The U.S. Securities and Exchange Commission is ordering Deutsche Bank AG (DB) to pay $55M to resolve charges accusing the firm of misstating financial reports during the peak of economic crisis. The regulator believes that the financial institution did not factor the material risk for possible losses of billions of dollars.
According to the regulator, in its order instituting a resolved administrative proceeding, Deutsche Bank overvalued a derivatives portfolio the bank had used to buy protection against losses involving credit default. Due to the to the Leveraged Super Senior trades’ “leveraged” nature the collateral for the positions was minimal compared to the $98 billion in purchased protections.
This generated a “gap risk” that the protection’s market value could potentially go beyond the available collateral. Also, because the sellers that put down the collateral could choose to unwind the trade instead of putting more collateral down in such a situation, this meant that technically the bank was protected only up to its collateral level and not its credit protection’s full market value.
The SEC says that at first, Deutsche Bank factored the gap risk into financial statements by dropping down the LSS positions’ value. However, when the markets began to fail in 2008, the firm modified the way it measured the gap risk. Each change implemented lowered the value given to the risk until the bank stopped making adjustments for it at all. For purposes of financial reporting, this meant that Deutsche Bank was no improperly valuing LSS positions and treating its protection as if it were fully collateralized. Internal calculations, however, determined that the gap risk was anywhere from $1.5 billion to $3.3 billion during this time.
By settling, Deutsche Bank is not denying or agreeing to the SEC’s findings. It maintains that it didn’t update the market value of the transactions because it didn’t think there was a reliable means to measure them when there were illiquid market conditions at the time of the financial crisis. It said that it has since improved its policies, internal controls, and procedures related to illiquid asset valuation.
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Read the SEC Order (PDF)
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