Deutsche Reported to Set Aside $2.7 Billion in FX Legal Costs and Fines

Last week Deutsche announced that in total, it is facing 1,000 lawsuits with potential payouts above 100,000 euros. We reported here last week that Bafin, the German regulator, announced that the FX benchmark probe was "much, much bigger" than the LIBOR case.  Now Reuters reports that sources tell it that Deutsche is setting aside $2.7 billion to cover future FX fines and settlements.

Put these together and, while it is not certain what has been found so far in the internal and various regulatory investigations, Deutsche clearly believes that there will be substantial costs going forward of at least that amount.  Of course, this does not necessarily mean that Deutsche believes that they are guilty as they may feel that they are meeting accounting/legal requirements in recognizing these costs at this time.  However, throw in several FX traders that Deutsche has suspended during its internal investigation, and it is difficult not to lean towards the view that where there is smoke there is fire.

Bankers' New Clothes? Authors' New Clothes? Whose Clothes are Real?

The Bankers' New Clothes:  What's Wrong with Banking and What to Do about It

We've just finished this popular criticism of modern banking by Anat Admati and Martin Hellwig.  We pay the highest compliment (in our view) that a book of this type can earn:  the authors are right.  Well, backtracking just a bit, the authors are qualitatively right on their central point.

Admati and Hellwig have one clear and dominant message:  banks should have much more equity.  The book pushes risk weighting of assets to the side and complains that modern banks - even after the Credit Crisis - may have equity that is just 3% of total assets.  The authors want 20-30% equity as the minimum rather than 3%.  Say it again - banks should have much more equity!

These bank antagonists spend much of the book (correctly) anticipating bankers' objections and giving sound refutations.  For example, increased capital requirements will not reduce lending IF banks choose to raise equity rather than reduce assets.  Also, bank ROE may certainly decline with increased equity, but the bank shareholders' RISK also declines - making the outcome more of a trade-off than a penalty to equity investors.

The downside of Bankers' New Clothes is everything else.  There is nothing resembling a justification of the 20-30% equity-to-asset prescription.  Admati and Hellwig simply state that bank equity was higher in the 19th century and was in this 20-30% range at the beginning of the 20th century.  This "analysis" is not adequate - the authors would have retained more credibility by admitting this shortcoming themselves.

While Admati and Hellwig give reasonably thoughtful discussions of recent failures of regulation, unholy alliances between governments and banks, the negative consequences of political meddling with banks, and the great desirability to just let banks fail, they then DEFEND and argue for the preservation of regulators, government and political control, and the imperative NOT to let banks fail!!

The Admati-Hellwig thesis is simple (and simple is good!):  force banks to have 20-30% equity relative to assets and don't change anything else.  We like the first part (qualitatively) ....

German FX Investigation: "Much, Much Bigger" than LIBOR; Investigation to be Completed "Hopefully Before 2018"

Reuters reported on the annual news conference held yesterday by the German financial regulator, Bafin. The biggest news relates to progress on their foreign exchange investigation.  The regulator said that the probe was "much, much bigger" than the interest rate benchmark case.  "There were clearly attempts to manipulate prices, that's what was disturbing."  The Bafin spokesman said that these attempts involved fix rates in many different currencies, excluding the largest, such as euro vs. the dollar.  The only currency mentioned was the Mexican peso.

For the first time the regulator let it be known that all FX banks in Germany have been asked to conduct internal investigations into potential misconduct and report back to Bafin.  However, there is no need to lose sleep awaiting the final results of Bafin's probe, as the spokesman said that "we're not going to be done in 2014 ... but hopefully before 2018'".  There are no indications that the spokesman was kidding.

While most regulator comments from around the world have been indicating that they are finding some misconduct on the part of banks attempting to manipulate FX fixes, interestingly, at the end of April, the UK FCA head of enforcement and financial crime said "we are at a relatively early stage of plowing through some pretty detailed analysis of what was happening".  " We are some way away from saying there was actually misconduct at all".  Several FCA officials have stated that their probe will last until at least 2015.

London Silver Daily Fixing to End August 14 After 117 Years

Reuters reports that Deutsche Bank has postponed to August 14 its decision to drop out of the London Silver Market Fixing.  In January Deutsche reported that as part of its retreat from much of the commodity business, it was going to sell its' memberships in the gold and silver fixes, run by five and three banks, respectively. They have not been able to sell either so far and announced that they will drop out of the processes on August 14.  The London Silver Market Fixing Ltd. said that the fix will cease at that date.  The possibility of another firm taking over the fix with replacement bank(s)  remains a possibility, although this might be a difficult time to attract anyone to establish benchmark prices.  The CFTC ended an investigation into the silver fix in 2013 without finding any wrongdoing.

Many lawsuits regarding the gold fix are currently in the process of being consolidated by the courts.  There do not appear to be any lawsuits regarding the silver benchmark.

Lehmanizing Europe .... Incredible!

EU Banks May Get Asset-Backed Security Leeway in Liquidity Rules

    As we found in the Global Association of Risk Professional (GARP) news story above, the EU regulators are set to permit banks to count ABS bonds within liquidity requirements.

But this is precisely how Lehman Brothers failed in 2008 !!!

    Of course, there is a long story one may tell about the failure of Lehman.  See the exhaustive and authoritative report of the Examiner for the Lehman Bankruptcy.  There are many investigatory paths to follow in the analysis of complex institutions such as Lehman.

    But if one had to identify the dominant failure mechanism and to state in a simple yet accurate manner, here it is:

Lehman failed due to its stuffing its "liquidity pool" with (what it called) investment-grade ABS which, in crisis, were illiquid, mis-priced, and otherwise unacceptable as collateral to any lender that took the trouble to review the bonds.

See here one brief discussion of Lehman's Liquidity Pool "own goal."

Does the EU truly wish to replicate Lehman in Europe?!  Whether in time of Crisis or not, ABS bonds - regardless of credit rating - are not liquid!

Money Managers Ask Congress To Increase Duties Of Trustees In Mortgage-Backed Financings

Saw this interesting blog post from the law firm of Perkins Coie regarding duties of trustees in mortgage-backed financings.  This debate about the duties of trustees pits the Association of Institutional Investors against the American Bankers Association and can be seen as one of the battle fronts in this war. The other battle front being in the courtroom where investors have taken on trustees of residential mortgage backed securities. For more info head to the blog post or check out this story on Bloomberg.

Legal Theories in LIBOR and FX Lawsuits

While this article in CapLaw discusses the history of the allegations, investigations and lawsuits in the FX and LIBOR scandals, we thought it most interesting to focus on the legal theories and their current status.

In LIBOR, the US consolidated case held that there was no antitrust damage as the LIBOR rate setting process was not competitive in nature and thus there could not be anti-competitive behavior.  However, "second-generation" lawsuits filed by plaintiffs claiming direct trading losses from derivatives with banks that provided benchmark LIBOR rates, are moving through the legal system.  Two large plaintiffs are the FDIC, on behalf of 38 failed banks, claiming fraud and collusion were used by the LIBOR setting banks to suppress rates, and Freddie Mac and Fannie Mae, claiming that LIBOR manipulations caused them to suffer losses on mortgages and financial derivatives.

LIBOR cases in the UK have been limited, with only two cases filed, one of which was settled and the other remains with the courts.

In the FX benchmarks, the US has consolidated numerous class action suits into one.  Differences between the rate setting process in FX vs. LIBOR make it unclear whether antitrust charges will hold up in the FX case.  Fraud and collusion charges remain in FX as well, but the later start of FX allegations, the complexity of the cases and the continuing regulatory and internal bank investigations, means that further clarity will not be forthcoming until at least late 2014.

Clients will Need to Pay for Trading at FX Benchmark Rates

We have said in previous posts that trading with a bank for a fix later in the day, without paying the bank for the service (most fix trades are executed at the midpoint, avoiding even the usual bid offer spread paid for an immediate trade), is the source of much of the trouble with fixes.  Clients wanted it and banks accepted it.

This article in FX Week (subscription) describes the problem that the banks have with these trades.  Trading before or during the fix can bring accusations of front running or manipulation, and trading after the fix risks incurring losses, which banks have been particularly unwilling to risk since the financial crisis.  Based upon the allegations in lawsuits and the regulatory and bank investigations underway, many suspect that some bank traders may have found ways to make profits on such trades anyway, including collusion among the banks.

For those who wish to continue fix trading, they may ultimately need to be willing to pay a bank to take on this risk or manage the risk around the fix themselves, either utilizing algorithms or traders with tight risk parameters.  Managing the risk by the firm involves staffing/trading costs as well as the cost of variances between realized rates and the fix.  At the moment there is no indication that banks are considering charging for fix trades, but with continuing compression in bank spreads on non-fix trades, eventually this may be part of the solution.