Back in May we brought you "The Real Story Behind Deutsche Bank's Latest Book Cooking Settlement," in which we detailed the circumstances that led the bank to settle claims it mismarked its crisis-era derivatives book to the tune of at least $5 billion.
Deutsche Bank settled the issue with the SEC for the laughable sum of $55 million a few months back.
The SEC inquiry was prompted, in part, by Dr. Eric Ben-Artzi who was fired from Deutsche Bank in 2011 after expressing his concerns about the bank's valuation methodology.
What follows is the real, play-by-play account of Ben-Artzi's dismissal from Deutsche Bank, told in its entirety for the first time.
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Your Services Are No Longer Needed
On November 7, 2011 Dr. Eric Ben-Artzi walked into a conference room at Deutsche Bank’s U.S. headquarters in lower Manhattan. Seated at a conference table was Sharon Wilson from the Human Resources department. Lars Popken, DB’s head of market risk methodology and Ben-Artzi’s manager, was videoconferenced in.
Ben-Artzi had just returned from FMLA paternity leave and although things had gotten tense just prior to his time off, he certainly didn’t expect what came next. Ben-Artzi’s job, Popken said, was being moved to Germany.
Ben-Artzi thought back to the summer when, in response to rumors that some U.S. positions were likely to be moved overseas, he had mentioned he’d be happy to relocate to Berlin. No such luck. Minutes later, he was terminated and Wilson hurriedly ushered him out of the building. Ben-Artzi wasn’t even allowed to collect his personal belongings.
The (Brief) Backstory
The events that ultimately led Deutsche Bank to boot Ben-Artzi from 60 Wall without so much as a cardboard box for his pictures, pens, and legal pads date back to 1998 and for the sake of brevity, we won't recount the whole story but encourage anyone interested in the entire narrative to review it here.
In short, Deutsche Bank was heavily involved in every single aspect of the market for third-party asset backed commercial paper in Canada prior to the financial crisis. They had an equity stake in the parent of at least two issuers, they served as a liquidity provider on over half of all Series A commercial paper issued by Canadian conduits, they sold the paper through their securities division, and perhaps most importantly, they structured the programs (e.g. LSS deals) that backed the paper. But in the simplest possible terms: Detusche Bank was deeply embedded in a market that collapsed in August of 2007.
As mentioned above, the events that unfolded between June and October of that year are a story in and of themselves, but suffice to say that the market for commercial paper issued by the Canadian conduits imploded on August 13, 2007 (BNP’s move to freeze three ABS funds four days earlier sparked a panic) imperiling retail investors, small- to mid-size corporations, and pension funds and triggering a massive (and incredibly messy) restructuring effort.
Most of this drama had ended by the time Eric Ben-Artzi arrived at Deutsche Bank in June of 2010 and the former Goldmanite likely had no idea what he was about to uncover when he began to look at how Deutsche went about accounting for their exposure to the Canadian conduits during the crisis.
Deutsche Bank played an outsized role in the market for LSS deals in the years leading up to the crisis. In fact, Deutsche Bank accounted for between $120 and $130 billion of the $200 billion (notional) in total LSS deals between 2005 and 2007.
When Ben-Artzi, who has a PhD in applied mathematics from NYU Courant, began to look at how the bank was valuing the gap option on the LSS trades, he made a rather disconcerting discovery.
As a refresher, here’s a simple explanation of the gap option problem with LSS deals:
The laughable thing about LSS deals was that they were effectively non-recourse, meaning that the protection seller was allowed to sell protection on a notional amount that was multiples of the collateral posted, but in the event the market moved against the seller enough to chew through that collateral and a margin call was made, that seller could just say “to hell with it” and walk away from the deal. More simply, I, the seller, insure $100 million in debt, but only post $10 million up front. If there’s a credit market meltdown and my $10 million is no longer sufficient and you, the protection (insurance) buyer, call me looking for more money to compensate you for the elevated risk, I can politely tell you to piss off. The risk that I tell you to piss off is called “gap risk.”
To be a bit more specific, the seller of protection (in this case the Canadian conduits) had the option to walk away from the deal without posting additional collateral (this is the “gap option”), and the value of that option changed depending on a number of factors including credit spreads and correlation.
As it turns out, Deutsche Bank began making these trades without even having a model to value the gap option -- standard models (e.g. a copula model) cannot be used for LSS trades. Not only that, the bank’s credit correlation desk didn’t even bother to consult the market risk methodology department (where Ben-Artzi worked and which was responsible for verifying the appropriateness of valuation models) and instead decided to simply discount the value of the trades by 15%. Sensing that this was likely inadequate, Deutsche briefly attempted to determine the actual value of the gap option on the trades, but when the numbers came back looking rather nasty, the bank did what any pre-crisis sell side firm worth its salt would do: they scrapped that model and went with something that made the results look more favorable. In this case, Deutsche simply set up the equivalent of a loan loss reserve for the entire book and called it a day. At the time (i.e. between 2007 and 2009), other players in the industry valued the gap option at between 2% and 8% of notional. Taking the midpoint there, and taking the midpoint between Deutsche’s estimated $110 and $120 billion in notional exposure, the value of the gap option for the bank would have been nearly $6 billion.
How Deutsche Bank Deals With 'Problem' Employees
Sometime around October of 2010, Ben-Artzi began to ask questions, starting with the Director and Head of Risk Research and Development. Discussions with management continued into the new year until finally, fed up with what he perceived to be an attempt to sweep the issue under the rug, Ben-Artzi contacted the SEC on March 7, 2011 and called Deutsche Bank’s employee hotline four days later.
On March 17, Ben-Artzi met with Robert Rice, then Deutsche’s Head of Governance, Litigation & Regulation for the Americas who said there was an ongoing investigation into some of the issues Ben-Artzi had raised. Later that month, Ben-Artzi suffered through a lengthy meeting with Rice and William Johnson, Deutsche’s outside counsel.
What’s important to note here is that Bob and Bill (as Rice and Johnson are known to their friends) weren’t exactly strangers. As it turns out, they both worked in the U.S. Attorney’s Office for the Southern District of New York with Mary Jo White and Robert Khuzami.
After his first stint in public service, Khuzami went on to become General Counsel to the Americas at Deutsche and by the time Ben-Artzi reported his concerns to the government in 2011, Khuzami had moved on to become Director of Enforcement for the SEC. Mary Jo White would of course become SEC Chair in 2013, and almost two years to the day after Ben-Artzi first met with Rice, Bob would be named Chief Counsel to White.
As such, Ben-Artzi was (and still is) essentially squaring off against a tight-knit faction of former attorneys for the Southern District of New York who have managed to turn the SEC into an extension of Deutsche Bank, much as Goldman has turned the Fed into an extension of the Vampire Squid. As an aside, Deutsche’s General Counsel Richard Walker worked at the SEC for a decade and served as Director Of Enforcement from 1998 until his move to join the bank in 2001.
On May 12, 2011, Ben-Artzi sat down to discuss the issue further with Rice and Matt Spaulding (then global head of finance for Deutsche). Also in attendance were two employees from the corporate and investment bank, Stefan Schafer and Andreas Kodell, both of whom had come over from London.
Maybe it was the jet lag, or maybe it was the fact that Ben-Artzi was essentially threatening to expose a multi-billion dollar "error" in the way the bank was valuing its LSS book, but whatever the case, Schafer and Kodell weren’t happy. The two proceeded to give Ben-Artzi a rather sharp tongue-lashing for questioning the bank’s valuation of the trades.
In the process, Schafer and Kodell did shed some light on Deutsche’s previous attempts to evaluate their exposure to the gap option. Unfortunately, they were unable to explain why Ben-Artzi’s calculations were incorrect and Spaulding was similarly unable to justify the bank’s initial use of a 15% haircut or explain how the subsequent decision to adopt a reserve against the trades was in any way sufficient. Lars Popken, who was also in attendance, remained surprisingly quiet.
On May 23, in a meeting that included Sharon Wilson from HR, Rice said Deutsche Bank would be providing no further information into how it valued the trades and suggested Ben-Artzi contact an SEC attorney.
At the end of that month, Popken assured Ben-Artzi that despite the controversy, no retaliatory action would be taken by the bank.
Ben-Artzi began his leave of absence on June 30 and returned to work on October 19.
Less than three weeks later, he was fired.
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If ever there was a story that exemplified virtually everything that is wrong on Wall Street surely this is it. Here we had one of the largest banks in the world by assets agreeing to facilitate leveraged bets in synthetic credit by Canadian special purpose entities which had virtually no equity whatsoever on their books. Deutsche knew the collateral for these bets came from the sale of commercial paper to clueless retail investors and pension funds, and not only did the bank not care, Deutsche actually encouraged the conduits to pile leverage on top of the posted collateral, creating an enormous amount of risk not only for the holders of the commercial paper, but for the bank itself. Deutsche then proceeded to guarantee the commercial paper in the event the market ceased to function only to refuse payment to noteholders when the market finally did collapse in August of 2007, leaving retail investors and pension funds out in the cold.
Meanwhile, the bank intentionally underreported its exposure by systematically refusing to model the gap option built into the trades and when someone honest finally came along and called them on their obfuscation, they summarily dismissed him.
Of course the punchline here is that convincing the SEC to acknowledge the sheer absurdity of the entire ordeal has been, and will continue to be well nigh impossible for the following reasons: 1) Robert Khuzami, the agency’s head of enforcement when Ben-Artzi’s complaint was filed, was Deutsche’s General Counsel to the Americas the entire time the bank was mismarking its LSS book, 2) Bob Rice, the SEC’s current Chief Counsel, was Deutsche’s Head of Governance, Litigation & Regulation during Ben-Artzi’s tenure at the bank, 3) the current SEC Chair, Mary Jo White, goes way back with both Rice and Khuzami as well as with Bill Johnson, Deutsche’s outside counsel at time of Ben-Artzi’s complaint, and 4) Deutsche’s current General Counsel worked at the SEC for 10 years, including a stint as chief enforcement officer.
In the end, all the boxes are checked. This story truly has it all: risky derivatives, leverage, the destruction of retail investors’ savings, hidden risk, the termination of honest employees, and the revolving door between Wall Street and the U.S. government.