Deutsche Bank Fair Value Fakeout Didn’t Prevent Backdoor Fed Bailout

The Financial Times reported late this week on the failure of Deutsche Bank to recognize $12bn of paper losses on complex derivative transactions during the financial crisis. The bank’s objective was to avoid a bailout by the German government.

The bank may have avoided a bailout by the German government but, as information later obtained by Bloomberg and a team led by Phil Kuntz revealed, hundreds of banks, including Deutsche Bank, borrowed billions from the US Federal Reserve and various programs during this period.

The argument pushed by some columnists, and the bank itself, is that “all’s well that ends well” and the end justifies the means. Deutsche Bank survived without a German bailout and that’s a good thing. The global financial system was saved and investor confidence was maintained.

Let’s “den Mist hinter sich bringen“.

“Deutsche Bank AG, Germany’s biggest bank, navigated the financial crisis without capital injections from the German government. The Frankfurt-based bank, which in 2008 reported its first annual loss since World War II, wasn’t so shy about getting liquidity in secret from the U.S. Federal Reserve. The lender tapped the Fed for $66 billion on Nov. 6, 2008 — $28.2 billion from the Term Securities Lending Facility, $21.8 billion from single-tranche open market operations and $16 billion from the Term Auction Facility. John Gallagher, a Deutsche Bank spokesman, declined to say whether the bank took emergency loans during the crisis from other central banks, such as Germany’s Bundesbank.”

Deutsche Bank was in debt to the Fed for 439 days. At the peak, November 6, 2008, it owed $66 billion.  Average daily borrowing was $12.5 billion.

If investors had known at the time what Bloomberg found recently, and only via years of litigation over Freedom of Information Act requests, they may not have believed the bank’s no-bailout propaganda.

The allegations against Deutsche Bank were made by three former bank employees as whistleblowers to the US Securities and Exchange Commission.

Here’s the quick explanation from the FT:

All three allege that if Deutsche had accounted properly for its positions – worth $130bn on a notional level – its capital would have fallen to dangerous levels during the financial crisis and it might have required a government bail-out to survive.

Instead, they allege, the bank’s traders – with the knowledge of senior executives – avoided recording “mark-to-market”, or paper, losses during the unprecedented turmoil in credit markets in 2007-2009.

Two of the former employees allege that Deutsche mismarked the value of insurance provided in 2009 by Warren Buffett’s Berkshire Hathaway on some of the positions. The existence of these arrangements has not been previously disclosed.

A more detailed account of the accounting drags Deutsche Bank auditor KPMG into the mess:

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. Deutsche refused to say how big its reserve was but a person familiar with the matter says it was sufficient, and a more appropriate option for the market conditions of the time.

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.

More on KPMG and the accounting in my next post.