Deutsche Bank "overstated" the value of a multi-billion-dollar portfolio of sophisticated derivatives during the height of the financial crisis, leading it to file inaccurate financial statements for at least a six-month stretch, securities regulators in the United States said on Tuesday.
The bank, without admitting or denying it did anything wrong, agreed to pay a $55 million penalty to the Securities and Exchange Commission to settle allegations that its "inadequate internal accounting controls" violated federal securities law. (Tweet This)
The settlement closes the door on a five-year investigation into allegations raised in part by former Deutsche Bank employees that the bank mispriced assets held in a large portfolio of derivatives in order to hide potential trading losses in the credit markets during the financial crisis.
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The settlement is one of the last remaining investigations arising from the financial crisis and sheds further light on the frantic activities that went on behind the scenes at big banks as they wrestled with the fallout from the collapse of Lehman Brothers in September 2008 and the near-collapse of the American International Group, the giant insurer.
Deutsche has long denied the allegations and in a statement released on Tuesday, the bank noted there was no industry standard at the time of the crisis for measuring risk in the derivative's portfolio. In the statement, Deutsche said it had cooperated with regulators throughout the investigation and said the settlement "will have no impact on previous financial reports."
The bank said the valuation dispute arose because the bank "did not believe there was a reliable method" for measuring risk in the portfolio given the turmoil in the financial markets in late 2008 and early 2009.
But the S.E.C. in a 13-page cease-and-desist order said that while valuing assets like the kind in the portfolio is "complex," Deutsche made an "unreasonable" decision to stop calculating the so-called "gap risk" for the portfolio as the crisis unfolded in fall 2008. The S.E.C. said that "by failing to properly address gap risk," the bank "overstated the fair value" of the its leveraged super senior trades.
Gap risk is defined as the risk that the leveraged trading positions in the portfolio would exceed the value of the underlying collateral and potentially created added exposure for the bank.
"Because areas of complex valuation, such as these, require the exercise of judgment, they also necessitate strong internal accounting controls in order to arrive at reasonable valuations for financial reporting purposes," the order said.
The S.E.C. settlement order, which is densely written and discusses things like "bespoke synthetic collateralized debt obligations" and "asset-backed commercial paper conduits" shows just how complex some of the trading on Wall Street was during the run-up to the financial crisis.
And it might explain why regulators brought so few cases involving valuation of assets and complex securities, even though many of the investment banks that needed government bailouts to survive had too many hard-to-value and hard-to-trade securities on their balance sheets.
Securities regulators began looking into Deutsche's handling of the portfolio of complex derivatives in 2010, which were contained in the bank's credit correlation book. Within the bank, the portfolio with a notional value of $120 billion was sometimes referred to as the "exotics book," because many of the derivatives were linked to the value of complex securities. Some of the trading in the portfolio was done to hedge the bank's exposure to potentially risky corporate bonds, leveraged loans and commercial paper as well as make trades for the bank's own account.
The investigation has dragged on for so long that Deutsche says it has since wound down the vast majority of the portfolio — once one of the largest credit correlation portfolios on Wall Street — by closing out positions in the credit markets.
The investigation was aided by at least two whistle-blower actions filed by former Deutsche employees who outlined some of the activity of the bank and how it was misvaluing the derivatives in its credit correlation book. News of the investigation and the involvement of one whistle-blower was first reported by Reuters in 2011.
The whistle-blowers, Matthew Simpson and Eric Ben-Artzi, and their lawyers have argued that the misvaluing of the derivatives portfolio masked the truth financial health of Deutsche during the midst of the financial crisis. Mr. Ben-Artzi has argued that the flawed valuations effectively helped the bank hide billions of dollars in losses and avoid the need for a potential bailout from the German government.
It is not clear whether Mr. Simpson and Mr. Ben-Artzi, both of whom provided documents to regulators and were interviewed several times by investigators, will be entitled to collect a portion of the settlement money the bank is paying.
The settlement did not allege any wrongdoing by individuals at the bank.
In late 2013, the Federal Reserve Bank of New York, in a move potentially related to the misvaluation of the derivatives portfolio, sent a letter to Deutsche directing it to fix long-standing deficiencies in its financial reporting procedures. At the time, Jordan Thomas, a lawyer for Mr. Ben-Artzi said the Fed's findings were consistent with some of the allegations raised by his client.
The bank in its statement said that since the financial crisis it "has enhanced policies, procedures and internal controls regarding the valuation of illiquid assets."