Oh man, what is going on in this FT article? Here is the bottom line:

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.

The “in effect” does a lot of work there; Deutsche Bank “in effect” hid billions of dollars of losses because there were no losses. Other than that!

Here’s a synopsis of what seems to have been going on:

  • Starting in 2005, Deutsche did some credit trades where they bought protection from some Canadian pension funds and sold protection to hedge funds, etc.
  • The bought and sold protection were not identical, with various technical bits of non-overlap that you can read about at your leisure down below.1
  • A credit crisis occurred, changing the risks involved in those non-overlapping bits from silly, abstract, purely theoretical risks into significantly more alarming and more-likely-to-occur but still purely theoretical risks.2
  • Deutsche’s people sort of ran around dopily trying to figure out what to do about it. Here’s a condensed version of the running around they did about the main risk, the “gap option” that DB was short in its leveraged super senior trades:

[T]he 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 … 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. … Then, in October 2008, … 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. … At this time, to account for the gap risk, the bank hedged it by buying S&P “put” options.

  • They got through things just fine since after all they’d basically bought protection against world-ending correlated defaults in investment-grade companies and those defaults didn’t happen:

“The valuations and financial reporting were proper, as demonstrated by our subsequent orderly sale of these positions,” Deutsche says. … A person familiar with the matter says that for all the sturm und drang over gap risk, at no time was the collateral jeopardised.3

  • No harm, no foul, but still a little scary, so after things settled down they did what they could to beef up their risk management for the next crisis, including hiring Eric Ben-Artzi, a math Ph.D. who’d worked at Goldman, in 2010.
  • Among his other talents, Ben-Artzi had at Goldman used models for some of these risks that were (1) more justified by the theoretical literature and (2) more conservative.
  • Then he went around being a dick about how they’d handled their risks ages ago – “For several months, Mr Ben-Artzi quizzed colleagues at Deutsche on how it modelled the gap option.”
  • In 2006-2008 mind you. That is, for several months in 2010, this guy was quizzing people about the quality of their work during the financial crisis several years ago, when he wasn’t there.
  • You’d have fired him too.
  • They did.
  • He went to the SEC, as did two other former DB employees, alleging that the various kerfuffling on the Deutsche correlation desk amounted to accounting fraud.

So: did it? I don’t know. Is that an interesting question? Not really? A bank is just a collection of contracts entitling it to future cash flows in various states of the world; you don’t really know what those contracts are worth until those states of the world obtain, so you don’t really know what a bank is worth, ever. I submit that that – not “ooh they mismarked the gap option by $12 billion vs. the preferred model in the literature” or whatever – has to be your starting point in thinking about bank accounting.

When you start there, your accounting is pretty much “whatever the rules say and your auditors allow.” Some things get marked to an objective market even if that makes you sad – the publicly traded stocks in your cash equities trading book, for instance. Some things get marked to historical cost, with some fudge-y reserve, even if that looks crazy – your whole-loan mortgages, for instance. There are good arguments that banks should mark more things to market, and there are good arguments that they should mark fewer things to market.

But some things live in a level-3 world where there are no specific rules and no obvious markets and you rely on good faith and estimates and conversations with your auditors. Tailored credit derivatives where Deutsche Bank was “65 per cent of all leveraged super senior trades” clearly fall in that bucket, so they talked to their auditors and the auditors signed off on what they did and, that’s kind of the end. Was the model (or series of ad-hoc models and reserves and absences-of-models) blessed by the auditors worse than Ben-Artzi’s? Sure! But so what? The model blessed by the auditors for loans – “hold them at historical cost” – is clearly worse than a market-based model, in the sense of “less reflective of the expected probability distribution of future cash flows.” And loans are the bulk of most banks’ assets. Accounting isn’t supposed to be a correct representation of your most likely future cash flows. It’s just accounting.

But this isn’t just a story about accounting. Here’s the FT on Ben-Artzi and the gap option:

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.

Now he’s a “whistleblower” so this is all expressed in terms of booking and accounting but it isn’t fundamentally that. It’s really a question of trade selection. If you just ignore this way-out-of-the-money gap option, then this trade is free money,4 and you will do it all day long. If you value it using customary theoretical principles, you will do it for a much smaller portion of the day. (If you value it using Nassim Taleb principles,5 you will take the other side of it.) There’s a reason Deutsche Bank was 65% of this market, and Goldman was … not.

And, y’know, good for Goldman, bad for Deutsche.6 Banks are supposed to take only economically justified risks, rather than just picking up proverbial pennies in front of proverbial steamrollers. Also: good for Deutsche for hiring Ben-Artzi to fix it, and bad for them for firing him. And probably bad for him for spending his time bashing around quizzing people about the past instead of preparing for the next crisis. I guess he’s not alone in that: regulatory, journalistic, and whistleblower-compensation incentives all point towards making this a story about “accounting fraud in the past,” rather than a story about “how banks should manage their risks in the future.” The crisis-era-accounting story seems to me like a much less interesting, and less useful, story.

Deutsche Bank: Show of strength or a fiction? [FT]
Deutsche hid up to $12bn losses, say staff [FT]
The Deutsche allegations [Reuters / Felix Salmon]
Update: The ghost of the leveraged super senior [FTAV / Lisa Pollack]

1. The ones named in the FT article:

  • The Canadian pension funds didn’t have to fully collateralize their trades; they were ~10x levered. This means that on a gap up in credit spreads, Deutsche would still be on the hook on its sold protection, but the Canadians might walk away from Deutsche’s now-undercollateralized bought protection. The article refers to this as the “gap option” because in effect the pension funds were long an option to walk away: the contract gave them risk of loss from 30 to 100 (or whatever), but since they only had to post 10 of collateral the CSA in effect gave them risk of loss from 30 to 40 (or whatever). That’s a put option and you can value it using models similar to the ones you use to value the tranche in the first place.
  • There was name mismatch: “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.” Maybe they’d be correlated, maybe not.
  • There was a quanto risk: DB bought protection in Canadian dollars and sold it in US dollars, meaning that if spreads widened as USD strengthened vs. CAD, DB would owe more USD on its sold protection while getting fewer USD in from its Canadian counterparties. There is something to be said for this:

2. The simple way of supporting “still purely theoretical” is that the bought protection was all leveraged super senior tranches and so DB didn’t have to care about collateral mismatches, etc. unless there were actually a lot of defaults on the names it had bought protection on. There’s no list of those names – these were custom tranches apparently – but, come on. A quick look at CDX NA IG 5 on Bloomberg (CDX IG CDSI S5 10Y Corp MEMC) shows only 11 companies (CIT Group, Constellation Energy, Countrywide, Duke Energy, Freddie Mac, Fannie Mae, IAC, Knight Ridder, Radioshack, WaMu, XL Group) whose CDS are no longer trading; most of these are mergers rather than, y’know, WaMus. Even if they were all credit events, though, that’s under 10% of an equally-weighted index; on a 30-100 tranche that has no effect. I mean it has a mark-to-market effect obvs, but not a final payout effect.

3. WAIT: is “sturm und drang” an FT interpolation, or do people at Deutsche Bank really talk like that? Please let them talk like that. Also: if you’re German, is “sturm und drang” just a normal everyday thing to say? Like, “ugh, my commute was a nightmare, there was all sorts of sturm und drang on the Q this morning.”

4. The option has a value equal to $X. A Canadian pension fund will pay you $X for it. You will book its value at $0. You have made $X of free money. QED.

5. I feel like that link needs a NSFW warning.

6. You could I suppose ask the contrarian question: was DB’s model worse than Ben-Artzi’s and Goldman’s? I mean, setting aside that DB didn’t seem to have a model so much as a series of uncoordinated guesses. DB modeled the chances of blowing through its collateral on these trades at, roughly, zero; and it didn’t blow through its collateral on these trades. Was its probability wrong? Oh, sure, I mean, go read this paper about estimating that probability; I won’t stop you. But at the end of the day it kind of looks like (1) Deutsche Bank thought it could buy credit protection a little cheaper by including a gap option in the contract, (2) it thought that gap option would not turn out to have any value at expiry, and (3) it was right on both counts. So Goldman, Ben-Artzi et al. shouldn’t be too smug. The job of a bank is not to impress quantitative-finance researchers.

Also, DB isn’t alone. Here’s a passage from the FT about another of the risks here:

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.

So, yeah: what dolts DB were, totally ignoring the possibility that the quanto risk would cost them more than $3 billion! But here’s how I’d do the math on that probability. If the losses exceed $3bn, then Berkshire is on the hook for $3bn. It got paid $75mm. Think what you will about Warren Buffett’s sagacity as a trader of derivatives,a but: How likely is it that Berkshire would agree to a contract that had a high probability of requiring it to pay out 40x what it got paid in premiums?b I submit to you that if Deutsche bought first-$3bn protection from Berkshire for $75mm, that first $3bn of protection was worth less than $75mm, which makes the next, like, $100bn of protection worth really not that much at all.c

a. Also about the likelihood that he was personally involved in negotiating this trade.

b. I know, I know, home insurance or whatever, but there’s not really a portfolio effect here.

c. Ooh, don’t put too much stock in that last bit of pseudo-math. Correlation! Fat tails! Etc. Still.

Comments (48)

  1. Posted by juniormistmaker | December 6, 2012 at 10:35 AM

    Jesus Christ Matt. At 9:30 in the morning?!?

  2. Posted by gUEST | December 6, 2012 at 10:36 AM

    The fuck, Matt?? Don't you know that no one likes to have to think at work in December?

  3. Posted by Bob Slidell | December 6, 2012 at 10:36 AM

    They "fixed" the glitch… So these things will just kinda naturally even itself out….

  4. Posted by agreatdaytothink | December 6, 2012 at 10:41 AM

    I bought really expensive protection against 6 footnotes (and smugly thought I was smart), but totally left myself exposed on the fat tail chance of footnoted footnotes. Ben-Artzi would not be impressed with me.

  5. Posted by guest | December 6, 2012 at 10:44 AM

    I think the issue is less whether the model was right or wrong and more whether model selection was determined by PNL needs, rather than justified in some way ex-ante. Interesting data point is that in the credit market I trade most actively, DB has very often been a BUYER of gap-risk via structured CDS, and they always seem to pay up for it. The reason they give is that they have taken on even larger amounts of this gap risk (at what they perceive as very favorable levels), and they need to demonstrate internally that they are valuing it correctly by showing an actual trade where they sell it. So they look to do a smallish trade for marks-justification purposes. Not so in the case of the IG LSS trades, though, and it is not unfair to ask why…

  6. Posted by Edmond_Dantes | December 6, 2012 at 10:52 AM

    1) Deutsche proudly wins 'World's Most Systemically Important Bank'
    2) They hire a chief risk officer from Goldman
    3) They fire him for asking too many questions about the 12 billion in losses they hid
    4) Why would anyone trade with these guys?

  7. Posted by PippyLongSausage | December 6, 2012 at 11:01 AM

    No lie Matt, I learned a lot from reading that. Will take a deeper look later on but nice work dude.

  8. Posted by agreatdaytothink | December 6, 2012 at 11:06 AM

    Well…

    CMBS tranched 13%-20% pricing moved from 100 to < 10 between 2007 and early 2009. Internal valuations team and desk spent signficant time debating the collateral, and on average marked portfolio to 80. Current market pricing has risen now to low to mid 70s.

    1) I think Chief Risk Office is a bet generous of a title
    2) These guys always doom-gloom, which is why its a good idea to placate them with dollars to make end-of-world macro bets
    3) Market implied tails, especially in a credit/liquidity crises are almost always priced too cheaply, and in a normal boring market ~50% time priced too cheap

  9. Posted by Guest | December 6, 2012 at 11:15 AM

    Almost as bad as Jay Dweck.

  10. Posted by MP. | December 6, 2012 at 11:23 AM

    Matt might be the best financial writer in the game right now. No joke.

  11. Posted by HighFrequencyHater | December 6, 2012 at 11:28 AM

    This.

    The accounting part of this is far less consequential than the fairly obvious fact they were buying risks that they had only tenuous grasp of pricing. The interesting part is that auditors were supposed to check the market to market process around that time, I'm not quite sure how they got them to sign off on model-> meh, call it 15% haircut -> what risk?

    Nothing inspires confidence like "fuck it, lets just get some ES puts and we'll be flat".

  12. Posted by NiceTruckThough | December 6, 2012 at 11:28 AM

    * Mark to model

  13. Posted by Hobbes | December 6, 2012 at 11:32 AM

    Matt, please remove your dick from my brain.

  14. Posted by ahhh yes | December 6, 2012 at 11:33 AM

    mark to imagination

  15. Posted by ABC | December 6, 2012 at 11:59 AM

    So how much would a whistle-blower get if "guilty"?

  16. Posted by guest | December 6, 2012 at 12:20 PM

    Matt, meet me at Minetta's. I'll be wearing cutoff sleeves and dripping with red sauce

    - CG

  17. Posted by fft | December 6, 2012 at 12:24 PM

    No, we don't go around saying sturm und drang. It's more like something you read in a mid-level periodical written by the equivalent of a Barnard/Oberlin grad.

    -Not German, but a fan of their work

  18. Posted by PermaGuestII | December 6, 2012 at 12:29 PM

    Bravo, Matt. Great post.

    A thought on a high level. Deutsche was ridiculously levered going into 2008: something like 40x, iirc, which is Lehman-esque. Should any of us really be surprised that they may have done some in retrospect dodgy things with their marks when the schiesse hit the fan?

  19. Posted by Guest | December 6, 2012 at 12:47 PM

    Awesome use of the word kerfuffling … golf clap

  20. Posted by Turnip Truck | December 6, 2012 at 12:49 PM

    Let's not bicker and argue about 'oo killed 'oo…

  21. Posted by History | December 6, 2012 at 1:00 PM

    "And probably bad for him for spending his time bashing around quizzing people about the past instead of preparing for the next crisis."

    Reviewing past fuck-ups counts as preparing for the next crisis.

  22. Posted by Lalala | December 6, 2012 at 1:06 PM

    What about those people at zeroh…. Where do we send you your gold medal?

  23. Posted by Guest | December 6, 2012 at 1:07 PM

    Reward for doing your job aggressively as trader: $$
    Reward for doing your job aggressively as risk officer: STFU or GTFO

  24. Posted by Inquisitive WASP | December 6, 2012 at 1:19 PM

    I wonder how Nervous Jew feels about all of this German risk taking?

  25. Posted by What does it mean? | December 6, 2012 at 1:21 PM

    So some guy from GS shows up and promptly begins throwing it in everybody's face how much more about derivatives he knows than they do and gets fired… Matt does the same and it's oddly enjoyable.

  26. Posted by Guest | December 6, 2012 at 1:24 PM

    Good Shit Matt, some of your best work for sure. I like how you zoom out to really ask what a bank "is" before you try to answer the question–the frame is as important as the answer and helps guide it.

    GOOD SHIT. Keep this up!

  27. Posted by 2 cubes over | December 6, 2012 at 3:08 PM

    concurred.

  28. Posted by der Gast | December 6, 2012 at 3:33 PM

    Not to lowbrow this comments string, but does anyone else think in this picture Jain looks like he may have also ignored his wife and kids until they went away?

  29. Posted by Guest | December 6, 2012 at 3:36 PM

    A well-written and entertaining article, but just flat wrong.

    No, it's not "just accounting". Accounting is intended to communicate to the owners of the company and to the government what the financial condition of the company is. If it's not doing that, what's the purpose of having any accounting at all? If it's not doing that because it's deliberately being distorted, then the owners and the regulators are being lied to. That's a problem.

    The "let's not worry about the past, let's just look to the future" sentiment is also way off. The unspoken message is: as long as the bank doesn't fail, you can get away with whatever you'd like, because nobody's going to go back and dig into the books. That's a formula for reckless behavior and shameless accounting fraud.

    Also, how many words and no mention of Sarbanes-Oxley?

    On the plus side, the "who knows how much a bank is worth anyway" and "let's just let bygones be bygones" attitude should good over pretty well in interviews for an open position with Citigroup's office of general counsel.

  30. Posted by Dooshbank | December 6, 2012 at 3:58 PM

    Or they were buying risk they had a (correct) directional view on. If that view was dictated by immediate PnL concerns they have a bigger problem than over-simplistic models. Otherwise, its not like DB was the only bank doing prop trades with the basis risk on their hedges. And $10bn of (notational) credit exposure to a basket of IG corporates (7 post-Buffet) is probably lot more along the lines of what a bank should do than $5bn of exposure to IG credit spreads.

  31. Posted by Guest | December 6, 2012 at 4:01 PM

    It's not a loss if you don't realize its a loss

  32. Posted by UBS Compliance MD | December 6, 2012 at 4:41 PM

    Uhm, don't think Sarbanes-Oxley is relevant here genius, in case you didn't know "Deutsche" means "German" i.e. not American, so no SOX jurisdiction, good try though champ.

  33. Posted by bankster | December 6, 2012 at 6:31 PM

    you sure about that MD? they have securities issued here and file with the SEC. According to SEC:

    Over 1,300 non-U.S. corporations from 59 countries file reports with the SEC. … Currently, approximately 30 German corporations report to the SEC — the largest ones being … Deutsche Bank.

    Of course, Sarbanes-Oxley generally makes no distinction between U.S. and non-U.S. issuers. The Act does not provide any specific authority to exempt non-U.S. issuers from its reach. The Act leaves it to the SEC to determine where and how to apply the Act's provisions to foreign companies.

  34. Posted by oki | December 6, 2012 at 6:38 PM

    Matt, why work here when you could be the General Counsel for every SIFI in the world? “Hey, by gone by baby, we are still here right”

  35. Posted by NonUBS Compliance MD | December 6, 2012 at 6:51 PM

    Sarbanes-Oxley applies to any company that trades on a U.S. exchange. Deutsche Bank trades on the NYSE (DB). Sarbanes-Oxley therefore applies.

    You'd think you'd have had time look that up since getting laid off.

  36. Posted by septic | December 6, 2012 at 7:20 PM

    Many of the marks were based on if you were long or short in 08. The accountants probably waited for the fees cheque to clear before signing off the accounts.

    What IS impressive is that DB kept it secret. If this news had got out at the time Lehmans tanked, the world would be a different place today.

    In defence of DB, with the latest news that BaFin was fully aware of their creative valuation techniques we can imply that DB had a German Government Guarantee.

  37. Posted by 3Q12 | December 6, 2012 at 7:52 PM

    *was* ridiculously levered?

  38. Posted by Wannabe quant | December 6, 2012 at 8:37 PM

    *grumble* *grumble* leveraged super senior synthetic CDO gap option pricing *grumble* *grumble*

    - grad student that actually has to write a synthetic CDO pricer this weekend and is actually reading the risk.net article

  39. Posted by yabba dabba | December 6, 2012 at 10:50 PM

    My model is better than your model. Management made judgements based on their considered judgement. This guys models werent law. They werent policy. They werent even real time. You made a case. You were over ruled. You were wrong. Get over it. And stop taking yourself do seriously.

    These quants got us into this mess. Got the Whale fired. Btw. Who ran this trade and where is he today
    And idid he make money on a stupid cdx unwind.? These honest men to be outed as shamans. And sent back to doing theoretical math papers. Dont let them be air traffic controllers

    .

  40. Posted by J. Cassano | December 7, 2012 at 7:30 AM

    Right on! I should be able to mark stuff anywhere I want. As long as I'm never forced to sell below that price, or suddenly blow up and need a massive government bailout, everybody wins! What you don't know can't hurt you.

  41. Posted by Wertzberger | December 7, 2012 at 8:52 AM

    When you sell protection, and you hedge by buying a swap from, lets say, citi bank. Shouldn't you calculate the risk (the price of citi cds) of Citi defaulting?

  42. Posted by guest | December 7, 2012 at 11:23 AM

    2nd

  43. Posted by agreatdaytothink | December 7, 2012 at 11:58 AM

    Probably not, because who is being a counterparty in a non-collateralized derivative with Citi?

  44. Posted by guest | December 7, 2012 at 12:31 PM

    ummm…he's zoomed out on only half the picture. the other side of a bank's balance sheet is its liabilities & equity. banks have deposits and debt that have to be paid at par–they are a concrete liability that have to be paid. so it does matter in fact what the valuation range of a bank's assets are, because these assets are what cover the deposits and debt. if in a downside case the 12bn loss leaves assets dangerously close to not covering the bank's liabilities, then depositors and bondholders get worried. they will pull their liquidity. the bank has to pay them cash, and they do this by liquidating assets, perhaps realizing the huge unrealized loss on their assets.

    just because you cannot 100% accurately value a bank's assets, doesn't mean you should try (or are not obligated to as a fiduciary obligation) to provide an educated range of what that valuation might be. deposit holders and bondholders do care.

    in the financial world unrealized gains and losses matter. the fact that hedge funds charge 20% performance fees on unrealized gains should prove that. the fact that bank runs happen based on unrealized losses prove that as well.

  45. Posted by Bob | December 9, 2012 at 9:33 AM

    Horribly written article. Look at intent. Any time you change accounting standards for a trade when something goes wrong, it is criminal…. Period.. End of story. As a derivatives trader myself… The fact that some entity within Buffetts empire wrote an option after "the gap move of all gap moves" does not mean that they were not managing that risk and hedging accordingly. Were they ripping DBs face off? probably. If we rely upon accounting firms, auditors, and regulators to unearth these instances…. We're all dead the next time. The author should consider a class in ethics 101.

  46. Posted by Perry O | December 10, 2012 at 6:27 AM

    Things would be a little more relaxed if banks (or money for that matter) were abolished… A bit too late for that though

  47. Posted by Album Releases | February 6, 2013 at 2:41 PM

    Great article! I love discovering new album releases!

  48. Posted by London Accountants | April 8, 2013 at 6:34 AM

    Good stuff.