Deutsche Bank’s Buffett Bond Valuation Brought to Light Nearly Two Decades Later
The banking titan Deutsche Bank has announced a previously unreported decade-long loss of $1.6 billion on a complex municipal-bond investment that it purchased prior to the 2008 financial crisis and “failed to confront head-on even as markets were upended and regulations tightened” (Strasberg & Morgenson, 2019). This signifies one of Deutsche’s largest losses from a single wager and is approximately four times as large as the bank’s profits in 2018, dubbing it one of the industry’s “biggest soured bets” over the past decade. For years the bank decided against reducing the value of these bonds and associated derivatives, disregarding financial auditors’ concerns. Although the bank raised billions of dollars in capital markets and boasted of its sound and stable financial controls to investors, it failed to disclose the mounting issues in bond valuation. Internally, the soured bet was noted on statements incrementally, perhaps to reduce appearances of financial risk. Nine years after the bond purchase, the bank finally liquidated the position. In addition to Deutsche executives, both external advisers and the supervisory board’s audit committee resolved that the giant should not restate financial results. Interestingly, financial regulators were made aware of the bond valuation issue; yet, policy remained unchanged.
In regards to valuing trading positions held on the books—specifically those that are difficult to trade, or “illiquid”—banks have a large amount of latitude in recording losses. This is not the first time that Deutsche has been accused of mislabeling illiquid holdings. The German lender paid $55 million in 2015 to resolve allegations made by the Securities and Exchange Commission. The SEC maintained that during the height of the 2008 financial crisis, Deutsche lowballed the risks involved in complex derivative positions by about $1.5 billion to $3.3. billion and misstated subsequent financial statements. While the bank neither admitted nor denied the allegations, it defended that it failed to update the market value of the transactions for it believed that there were no sound valuation measures within the illiquid markets of the crisis. Additionally, in April of 2015, Deutsche paid a $2.5 billion penalty to settle British and U.S. allegations that the institution rigged the London interbank offered rate, referred to as Libor, as well as other financial benchmarks. It was purported that Deutsche allowed employees to tweak rates in order to benefit their trading positions. The bank’s tampering induced a chain of skewed interest rates, for rates such as Libor are used to determine the rates of corporate loans, complex financial derivatives, and mortgages. In fact, it was not until mid-2013 that the bank finally decided to implement formal preventative policies against aforementioned misconduct. In the past, Deutsche has been criticized for failing to fully comply with the request of U.S. and British authorities, heightening suspicions and fueling further skepticism surrounding the bank’s activities.
Further, Deutsche purchased nearly $7.8 billion in 500 municipal bonds in 2007. The portfolio funded hundreds of endeavors, including public works in Puerto Rico, transportation projects in New Jersey, and schools in California. Although the bonds were insured by “monoline” insurers—who assumed responsibility for principal and interest payments upon the default of the borrowers—the eruption of the financial crisis created concern about whether municipalities would fulfill bond obligations and if insurers would be capable of covering defaults. Deutsche purchased additional protection against default from Warren Buffett’s Berkshire Hathaway on March 26, 2008. The bank spent $140 million upfront on the “Berkshire trade,” a deal which involved derivatives called credit-default swaps, or credit derivative contracts. Around 2011, the bank’s financial auditors from KPMG LLP questioned whether its $115 million reserve was substantial enough to cover potential bond losses. Despite speculation, managers at the institution insisted that Deutsche was accurately estimating default probabilities and municipal-bond recovery through careful surveying of market conditions.
Regardless of management’s assurances, in the fall of 2012, internal investigation revealed that the bank’s valuation was off-base, resulting in reserves being increased to $161 million by the end of the year. Deutsche Bank adopted a “bad bank” corporate structure in order to segregate its high risk and illiquid assets, including the Berkshire municipal bond-investment, from financially sound investments. By reducing the risk of capital-draining assets, the bank aimed to protect its operations, enhance transparency, and bolster investor certainty in the shaky institution. Deutsche hoped that the bad bank would signal its repositioning towards stricter regulatory controls and a slimmer corporate structure.
Even though the bank raised $3.3 billion after issuing a new round of shares in April 2013, the municipal-bond portfolio continued to raise concerns. As a matter of fact, Deutsche valued the credit default swaps at nearly $1 billion less than Berkshire Hathaway’s valuation, forcing reserves to rise to $579 million by the end of 2013; however, even these funds were insufficient in covering the risky bond positions. As of 2016, internal reserves accumulated to over $1 billion which, according to internal risk and valuation managers, was not a large enough sum to remedy the trade.
Deutsche executives gathered in Frankfurt, Germany on May 17, 2016 to discuss the status of bond liquidation with the non-core operations unit. The municipal-bond portfolio’s opportunity cost was estimated at $400 million, increasingly tying up unfathomable amounts of capital. John Cryan, the bank’s CEO at the time, warned that the portfolio had to be gone before Deutsche closed its books for the second quarter at the end of June. Finally, in the summer of that year, Deutsche Bank rid itself of the potentially fatal bond position. Mr. Cryan, who was fired in April of 2018, commented that “in early July, we successfully unwound a particularly long-dated and complicated structured trade, which was the largest single legacy trade.” Under the control of CEO Christian Sewing beginning in 2018, Deutsche executives continued to debate whether past financial results linked to the municipal portfolio needed to be restated. The bank, once again, decided against it. Deutsche has not disclosed the exact details regarding its losses. While the “Berkshire trade” debacle appears to be resolved, who knows what other secret securities Deutsche Bank may be hiding.
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Strasburg, J., & Morgenson, G. (2019, February 20). Deutsche Bank Lost $1.6 Billion on a