
Deutsche Bank Ignored Its CDS Problems Until They Went Away - dsri
http://www.bloombergview.com/articles/2015-05-26/deutsche-bank-ignored-its-cds-problems-until-they-went-away
======
Daneel_
Every time I think I know a little bit about economics, I read articles like
this and realise I'm playing with wooden blocks while the big boys are playing
with space shuttles. ...except they made the space shuttle out of wooden
blocks, and they're just pretending _really_ hard that it's going to work.

~~~
mathattack
If you have a small group of brilliant computer scientists, they can create
world changing software. How many folks were required to get Snapchat or
Youtube off the ground?

What happens when this level of genius in small groups is cut loose on
financial markets where "Make money is the only goal"? You get these space
shuttles. They are so complex because that's all these people ever think
about.

~~~
adwn
> _If you have a small group of brilliant computer scientists, they can create
> world changing software. How many folks were required to get Snapchat or
> Youtube off the ground?_

Snapchat is world changing and the work of brilliant computer scientists? Did
I miss something? I can only hope that your post was intended to be sarcasm.

~~~
ccvannorman
I think the meaning is "It only takes a small high powered team to 'change the
world'/add tremendous value if they have skills and a good idea." Snapchat is
one example of many.

------
Aloha
I hate to use a redditism here, but could someone ELI5 this for me?

I got lost somewhere around the first appearance of the word tranch,

~~~
ianpurton
In the financial markets you can buy insurance such that if a company fails
e.g. Microsoft, you get a payout. It's called a credit default swap.

Deutsche bank sold lot's of this type of insurance.

If the markets had turned and some large companies had gone bankrupt they
would not have had the means to pay the people who bought this insurance.

Basically they took very low quality insurance and re-packaged it as high
quality insuarance.

~~~
Zigurd
Excellent explanation. CDSs are insurance. So why can't you buy the equivalent
product from an insurer, labelled and regulated as insurance? Because the
capital requirements under insurance regulation would have been prohibitive.

So why weren't the banks charged with illegally selling insurance products
and/or violating insurance regulations? Because fuck you, peon.

------
dunkelheit
The insurance in question would only pay off under some very improbable and
dire circumstances. And under these circumstances the chances of getting a
payoff are rather slim because, you know, the world is crashing and burning.
Some time during the crisis the risk became very real which was reflected in
the market prices of credit protections. But DB and "investors" continued to
act as if the risk was small.

What I don't get is who paid for that risk in the end. I suspect it was the
government which bailed everyone out with public money so that the doomsday
scenario was never realized.

------
webtards
The money moves around and around and around (notionally) a dizzyingly large
number of times because the more opaque the process and end product, the less
immediate introspection it receives, the less well the average Joe can
understand it, and the firm can continue 'alchemy'. Kudos to the regulators
for the arduous task of unravelling the large ball of string and following it
to the conclusion!

~~~
wpietri
It reminds me a lot of large code bases. At some point people face a choice
between a) forcing sufficient simplicity and clarity that one has a chance of
understanding what's going on, and b) saying "fuck it" and letting complexity
metastasize to the point nobody really understands what's going on.

The difference, of course, is that with software the opaqueness is pure cost.
Whereas in the financial markets the opaqueness is often a profitable resource
from somebody.

------
th3iedkid
Long time back i was studying Asset Backed Commercial Papers (ABCP) as a
special purpose vehicle conduit and its effects on market runs during the
financial crisis.

For those who want to understand it , these might possibly help(These are only
personal notes.):

[part 1][https://medium.com/finance-and-economics-studies/read-
note-o...](https://medium.com/finance-and-economics-studies/read-note-on-
asset-backed-securitization-special-purpose-vehicles-and-other-securitization-
issues-a715f980bb1c?source=latest)

[part 2][https://medium.com/finance-and-economics-studies/asset-
backe...](https://medium.com/finance-and-economics-studies/asset-backed-
securitization-special-purpose-vehicles-and-other-securitization-
issues-98e7ad3231f9)

------
randomname2
Deutsche Bank is hardly a bank in the traditional sense considering their
balance sheet. With $72.8 trillion euro in derivative exposure (the largest in
the world, 21x the GDP of Germany) this will have to blow up in a spectacular
fashion once one of these counterparties fail:

[http://imgur.com/MNECKC4.jpg](http://imgur.com/MNECKC4.jpg)

A former Kansas Fed president called them "horribly undercapitalized", with a
leverage ratio of 1.63 percent:

[http://www.reuters.com/article/2013/06/14/us-financial-
regul...](http://www.reuters.com/article/2013/06/14/us-financial-regulation-
deutsche-idUSBRE95D0X620130614)

~~~
cm2187
The notional amount doesn't tell you anything meaningful in term of risk. Say
I am Deutsche, you are Citi. I trade a €1bn 10 year interest rate swap with
you and then another €1bn 10 year interest rate swap with you in the opposite
direction. The risk is exactly zero (the two transactions will be netted to
zero in case of an insolvency) and the cash flows will perfectly offset each
others. We each have €2bn of notional of derivatives outstanding.

Banks like Deutsche aren't in the business of taking large directional
derivative bets. They are market makers so the quasi totality of these 72
trillions are offsetting positions, which are mostly collateralised, i.e. each
counterparty has to post assets to match the evolution of the value of the
derivative in order to keep the credit exposure minimal.

With such a massive book, there will be residual risks all over the place but
72 trillion is a meaningless number for assessing them.

~~~
randomname2
Yes, gross derivative exposure is irrelevant... until there is a breach in the
counterparty chain and suddenly all net becomes gross (as in the case of the
Lehman bankruptcy), such as during a financial crisis.

Perhaps rather than total notational outstanding, a more meaningful number is
the amount of real assets this is all backed by. According to the IMF we have
$600 trillion in gross notional derivatives backed by a $600 billion in real
assets, i.e. 1000x systemic leverage:

[http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf](http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf)

One can imagine this to become just a tiny bit problematic once collateral
chains start breaking, such as when "AAA-rated" AIG failed :)

~~~
cm2187
Your exposure is not the notional, it is the mark-to-market minus any
collateral received or posted. This will be a small fraction of the notional.

~~~
randomname2
Well the point still stands... in case of an "event" that blows up collateral
chains, Deutsche will be in big trouble.

Also, interestingly, from the piece I quoted, a lot of these derivatives get
to be created without any collateral being posted at all:

"Another important metric is the under-collateralization of the OTC market.
The Bank for International Settlements estimates that the volume of collateral
supporting the OTC market is about $1.8 trillion, thus roughly only half of
exposures. Assuming a collateral reuse rate between 2.5-3.0, the dedicated
collateral is some $600 - $700 billion. Some counterparties (e.g., sovereigns,
quasi-sovereigns, large pension funds and insurers, and AAA corporations) are
often not required to post collateral. The remaining exposures will have to be
collateralized when moved to CCP to avoid creating puts to the safety net. As
such, there is likely to an increased demand for collateral worldwide."

~~~
arjunnarayan
> Well the point still stands... in case of an "event" that blows up
> collateral chains, Deutsche will be in big trouble.

Not for bilateral derivatives that can always be netted, even in bankruptcy,
which make up the bulk of the notional outstanding. If you read the ISDA
Master Agreement[1], derivatives can always be netted as there is a provision
that exempts derivatives from the usual bankruptcy automatic stays to stop
literally this exact threat you posited [2]. Even beyond the bilateral case,
the multilateral cases are increasingly cleared through central
clearinghouses[4]. But even when they aren't, multilateral nets can still be
pushed through, in one of two ways: 1) even when Lehman failed, there were
some multilateral nets that greatly reduced the exposure, under mutual
agreement by all creditors, and 2)The Dodd-Frank Act, since 2009, has also
greatly helped this, giving the FDIC and Fed enhanced powers under the Orderly
Liquidation Authority[3], which allow them to multilaterally net to reduce
contagion risks even if there is no such master agreement that a priori would
have let them do so[5].

[1]
[http://en.wikipedia.org/wiki/ISDA_Master_Agreement](http://en.wikipedia.org/wiki/ISDA_Master_Agreement)

[2] A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives
and Repurchase Agreements, by Duffie and Skeel, alternatively see [3], or [4]

[3]The New Financial Deal: Understanding the Dodd-Frank Act and Its
(Unintended) Consequences by David Skeel.

[4] The Risk Controllers by Peter Norman.

[5] Even pre Dodd-Frank, when there wasn't a law that let this happen, usually
the creditors come together and fix things, a la LTCM "bailout"[6], which was
funded entirely by the creditors and unwound in an orderly fashion through
multilateral netting. Bear Stearns and Lehman Brothers were the only creditors
that stiffed everyone else, by refusing to participate, and that was partly
why they got fucked in 2009 since the other bankers remembered their
unwillingness to help out in 1998, and reciprocated.

[6] I hate that this is called a Bailout. No taxpayer funds were spent. The
creditors (i.e. big banks) bailed out one of their own by pooling together
money and fixing their shit. The only governmental involvement was that the
Fed president called the CEOs of the big banks and said "yo fix your shit
before it spreads", and they did. That's not a bailout in the sense of
"taxpayers bailed them out". They bailed themselves out.

------
zemanel
Off topic but this reminded me of a movie i saw last year, "Blackbox BRD"
([http://en.m.wikipedia.org/wiki/Black_Box_BRD](http://en.m.wikipedia.org/wiki/Black_Box_BRD))
which relates to Deutsche Bank past and has an interesting interview with a
high level staff (Bank president?) and found it curious to glimpse on how they
think (or thought).

------
dba7dba
Ignoring problems until they went away? Sounds like my IT department...

------
PhantomGremlin
I love Matt Levine's articles. He's good at simply explaining the arcana of
Wall Street.

But when I read this article, I can only say one thing: Why?

Why is Wall Street spending all this time and energy in creating all these
different securities? I suspect that any excess "profits" or "returns" to be
had from them accrue 90% to the bankers and 10% to the muppets funding them.
So why do the muppets keep playing this game?

~~~
zzleeper
To expand on the other replies, and based on experience:

1) The way you get to sell products to investors is by promising some sort of
alpha: "My fund is less risky, my derivative pays more for the same risk,
etc."

2) But magic does not happen in the financial markets (and when it does is
through the old stories.. diversification, transferring the risk to those of
broader shoulders, etc.)

3) So what you do is _HIDE THE RISK_. There are many ways to do that, and they
usually involve COMPLEXITY. Complexity and opacity are your friends, as they
confuse investors who don't realize there is a hidden risk somewhere there, or
a scenario you haven't told them (but put on page 350) where if A B and C
happen, then he will lose a lot of money.

I'm not joking here.. sometimes complexity is good as it allows you to e.g.
reduce mismatches in your risks (your income is in USD and expenses in EUR,
your debts are long term and assets short term, etc.). However, the ultimate
purpose of most complex products is that they allow you to sell stuff that
appears better than it really is. And IT WORKS. Everytime. Against
millionaires and against folks buying silly combos of insurances plus deposits
(forgot their names).

~~~
wpietri
And I would almost be ok with this if the complexity-generators understood all
their complexity and were using it as a great trick to steal money from
idiots. What really scares me is that a) even the complexity-generators can
easily miss potential issues, and b) when you throw all this complexity
together, nobody has any clue what's going on.

And then we wrap it up all with a bow by allowing finance people to
alternately claim that a) they are so smart they deserve to personally make
millions to billions, and b) they couldn't possibly be held accountable for
systemic fuckups, because nobody could possibly have known. I'll accept one or
the other, but the combination is incredibly dangerous.

