the bank competes on fighting as hard as it can for daily profits. There’s no delusional marking-to-par at Goldman: it’s far more disciplined than that.

But if everybody behaved like Goldman, the result would be a disaster. Specifically, it’s fair to say that if you have a broad economic crisis and there’s not much liquidity in the credit market, then if you assiduously marked every asset to market, the entire banking system would be insolvent. Indeed, a common-or-garden cyclical recession can sometimes come close to having the same effect. If one or two investment banks mark their balance sheets to market every day, that’s fine. But if every bank in the system were to do such a thing, there would never be a bank in the country more than a decade or two old. After all, as even some Goldman executives will now quietly admit, no amount of clever counterparty hedging can protect a bank against the risk that the global financial system collapses.

Deutsche was not selling its super-senior portfolio during the crisis, it was holding on to it. Should it have marked the value of that portfolio down by $12 billion, on the grounds that mark-to-market rules required it to do so? I have no idea: the whistleblowers think it should have, while Deutsche Bank is adamant that it has investigated the allegations and found no particular cause for concern.

But here’s a certainty: seeing Deutsche Bank take a $12 billion writedown at the height of the crisis would have been almost as bad for the system as a whole as seeing Lehman go bankrupt. The time for kitchen-sink writedowns is when you can afford them, not when you can’t. And while there’s a convenient fiction that quarterly accounts are simply the product of following clear and simple rules, no one really believes it — especially not in the ultra-complex world of derivatives accounting.

It’s pretty clear that the world is a better place for Deutsche Bank not having taken a gratuitous writedown on the grounds that even though it had billions of dollars of collateral from the Canadians, that might not be enough to cover what they owed if the crisis got even worse. I remember those crisis days vividly; they were characterized by policymakers on every continent doing everything they possibly could to boost the liquidity and confidence in the financial system. (Well, except for maybe Sheila Bair.)

The whistleblowers say that when Deutsche Bank reported record profits at the end of the first quarter of 2009, it was reporting fiction, because there should have been enormous charges related to derivatives valuation. But I’m happy that Deutsche managed to find a way to keep its accounts in shape during those most dreadful months. Here’s the FT again, talking about early 2009:

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.”

Ackerman’s performance paid off: his share price rallied, and soon the worst of the crisis was behind us. If he had taken an eleven-figure charge in the first quarter of 2009, that would have been the absolutely worst possible time to do so, both for his bank and for the financial system as a whole. Deutsche Bank survived, the positions turned out to be healthy, and when you see situations as unique and exceptional as this one, there’s a strong case to say “no harm, no foul”.

No good would have come of Deutsche doing what the whistleblowers say it should have done; instead, its profits helped to restore badly-needed confidence in the system as a whole. It’s not exactly a shining precedent. But given how unique and terrible this crisis was, I’m inclined to give Deutsche a pass.


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