Felix Salmon

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.

Now that the election is over, there’s a bit of time to revisit that very important CPDO decision I wrote about on Monday. There’s a lot of material to be mined here, and the Internet is slowly delving its way into it: I particularly love, for instance, the way that Daniel Davies started tweeting out noteworthy paragraphs.

But first there’s Paul Davies, who does a great job of explaining the revolving-door aspect to the case. You know how banks will hire regulators, at multiples of their former salary, and turn the former gamekeepers into poachers? Well, exactly the same thing happens to S&P: it pays better than the US government, but not nearly as well as the structured-credit department at ABN Amro. And thus a whole slew of S&P alumni ended up at the Dutch bank, putting together deals precisely designed to be the absolutely worst possible product in the world which could still, somehow, get a triple-A rating. In order to do that, you need people who know how the ratings sausage is made — and the easiest way to do that is to simply hire them.

S&P was well aware of what ABN Amro was doing, of course, but they had no incentive to frown on its behavior. For one thing it was good news for staffers that there was a healthy bid out there for their services; for another, ABN Amro paid S&P itself huge amounts of money to rate these deals. Everybody won — except the credulous investors who thought that ratings were honest, arm’s-length things.

Matt Levine points out that conceptually, the CPDO is “the perfect ratings arbitrage”, because the rating just tries to calculate the probability of default, without regard to the recovery value given default. As a result, the CPDO was specifically designed to have a recovery given default of very near zero, since that would increase the yield on the instrument without increasing the default rate. (This is exactly the same reason why it was S&P, rather than Moody’s, which downgraded the US from triple-A last year.)

Louise Bowman, meanwhile, finds this email exchange, between a couple of S&P quants:

Mr Venus: I am done with the whole CPDO – wish I was never involved in that whole mess that was made.

Mr Ding: What a wuss.

Mr Venus: That thing is done by 3 people: Cian, Sriram and you. I am not responsible, I just helped build an internal model. You are the wuss for bending over in front of bankers and taking it.

Mr Ding: primarily me and the banker…so what? I would not mind if they put my name on that article, grow up kid.

Mr Venus: You rate something AAA, when it is really A-? You proud of that little mistake? It’s nothing to do with growing up, it’s about doing your job to a high standard. If you want to talk about growing up, you should admit to Perry [Inglis] that you made a mistake with your analysis.

But the smartest lines, still, come from the judge, Jayne Jagot. For instance, she spends a lot of time demolishing the S&P argument that the investors didn’t understand what they were buying, and therefore that it was the investors’ fault, not S&P’s fault, that the investors lost money. Jagot demonstrates clearly that the investors knew full well that they didn’t understand the CPDOs, and that it wasn’t necessarily stupid of them to invest anyway:

The notion that it was necessarily imprudent of the councils to invest in a product they did not understand, on analysis, is specious. It is a superficially attractive catchphrase which does not withstand scrutiny. An investor who obtains expert advice and relies on an expert rating is not imprudent merely because the investor does not understand the investment. So in this case the councils’ lack of understanding and their knowledge of their own lack of capacity to understand was the reason for relying on the expert advice and recommendations of LGFS and the expert opinion of S&P embodied in the rating.

The fact is that in the fixed-income world, investors almost never understand what they are buying. A bond is a set of predictable cashflows, with a sting in the tail: it has some unknowable probability of default. Different analysts can try to calculate that probability by different means, but in reality bond investors simply don’t have the time or the expertise to do that for every bond they buy. That’s where ratings come in handy: they’re a way for bond investors to outsource a lot of the hard work they don’t have the time or the human capital to do themselves. And the ratings agencies know it: as Jagot says, “S&P is paid to assign a rating for a structured financial product for one purpose only.”

And then there’s the bigger picture: the fact that Jagot was able to deliver this magnum opus of an opinion at all. It’s clearly the product of vast amounts of work, and a positively enormous amount of lawyering on both sides. The victims, in this case, were relatively small Australian municipalities: how did they manage to afford to fight this court case this far?

The answer is, they didn’t: all of the legal fees were paid by a litigation funder called IMF (Australia), which will take a cut of any proceeds. They write:

Litigation finance is a critical mechanism to enable cases to be brought and litigated against large corporations, banks and other powerful institutions, often by small and mid-sized companies and entities.

The Australian Federal Court’s finding yesterday — in favor of local municipalities — that S&P’s AAA ratings were “misleading and deceptive” could never have been achieved without litigation funding support from IMF (Australia), Bentham’s parent.

I have no problem at all with companies like IMF funding these lawsuits. It’s incredibly hard for investors to successfully sue big financial-services companies like S&P, and litigation funders help to level the playing field. Even if they end up getting paid no money at all, they have at least caused Jagot’s wonderful opinion to see the light of day. And that alone is a massive public service.

On Tuesday I moderated a panel at the New York Forum which featured, inter alia, Duncan Niederauer, the CEO of the New York Stock Exchange, and Richard Robb, the CEO of Christofferson Robb, a money management firm which does its fair share of speculation.

My question at the beginning of this clip, for Niederauer, didn’t come entirely out of the blue. Amar Bhidé had previously talked about the casino aspect of markets, and Andrew Ross Sorkin had talked about the distinction between speculation and investment. But Niederauer was not happy when I pushed him on these concepts. Wall Street is increasingly a game of speculation rather than investment, I said, and asked how a casino operator pushing people to make bets over the course of a millisecond was not part of the problem. Rather than engaging with the question, he simply shut me down: “I thought my job description was quite different than what you just described,” he said. “So you must be talking to someone else.”

Niederauer then used all his media training to pivot and give a mini-speech instead about how self-regulation was better than Dodd-Frank. But Richard Robb, to his credit, engaged, even if what he said doesn’t stand up to scrutiny. “I don’t know what the difference between investing and speculation looks like,” he said, throwing up a straw man of everybody working at peoples’ tractor collectives. Robb’s prescription was essentially to do nothing but ban a few of his competitors: stop big banks from doing what he does, leave him alone to do anything he wants, and “let innovation find its own way, and if it’s parasitic and unproductive, it will not be rewarded by the capitalist system.”

That’s clearly false, of course: we can all think of parasitic and unproductive Wall Street innovations which have made millions of dollars for bankers and traders and money managers. Richard Robb himself gave a good example earlier on in the panel: structured investment vehicles.

And so Sorkin jumped in, making the good and obvious point that “it’s actually very easy to see what speculation is and what investing is.” Here’s one simple distinction: speculation is where you buy something in the expectation that it will rise in price, where investment is where you put money into something so that over the long term you can make a profit from the resulting cashflows, be they coupon payments or dividends. And as Sorkin said, if you make an investment for two seconds, that’s clearly speculation.

Robb’s response to Sorkin I think was one of the most telling points of the panel. “How about two days?” he asked. “Two weeks? Two months? Where would you draw the line?”

I could barely believe what I was hearing — was Robb really suggesting that holding a position for two days might be considered investment rather than speculation? Or even two months? All of them are speculation — and the fact that the likes of Niederauer and Robb can’t see that is I think a big part of the problem.

The subject of the panel was financial innovation, and Robb genuinely believes that he’s something of a centrist on the issue: he makes great play of agreeing with his friend Bhidé, for instance. But the fact is that if you’re talking to alumni of Goldman Sachs (Niederauer) or the University of Chicago (Robb), or someone who used to run the derivatives desk at a too-big-to-fail bank (Robb, again), then their idea of what’s good for the world is always going to be pretty skewed. They’ve made millions of dollars in the Wall Street casino, and they’re precisely the people being put on panels to ask whether the casino is a good thing. It’s reasonably easy to predict what they’re going to say — and to discount it heavily.