Khuzami Deathwatch: SEC Ignores Tips About $12 Billion of Hidden Losses at Deutsche Bank

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.

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  1. Damian

    This is pretty simple:
    Banks became debt pass-through entities, so a known liability (their own bonds) and variable assets (the bonds they own, including CDOs). If they ever tried to sell all their assets, the price would plummet and there is no value in the company equity.

    The funny thing, accountign rules allow banks to have the variable asset (the price can change, default) fixed at a price (par, price paid via hold to maturity) whilst banks can change the know liability (they WILL have to pay the amount due on the debt).

    This means they can fiddle the books, but most importantly, maximise the difference to make them appear well capitalised. The fact is, all their assets we bought in the bubble years and they are all insolvent…eventually. Unless cheap central bank money can save them.

  2. Clive

    The problem with banks and their approach to Risk Management is that what has been progressively in-cultural-ated over the past decade (i.e. the bubble era) is that it’s okay to have what are, objectively, small scale violations (e.g. Sarbox compliance for minor processes and systems) because, well, they’re small potatoes but the banks figured that the bigger impact infractions would still be caught.

    As any parent knows, that’s not the way it goes down. If you let your 5-year old pilfer your loose change (a phase most children go through at some stage, a pushing and exploration of the boundaries rather than a serious sign of incipient criminality) and condone it either actively by laughing it off or implicitly through ignoring it then pretty soon your little darling is shoplifting and/or threatening other kids with violence to extort money. The problem is by not practicing tough love with the minor transgressions, you teach that you might be able to get away with bigger ones too.

    So with the banks. This Deutsche scandal looks like it started the same way — a (relatively) trivial and somewhat crude ruse to circumvent mark-to-market rules that as time went on and more and more people got involved, including the auditors, it accreted more mass into it’s sphere of influence before finally the inevitable happened, suddenly you have a star gone nova. And everyone (well, everyone except NC readers maybe) thinks “how did *that* happen ???”. I’d be willing to bet that originally the loss projections started off by being tweaked only a few per cent favourably. That wasn’t detected or was actually encouraged so the inevitable response, as the situation worsened with the actual losses on the instrument increasing, was to double up.

    Same thing happened with the London UBS “rouge trader”.

    Okay, that’s described the problem (actually, Yves’ feature does that better than I !) What’s the solution ?

    At this point we usually go through the familiar routine of regurgitating the “better regulation” “break up the big four auditor cartel” “end TBTF” arguments. And or all of these would work, but there’s precious little, in my opinion, chance of these measures actually being implemented properly. I used to think so but now I don’t.

    No, what will fix this is that after, say, another 2 to 5 years of seemingly unending scandals, no-one will touch these institutions for investment purposes. It’s already stating to happen, the TBTF that I know is already being crippled by outrageous cost of capital. It’s responding (see Citi feature earlier) by slash and burn cost cutting. But that will only get it so far.

    The price though is that everyone here has to keep on with the publicity and the analysis. Without the bight light of an aware and interested portion of the population shining on the problem, these institutions will never change.

  3. JGordon

    I just read in the paper today that someone’s lover was driving a $70,000.00 Corvette that may have been purchased with ill-gotten money. That was the top financial story of the day in that paper. And this is why Americans are generally a bunch of clueless, insane degenerates who will applaud when Obama installs Khuzami at the head of the SEC.

    1. Mafer

      You are being a little too hard on Americans. Americans will not applaud for Khuzami. In fact, if they heard his name they would think he was some new brand of designer jeans.

      1. curlydan

        They will cheer his appointment (if it happens) when the stock market gets a boost from the announcement, though.

    2. Stan Getz

      I guess a minor hope would be that Obama gets a vindictive streak and after Geitner leaves, may allow some to pursue these areas of fraud. Obama will likely make the calculation that he needs big finance’s blessing for the remainder of his presidency. In fact his positioning on the illusory cliff alone reflects his consistent fealty to big finance. The only curiosity I have is whether he really believes that looking the other way on all the financial fraud allows healthy bank=healthy economy or its a political calculation about serving that power to keep his. Given how the theory has failed to revive our moribund economy, I suspect its a calculation. Obama is so consistent in procuring disappointment, like Clinton we see his gifts and cam understand why character wasn’t its companion.

      1. Clive

        I’m tempted to agree with you Stan. Obama, egocentric and self absorbed to the point of personality disorder though he is, cares about his “legacy”. So perhaps he might end up doing the right thing for the wrong reason: get tough with the financial services industry. But then again, over optimism is a failing of mine…

      2. curlydan

        If only Obama could folow Bill Maher’s new rule:
        “New rule,” Maher announced. “Now that he’s been reelected, President Obama must get back at all those right-wing hacks that tried to paint him as an angry black man pushing a liberal agenda, by becoming an angry black man who is pushing a liberal agenda.”

        I highly recommend you watch the full clip.

      3. LucyLulu

        Another one chiming in on the focus now being what his legacy will be. Right now he’s worried about the big fiscal cliff/debt ceiling’s effect on that legacy, figures it could make or break him in the history books. Notice how engaged he’s become with business CEO’s and trying to mend those relationships, and from what the rumors say, having good luck. So it all depends on how he’d expect that prosecuting fraud would affect “turning the nation around to a sustainable path”. Did he buy the story that it would bring the banks to their knees, drumroll??? And will he keep up the headlocks with the GOP? I think he wants to, purely on principle, he wants to stick it to them for all the invalidation of his presidency the last 4 years with Kenyan Muslim and socialism memes. So he needs a coalition on his side. The Democrats are too woos-y to be of any use one way or the other.

    3. rich

      This is how you steal.

      Then we look into the role of Senator Feinstein’s husband Richard Blum, the head of the world’s largest commercial real estate company, who has an exclusive contract with the U.S. Postal Service to list and sell its valuable and historic public property as the Congress deliberately bankrupts the Post Office in the name free enterprise. U.C. Berkeley professor of Geography, Gray Brechin joins us to discuss the theft of our national heritage which the press is ignoring while only reporting that the Postal Service is in default, but not why, and who is profiting from its deliberate destruction.

      1. Maureen

        Thanks for the link, Rich. This is a whopper of a story. And if one looks a little further into Richard Blum’s holdings in CBRE, one finds — no surprise — that, under scrutiny, Blum Capital reduced its holdings last September to under 5% (14.7M shares). An article states that this is the first time Blum Capital’s holdings have been below 20M since 2006. 2006 just happens to be the year that the congressional bill passed, as discussed in the linked interview, which virtually forced the U.S. Post Office into bankruptcy. The liquidation, which privatizes historic and other post office properties, is taking place under the media radar.

        1. sd

          Friendly reminder – Perini construction got one of the early 2003 no-bid contracts in Iraq. At the time, Blum held a significant position with the company.

          Feinstein is about as corrupt as they come.

  4. jake chase

    Unfortunately, the entire idea of bank capital and asset valuations is simply fantasy. You would have to incarcerate every bank executive in every mega bank, and every important partner in every accounting firm, perhaps in every law firm. When does fantasy end and fraud begin? I am not saying that this post is not technically correct. It may be. But the ultimate culprit is the Basel regime of bank regulation, coupled with central bank coddling of bankers, all of which has been designed specifically to enable bubble blowing and executive looting and nothing else. No doubt Khouzami will be scapegoated for this, but he is only a bit player. Call me when you go after Dimon or Rubin or the celebrities from BofA or Wells Fargo whose names I have never bothered to learn.

    1. JamesW

      jc, a usual, makes some excellent points, but I would qualify several:

      “..the entire idea of bank capital and asset valuations is simply fantasy.”

      True, a bank buys an instrument based upon debt on the asset side, the issues an instrument based upon that asset/debt-based instrument, on the liability side, and on it goes…certainly, a chained-fantasy stroy.

      “When does fantasy end and fraud begin?”

      When they design and rig that fantasy to “award” themselves with untold wealth while destroying the savings, homes, equity, individual wealth and any hope for progress of the the peoples of this and many other countries.

      “But the ultimate culprit is the Basel regime of bank regulation..”

      Possibly, but I would submit that those who actually own the banks and other major corporations (at this point the typical member of that most ignorant of consumers, the American, chimes in with, “..but it’s the pension funds and the rest of us who own the banks…”) — who owns JPMorgan Chase, and Morgan Stanley, and GE and AT&T/Verizon?

      Their wonderful crime today is they’ve managed to game everything that the typical doofus American consumer, formerly citizen, hasn’t a clue who actually owns anything today. Last I heard, the du Pont family owned GM — has that really changed?

      Every time Congress has put together a committe to address the financial structure of foundations and trusts (established in 1913, the same time they passed the legislation for the Fedeal Reserve Act, the 16th Amendment and the oil depletion allowance), the super-rich manage to insert one of their lackeys to misdirect any real investigation (ref: the Peterson Commission on Foundations and Wright Patman’s research into trusts and foundations).

      “Call me when you go after Dimon or Rubin…”

      Contact me, when anyone plans to go after the Rockefeller family (especially David), the Morgan-Schilling family, the du Pont-Donaldson family, the Mellon family, the Koch family, etc.

  5. pws

    It wasn’t stupid for the banks to back a pro-banker Republican candidate. It’s true that the Republican party is a party of corruption these days, but there was always the chance that some Republican candidate, in a quest for personal power (the presidency is a big prize) might take on obvious, glaring, disgusting corruption like this in a quest for the White House.

    While in practice the Republican party is one of the corruption oriented parties in our country, in theory they don’t have an ideological commitment to corruption.

    The banks couldn’t take a chance, and they already had the measure of Obama (who is pretty well stewed in his own corruption at this point to be able to act freely).

  6. Conscience of a Conservative

    Arguably the heads of banks could be invaluable inside places like the Fed , SEC or other regulatory bodies. Unfortunately the benefits are reduced by the weight of compmorises they took along the way.

    As far as Deutsche Bank is concerned, what we see is once again they fail to address tail risk and when confronted with that tail risk either engage in fake regulatory arbitrage or outright lying and firing those who take a proper stance.

    Time to make banks more subject to market forces and not engage in the kabuki theater done with their regulators.

  7. charles sereno

    Bankers are not stupid. Not that kind of “politics” stupid. They went for Romney with a wink and a nod, and everyone important knew it. Ironically, Khuzami wasn’t shuffled up particularly because of his prior relationship with the Kaiserin (Deutsche Bank, Welfare Queen), but it may yet prove his downfall (cf, Petraeus).

    I try not to abuse this space at NC and may I be forgiven. We are all indebted to Eric Ben-Artzi.
    Finally, thanks so much, Yves, for pursuing this.

    1. JamesW

      “Bankers are not stupid.”

      Ha! I beg to considerably differ — I’ve met plenty of not only idiotic banksters, but plenty of completely ignorant CEOs, COOs, etc., who only know how to offshore jobs and investment, and that’s ALL they know how to do.

      The concept of effient business operation and amortization is so far beyond them it’s pathetic!

      Many of those laid-off bankers at the smaller banks are clueless as to the causes of the economic meltdown — truly, truly stupid.

  8. Hayek's Heelbiter

    Herr Josef (Ackermann), the former president of Deutsche Bank and acting head during the period under investigation, skated on his Mannesman/Vodafone mischief, against far, far toothier prosecutors. Escaping a bought-and-paid-for examination by a gumless and gormless SEC head and close friend will be an easy cakewalk for him.

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