"The Berkshire Trade": How Deutsche Bank Conspired To Conceal A $1.6 Billion Loss

On a day when Frankfurt's most problematic lender was already in the headlines  for its internal deliberations about how to shield itself from the operational and reputational blowback should the President of the United States default on $340 million in loans, a team of investigative reporters from the Wall Street Journal stunned readers by publishing a fascinating, if embarrassing for the German lender, story about a losing bond trade that cost the bank some $1.6 billion over ten years, and would have never been disclosed had it not been for some impressive financial sleuthing.


According to the WSJ, not only did Deutsche magnify its losses by waffling over what to do about the trade, but senior managers at the bank also signed off on efforts to try and conceal losses from regulators and the public by shuffling what insiders at the bank nicknamed "the Berkshire Trade" off of the bank's trading books and concealing it in the opaque "non-core operations unit" - aka Deutsche's "bad bank," a sort of Pet Cemetary for the bank's most toxic assets. Because the trade involved illiquid municipal bonds, the bank had a lot of leeway in how to value the position and whether to even disclose it (it didn't). But when insiders started to question the bank's internal figures, and managers were finally forced to recokn with the magnitude of the losses, panic apparently set in, and attention immediately shifted to how the bank could cover it up. Soon, KPMG, the bank's auditor, also started asking questions, and the bank hatched a plan to "reclassify" the trade to free up reserve capital - though it was scuttled by legal.

Eventually, the bank arrived at a "Godfather"-style solution: Moving all its toxic assets to the "bad bank."

Around that time, Deutsche Bank’s financial auditors from KPMG LLP raised questions about whether the bank had set aside sufficient reserves for the bond positions, according to people involved in the matter. In December 2011, Deutsche Bank managers reassured KPMG, partly through a 14-page white paper. The paper, reviewed by The Wall Street Journal, argued that the bank was doing a good job surveying the market and estimating municipal-bond recovery and default probabilities. A KPMG spokesman declined to comment.

Within months, the valuation debates sparked an internal bank investigation. Some executives hatched “Project Marla,” a plan to reclassify the bond investment as a “financial guarantee,” eliminating its day-to-day price volatility on the bank’s books. The bank would move the bond portfolio out of its trading book and into loans and receivables. Legal and accounting objections inside the bank scuttled the plan.

In the fall of 2012, an assessment by Deutsche Bank of other Berkshire-insured municipal holdings suggested the bank’s valuation was off-base. The bank boosted reserves to about $161 million at year-end.

Late that year, Deutsche Bank unveiled a so-called bad bank, called the noncore operations unit, to wind down or sell positions that were troubled or expensive to maintain. It contained hard-to-sell assets including the Cosmopolitan Las Vegas casino, structured real-estate loans and many opaque derivative positions. The municipal-bond investment went onto the pile.

When the position was finally liquidated in 2016, the resulting loss was nearly four times its entire 2018 profit - and the biggest loss in the bank's history. And - most shocking of all -  neither the bank's auditors, nor regulators, nor management forced the bank to disclose it to the public and its shareholders aside from some casual mentions.

The bet, a package of municipal bonds and associated derivatives that the bank bought during the runup to the financial crisis, was referred to as "the Berkshire Trade" by insiders because, in March 2008, the bank bought $150 million in additional default protection from Berkshire Hathaway as a hedge.

WSJ's account of the investment is based on interviews with more than a dozen insiders and hundreds of pages of documents related to bank valuation policies. Despite all of that research, the reporters weren't able to pinpoint the exact nature of the "Berkshire Trade".

Though they offered a few hints: Back in 2007, while Greg "I am short your house" Lippman was putting on the big housing-market short that would one day make him famous, Deutsche was buying a portfolio of muni bonds that reads like a laundry list of some of the most regrettable muni-bond market blowups (though, of course, hindsight is 2020): New Jersey public transit, California public schools, public works in Puerto Rico.

In 2007, Deutsche Bank bought the roughly $7.8 billion portfolio of 500 municipal bonds, which funded schools in California, public works in Puerto Rico and transportation projects in New Jersey, among hundreds of other uses. The bonds were insured by specialized “monoline” insurers to protect the bank against defaults by the issuers.

Then the financial crisis took hold, sowing concerns about whether municipalities would make good on their bond obligations—and whether insurers would be strong enough to cover potential defaults.

The trade, which was soaking up hundreds of millions in capital every quarter, eventually became a major headache for former DB CEO John Cryan.

On May 17, 2016, top Deutsche Bank executives met in Frankfurt, Germany, for an update on the noncore unit. The biggest obstacle to lessening risk was the municipal-bond portfolio. It was tying up at least $400 million in capital that could have been used elsewhere, and getting worse, according to internal estimates. Executives including then-CEO John Cryan wanted the position gone by the end of June, when the bank would close its books on the second quarter.

Mr. Cryan privately fumed about the position, citing it as a prime example of trades that tied Deutsche Bank’s hands and demanded precious capital and attention from traders, lawyers and accountants long after any hope of profit had evaporated, according to people involved in discussions about the position.

That summer, the bank finally dumped the position. On its second-quarter earnings call that July, Mr. Cryan referred obliquely to the transaction. “In early July, we successfully unwound a particularly long-dated and complicated structured trade, which was the largest single legacy trade” in the noncore unit, he said. He didn’t specify the amount of the loss.

When the position was liquidated and the bank started a discussion with regulators about whether it should restate past quarterly results, it was eventually decided that no revisions were necessary.

Bank executives, the supervisory board’s audit committee and external advisers all were involved in the decision not to restate financial results, and the bank shared results of the review with regulators, said one person briefed on the process.

Setting aside the fact that the WSJ has exposed bank executives - including the now-departed Cryan - dissembling in their efforts to conceal the losses from public scrutiny, the story may also shed some light on Deutsche's involvement in all of those interest-rate and FX-rigging scandals: Deutsche can't trade its way out of a paper bag.