Articles Posted in Derivatives

Deutsche Bank has agreed to pay a fine of $55 million to settle charges by the SEC that it filed misstated financial reports during the height of the global financial crisis relating to a multibillion dollar portfolio of derivatives.

The SEC’s multi-year investigation culminated in an Order Instituting a Settled Administrative Proceeding, available on the SEC’s website. According to investigators, the bank overvalued a portfolio of derivatives consisting of Leveraged Super Senior (“LSS”) trades, through which it purchased protection against credit default losses. This leverage created a “gap risk”, which the bank initially took into account in its financial statements, by adjusting down the value of the LSS positions. However, according to the SEC’s Order, when the credit markets started to deteriorate in 2008, Deutsche Bank steadily altered its methodologies for measuring the gap risk. Each change in methodology reduced the value assigned to the gap risk until Deutsche Bank eventually stopped adjusting for gap risk altogether. In other words, the bank slowly tweaked its formula over the months so that the risk didn’t show in its financial reports.

Therefore, “at the height of the financial crisis, Deutsche Bank’s financial statements did not reflect the significant risk in these large, complex illiquid positions”, according to Andrew J. Ceresney, Director of the SEC’s Division of Enforcement.

Reuters reports that Morgan Stanley’s annual 10-K, filed March 2, 2015, indicates that the New York Attorney General intends to file a lawsuit related to 30 subprime securitizations sponsored by the company. This follows lawsuits and similar allegations by attorneys general in California, Virginia and Illinois. The New York Attorney General indicated that the lawsuit would allege that Morgan Stanley misrepresented or omitted material information related to the due diligence, underwriting and valuation of loans and properties. In the 10-K, Morgan Stanley stated that it does not agree with the allegations.

Morgan Stanley also reached a $2.6 billion agreement in principle last month with the U.S. Department of Justice and the U.S. Attorney’s Office for the Northern District of California to resolve claims related to what it called “residential mortgage matters.”

It remains to be seen whether investors will reap any of the benefits of these government actions seeking to mend the damage done by the subprime mortgage crisis and the proliferation of mortgage-backed securities (MBS), residential mortgage backed securities (RMBS), and collateralized debt obligations (CDOs).

Fraud in the privately traded markets? Aline van Duyn of the FT wrote a fascinating piece over the weekend about the lessons of the Galleon case going much wider than stocks. We agree. Next wave of large and complex fraud will be in non-exchange traded products. Here is the piece.

Lessons of Galleon case go wider than stocks

By Aline van Duyn in New York

Over-the-counter (OTC) derivatives can be scary. Derivatives may pose an unsuitably high amount of risk for non-institutional investors yet are being sold by dealers around the world to investors who do not clearly understand the products.

According to Reuters yesterday, U.S. Representative Stephen Lynch said that “taking a ‘soft approach” to regulating OTC derivatives would be a mistake, but that appears to be the direction lawmakers are leaning.” Representative Lynch further said “by allowing a significant part of the derivatives market to just go off unregulated … we’re setting ourselves up to fail.”

After the meltdown of 2008 and 2009, now is the opportunity to address the concerns related to OTC derivatives. Hopefully, Representative Lynch’s perspective will prevail and public investors will be further protected.

Over-the-counter (OTC) derivatives are very complicated investments. OTC derivatives are sometimes defined as contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. They include swaps (such as credit default swaps (CDS)) and interest rate, currency and commodities contracts. The OTC market is supposedly made up of banks and other highly sophisticated parties such as hedge funds. Then why have OTC derivatives been sold to less sophisticated investors? Good question.

The U.S. Secretary of the Treasury, Tim Geithner, announced last week the Obama Administration’s broad plan on regulatory reform of OTC derivatives. Much of the news coverage focused on the systemic risk portions of Mr. Geithner’s memo. However, the last section of the memo stated that Treasury’s objective is also “ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.” This is a very important mandate.

Our firm represents investors who were improperly sold various over-the-counter derivatives without the requisite risk disclosure made by the parties selling them. OTC derivatives fraud cases have become more and more prevalent as the OTC market mushroomed to greater than $600 trillion in notional amount in 2008. There is no room for fraudulent misrepresentations in this extremely complex market. Investors should be wary. Let’s hope the government follows through on its objectives and protects investors from the risks posed by OTC derivatives.

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