Deutsche Bank AG DB is set to pay $55 million to U.S. Securities and Exchange Commission (SEC) to settle claims that it had hidden at least $1.5 billion in paper losses during the worldwide financial crisis. Per the SEC order, amid the global financial crisis, Deutsche Bank’s overvaluation of certain Leveraged Super Senior (LSS) trades led to misrepresentations in the bank’s financial statements for full-year 2008 and first-quarter 2009.
Apart from the monetary penalty, the SEC order requires the German banking giant to cease and desist from committing any violations and any future violations of securities rules.
In Brief
Deutsche Bank purchased credit protection from certain Canadian counterparties in the period between 2005 and 2006 in the form of bespoke synthetic collateralized debt obligations (CDOs). The company purchased around $98 billion of LSS tranches of over 30 CDOs. The bank was required to account for its LSS positions as derivative instruments to be measured at fair value.
The LSS trades were leveraged around 11 times, reflecting that the Canadian counterparties posted collateral of around 9% of $98 billion purchased protection. This leverage created a ‘Gap Risk’ as the market value of the trade could surpass the value of the collateral.
As an owner of the protection, Deutsche Bank was eligible to receive a payment in the event of significant credit default losses in the underlying securities. Hence, the value of LSS increased when the market crashed during the financial crisis. Consequently, the Gap Risk increased in the LSS trades.
Deutsche bank employed various methods to ascertain the Gap Risk in the LSS trades. The changing methodologies began in 2008 and reduced the value assigned to the Gap Risk. Further in Oct 2008, the bank stopped adjusting for Gap Risk altogether and ultimately valued the Gap Risk at zero dollar.
Deutsche Bank argued that it had ceased to measure the Gap Risk as there were no proper methods. However, the SEC stated that there were methods that could measure the Gap Risk. Notably, for the purpose of investigation, the SEC staff calculated the bank’s Gap Risk to be at least $1.5 billion for 2008 and first-quarter 2009. Further, Deutsche Bank estimated the Gap Risk outside financial reporting in the range of $1.5 billion to $3.3 billion.
Per the SEC order, “Deutsche Bank’s deficient internal accounting controls contributed to Deutsche Bank’s failure to adequately assess the Gap Risk, resulting in the misstatement of its financial statements.”
Deutsche Bank, on the other hand, neither accepted nor denied the allegations. The bank said, “The SEC acknowledged the bank's cooperation throughout the investigation, and did not bring any charges against individuals in this matter.”
Bottom Line
We remain encouraged by the company’s efforts on gradually resolving legal issues. The latest settlement is unlikely to impact Deutsche Bank’s financials. Further, the settlement will put to rest a long-drawn investigation and bring reprieve to the company.
However, this wouldn’t end the company’s legal woes. Among other issues, the company is under investigation by regulatory and law enforcement agencies globally in relation to the misconduct concerning the manipulation of foreign exchange rates.
Deutsche Bank currently carries a Zacks Rank #3 (Hold). Some better-ranked stocks in the foreign banks space include UBS Group AG UBS, HSBC Holdings plc HSBC and Erste Group Bank AG EBKDY. All these stocks sport a Zacks Rank #1 (Strong Buy)
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