By Bob Ivry, Jody Shenn and Michael J. Moore - Apr 13, 2011 Bloomberg Opinion
Deutsche Bank AG (DBK), whose bets against subprime mortgages helped it weather the financial crisis, pressed to sell a $1.1 billion collateralized debt obligation to clients in 2007 as the co-head of its CDO team foresaw a market slump, a U.S. Senate panel found.
“Keep your fingers crossed but I think we will price this just before the market falls off a cliff,” Michael Lamont, the group’s co-head, said in a Feb. 8, 2007, e-mail about Deutsche Bank’s Gemstone CDO VII Ltd., according to a report released yesterday by the Permanent Subcommittee on Investigations. The Frankfurt-based firm sold $700 million of the instruments, which lost most of their value within 17 months.
The bi-partisan panel, led by Michigan Democrat Carl Levin, placed Germany’s biggest bank in a spotlight alongside Goldman Sachs Group Inc. (GS), saying that the firms’ creation and sales of mortgage-backed investments “illustrate a variety of troubling and sometimes abusive practices.” The “case study” also focuses on Greg Lippmann, Deutsche Bank’s then-top CDO trader, who led its bets against subprime home loans and described some Gemstone VII collateral as “pigs” and “crap.”
“The bank sold poor quality assets from its own inventory to the CDO,” according to the report. Then “the bank aggressively marketed the CDO securities to clients despite the negative views of its most senior CDO trader, falling values, and the deteriorating market.”
Internal Disagreements
CDOs package assets such as mortgage bonds and buyout loans into new securities with varying risks.
Lamont, who now works at New York-based hedge fund Seer Capital Management LP, declined to comment. So did Lippmann, 42, who left Deutsche Bank last year to start LibreMax Capital LLC, an investment firm based in New York.
While Lippmann’s trades yielded a $1.5 billion total return, the bank’s other executives long disagreed with his assessments. The firm’s New York-based residential mortgage- backed securities group and one of its London hedge funds amassed home-loan positions that reached a market value of more than $25 billion in 2007, the panel said. The company, led by Chief Executive Officer Josef Ackermann, 63, lost almost $4.5 billion on the mortgage-related investments that year after Lippmann’s gains.
“There were divergent views within the bank about the U.S. housing market,” Michele Allison, a spokeswoman for the company, said in an e-mailed statement. “Moreover, the bank’s views were fully communicated to the market through research reports, industry events, trading-desk commentary and press coverage.”
Biggest Trading Gain
Lippmann, whose bets against the housing market were also described in Michael Lewis’s “The Big Short,” had repeatedly tried to warn co-workers and clients in 2006 and 2007 about the poor quality of the mortgage securities underlying many CDOs, according to the report. The return on his bets against mortgages “was the largest profit obtained from a single position in Deutsche Bank history,” he told the subcommittee.
Disagreements among executives were common in firms across Wall Street as the mortgage market began to unravel, said Edward J. Grebeck, chief executive officer of Tempus Advisors, a debt- consulting firm in Stamford, Connecticut.
“I’m surprised the subcommittee’s report is focused only on Deutsche Bank and Goldman,” he said. “You could investigate any bank that put together structured products and look for conflicts.”
Hearings
Levin and Senator Tom Coburn of Oklahoma, the panel’s top Republican, held public hearings on the financial crisis last year, examining regulatory failures, the collapse of Washington Mutual Inc., the role of credit-rating firms in fueling bets on high-risk debt and the business practices of New York-based Goldman Sachs and rival investment banks.
Deutsche Bank underwrote 47 CDOs with a combined value of $32 billion from 2004 to 2008, according to the subcommittee. It made $4.7 million in fees from Gemstone VII, the report said.
The panel faulted the bank throughout Gemstone VII’s creation and sale. Nearly a third of the mortgages backing the CDOs were originated by three subprime lenders -- New Century Financial Corp., Fremont General Corp. and Washington Mutual Inc.’s Long Beach mortgage unit -- known for the poor performance of their loans, the report said.
While Deutsche Bank had “the right to reject” securities that were slated for Gemstone VII, Lippmann allowed bonds he viewed as toxic to be included, according to the report. He told the panel his responsibility was only to ensure that bonds bought by the CDO were priced accurately based on current market values, and an e-mail from him showed he sought to reduce the valuation of one.
Demand for Debt
About $27 million of the CDO’s assets came from the bank’s own inventory, including one bond that Lippmann referred to by asking another trader in an instant message, “DOESNT THIS DEAL BLOW,” according to the report.
“The way the politicians use these e-mails is to hang them out as evidence that misconduct occurred, but there is in fact a market for low-quality credit paper,” said Roy Smith, a finance professor at New York University’s Stern School of Business in Manhattan. “There has been for years, and the market is very legitimate.”
After assets set aside for Gemstone VII dropped in value, Abhayad Kamat, a member of the CDO group assembling the vehicle, told a Deutsche Bank sales team to use valuations from the CDO manager, Dallas-based HBK Capital Management, rather than from the bank’s traders, the report found. HBK’s values were 1.1 percent higher.
‘Significant Vintage Risk’
When a member of the sales group asked about the decision, Kamat responded in an e-mail that the values “we got from Jordan are too low,” referring to Jordan Milman, then a trader on Lippmann’s team, according to the report. He emphasized that the salespeople should identify HBK as the source of the valuations, the report said.
Kamat didn’t return telephone messages seeking comment.
The Senate panel said that Lamont’s group prepared an internal report listing risks to the bank from the deal that cited the 88 percent concentration of the CDO’s portfolio in 2005 and 2006 residential bonds without highlighting the “significant vintage risk” in disclosures to investors.
‘A Lot Bumpier’
“E-mails reviewed by the subcommittee show that CDO personnel at Deutsche Bank were well aware of the worsening CDO market and were rushing to sell Gemstone 7 before the market collapsed,” the report found. In a message on Feb. 20, 2007, the day before Gemstone VII was priced, Lippmann told Lamont that the CDO market was “going to get a lot bumpier very soon.”
Lamont, in his earlier e-mail that month about keeping “fingers crossed,” suggested turmoil may also present a buying opportunity. A plunge, “as usual will likely find you well- positioned to acquire new risk at a good price,” he wrote in the message to HBK’s collateral manager, who had authority to move assets in and out of the CDO. “We are all focused on pricing as soon as possible.”
Deutsche Bank failed to sell $400 million of the CDO’s slices. Buyers included M&T Bank Corp. (MTB), based in Buffalo, New York, and Charlotte, North Carolina-based Wachovia Corp., Frankfurt-based Commerzbank AG (CBK) and Standard Chartered Plc (STAN), based in London, according to the report. They lost “all or most of their investments,” the subcommittee said. Wachovia is now part of San Francisco-based Wells Fargo & Co. (WFC)
To contact the reporters on this story: Bob Ivry in New York at bivry@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net; Michael J. Moore in New York at mmoore55@bloomberg.net.
To contact the editors responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net; David Scheer at dscheer@bloomberg.net; Gary Putka at +1-617-210-4625 or gputka@bloomberg.net.
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