Sunday, December 9, 2012

Colin Lokey looks at Deutsche Bank and the $12 billion loss that never was

In a Seeking Alpha article, Colin Lokey provides a detailed examination of Deutsche's handling of its credit default portfolio and the $12 billion loss that never was.

There are a number of key takeaways from this article that should be familiar to regular readers including:

  1. Had the details of the trades been disclosed, the market could have assessed the value of the positions;
  2. In the absence of ultra transparency and disclosure of the trade details, investors are at a 'hopeless disadvantage' when it comes to evaluating the risk of firms like Deutsche; and
  3. Investors should avoid investing in firms like Deutsche that do not provide ultra transparency.
From the article,
In fact, [former Deutsche risk manager Matthew] Simpson's claims -- which eventually found their way to the SEC in the form of a Sarbanes-Oxley whistleblower case -- revolve around the routine mismarking of credit positions in a deliberate attempt to inflate profits and bonuses, according to the Financial Times.
Enter Eric Ben-Artzi, the PhD mathematician and former quantitative analyst at Goldman hired by Deutsche in 2010 to model risk. On November 4, 2011 Ben-Artzi filed the SEC whistleblower complaint at the heart of last week's controversy surrounding Deutsche Bank and its crisis-era derivatives book. 
common refrain this past week was that the trades at issue "are complicated"; that valuing those positions was a "very complex" exercise. The implication here is that the average investor shouldn't concern himself with such matters let alone opine on the merits of Ben-Artzi's claims; these things after all, are best left to the experts. The problem with this is that Ben-Artzi is the expert. 
Ben-Artzi modeled "gap risk" (the point of contention underlying the whole fiasco) at Goldman and based on this experience determined that Deutsche's failure to account for the gap option in its book of leveraged super senior securities (effectively the bank was treating the securities as if they weren't leveraged) allowed the bank to hide some $10 billion in paper losses between 2008 and 2010..... 
"When credit spreads deteriorate, [Ben-Artzi] 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."
Ben-Artzi determined, based on the model developed by Goldman, that the gap option risk was in this case worth some $10.4 billion, enough which, if recognized, might have caused the bank's tier one capital to fall below the government-mandated 8% causing Deutsche to require a government bailout.
You can see why Ben-Artzi found it unconscionable that Deutsche would not account for this in their treatment of the leveraged trades. It's not a matter of protecting your interests, it's a matter of presenting an honest assessment of your financial condition to shareholders....
This point cannot be emphasized enough.  We are talking about honestly presenting the financial condition of Deutsche.
In sum, I would encourage readers to be skeptical of analysis which seeks to exonerate Deutsche on the grounds that marking its book to market would have caused the firm to collapse. Here is an example of this type of argumentation from Felix Salmon
"'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." 
He continues: 
"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. 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."(emphasis mine) 
In my opinion, this sort of analysis is egregious.  
You do not get to choose when to take writedowns based on whether or not you think your balance sheet can withstand the blow. 
Besides being outrageously counterintuitive, this flies in the face of accrual based accounting and the matching principle. 
Furthermore, how can investors be expected to make informed choices when the companies they are evaluating are hiding losses behind the scenes because now doesn't seem like a convenient time to recognize them?
Please re-read the highlighted text as Mr. Lokey nicely summarizes why regulatory forbearance should never, ever be adopted.

By definition, allowing financial firms to hide their losses means that investors cannot make informed choices.

Without the ability to make an informed choice, the capital market for banks freezes.  The interbank lending market proves this point as it froze at the beginning of the financial crisis and has not thawed since.
There are two takeaways here. 
First, as I have noted before, the average investor is at a hopeless disadvantage when attempting to evaluate the merits of an investment in a major bank. 
Second, investors should steer clear of Deutsche Bank's shares. Even if you don't believe the firestorm surrounding this issue will have a meaningful effect on the bank, no one should voluntarily take an ownership stake in a company devoid of transparency on positions as large as that in question.
I would like to thank Mr. Lokey for eloquently making the case for requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

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