Two days ago, we said it was time to fire the SEC’s chief of enforcement Robert Khuzami, who has not provided the tough policing warranted by the biggest financial crisis in the agency’s history. Our call was based on compelling evidence of failure. Specifically, a year and a half after Dodd Frank created a $450 million whistleblower fund, which Khuzami confirmed had produced hundreds of high quality leads, the agency had taken only one referral far enough to merit a payout, that of a measley $50,000. We stressed that this was an astonishing lapse:
… whistleblowers are insiders and therefore should in many cases have access to the sort of internal documents that would serve to substantiate conduct and save the SEC a ton of time. In other words, this should be a prime, potentially its best, source of leads, since the SEC would be further along in case development if any of these tips had meat (ie, both damning info and on target with a clear violation).
We didn’t anticipate that the story of Khuzami’s negligence would blow so big so quickly. 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. Bank analyst Chris Whalen wrote in 2011:
Even Deutsche Bank, arguably the most important bank in Western Europe, has just €50 billion in capital supporting €1.7 trillion in total assets. Only by ignoring the sovereign and off-balance sheet footings of Deutsche and other major EU banks can anyone even for a moment pretend that these banks are solvent.
The bank’s year end 2011 balance sheet shows even higher leverage: equity of €55 billion versus €2.2 trillion in assets.
Although 2009 appears to be when the mismarking reached its peak, there was evidence of monkey business before that. The FT’s Lex column points out that the German bank miraculously managed to report profits in the third quarter of 2008, which closed right after the Lehman/AIG implosions. That miracle was achieved by reclassifying €25bn of trading assets, which skeptical investors were told was permissible thanks to changes in accounting rules.
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. If Deutsche had gotten a formal bailout, the odds are decent that changes in management and operations would have been forced on the bank (remember, Germany is more oriented towards industrial capital than financial capital, so the odds of a big bank welfare queen getting to carry on as before are less likely than the example of Citigroup would suggest). 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.”
Of the three whistleblowers’ allegations, the one presented in the most detail is from a Deutsche Bank risk manager, Eric Ben-Artzi, who was fired three days after making his whistleblower submission a year ago and is suing for retaliation. Ben-Artzi is ex Goldman and upon joining the German bank in 2010, noticed serious irregularities in how Deutsche valued certain risks, particularly related to leveraged super senior trades, and sought to work back to how big the exposures were at their most extreme point. Leveraged super senior was a levered way to mimic the performance of a super senior CDOs and CLOs (collateralized loan obligations). As we now know, virtually all AAA CDO tranches went to zero, so this was a levered way to lose money. CLOs, by contrast, traded down during the crisis but for the most part recovered. They were extremely illiquid and were mainly funded short term, via asset backed commercial paper. Deutshe was 65% of that market, and the notional value of its book was $130 billion. This appears to be a classic example of looting. Traders booked $270 million of profits up front (as we discussed in ECONNED, was permitted under Basel II rules if you took an AAA exposure and hedged it with a highly-rated counterparty), which also boosted the bonuses of everyone up the line.
Ben-Artzi focused on the “gap option,” which was the risk that counterparties would default on the hedges that Deutsche had put on the trade. He determined the exposure was was as high as $10.4 billion during the crisis. The FT gives an admirable account of all the various ways Deutsche tried to fudge both the modeling of the risk and the hedging of the position, including simply ignoring it:
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.
It gets even better. They pretended they had dealt with the problem by buying S&P puts. As reader MBS Guy wrote: “This is basically total bullshit, but was blessed by senior management and, presumably, accountants and regulators.”
For the LSS based on CLOs (which were structured bonds based on portfolios of levered loans), Deutsche had another risk management festering wound:
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.
And get a more specific allegation of a deliberate misvaluation involving none other than Warren Buffett:
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…
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.
Mind you, this is only a summary of only some of the major risk management twists, turns, and omissions. The FT account points out that the allegations of another whistleblower, former derivatives trader Matthew Simpson, who filed his complaint prior to Ben-Artzi, includes not only the gap option hedge failures and misreporting, but also the active mismarking of positions. And an even earlier whistleblower, mentioned only in passing by the FT, also told the SEC about gap option misreporting and widespread position fudging.
It’s hard to ignore these allegations, particularly since Deutsche fired both Ben-Artzi and Simpson, who settled his anti-retaliation suit for $900,000. And it wasn’t as if the SEC somehow hadn’t gotten around to these charges among the hundreds of complaints in its whistleblower queue. From the FT’s overview article:
All of the men spent hours with SEC enforcement attorneys and provided internal bank documents during multiple meetings, people familiar with the matter say.
Khuzami’s position is hopelessly conflicted. He was general counsel for the Americas for Deutsche from 2004 to 2009, so this behavior took place on his watch. Although he has recused himself from this probe, that’s inadequate. Recusal does not work when the people working on the matter in the end have the party with the conflict as their boss. They can’t pursue any real dirt that could implicate him without hurting themselves. If it came to naught, they’d still fear the risk of reprisal if he survived. And if he were forced to leave, they’d be faced with a new boss who might not be at all to their liking.
The only way to have an effective investigation is either to have Khuzami resign or to have the matter handed off to a completely independent firm (and even that’s a stretch, both from the agency side, and from the dearth of firms with decent securities law expertise that would be willing to face off against a major bank. Just as with the bankruptcy bar, you either work for the banks [the creditors] or against them [for the debtors]). It’s also a wee bit too cozy that Deutsche’s current general counsel is also a former SEC head of enforcement. And KPMG, the accountant that blessed all this highly dubious financial footwork, and Fried Frank, which led an investigation initiated by Deutsche and apparently found nothing much wrong, also don’t come out looking very good.
MBS Guy offers a line of speculation:
Ultimately, this is the type of issue that explains why banks abandoned Obama and lobbied and campaigned so hard for Romney. They were trying to buy having this type of issue being swept under the carpet. The accommodation they had gotten from the Administration was huge, but it wasn’t enough – they knew they had bigger issues lurking in the background and wanted insurance that the issues would get buried. I think it was a pretty stupid use of money by the banks, considering how pro-bank Obama and Geithner are.
While that may sound plausible, senior bankers carry on as if they have done absolutely nothing wrong and deserve to continue to be Masters of the Universe, despite nearly blowing it up. So I suspect they are too deeply convinced of their own innocence, despite the considerable evidence to the contrary, to support Romney as a way of protecting themselves against crisis-related bad behavior coming to the surface. Obama, Geithner, Eric Holder, and Khuzami have been their best friends: they rough the banks up just an itty bit to appease the masses and give Team Dem a few soundbites around election time. If Congress takes interest in this case and starts digging, the banks might come to recognize how much air cover the Administration has actually been giving them.