The Journal Is Mixed on Deutsche Bank Conflicts

The Wall Street Journal has a long page-one look at Deutsche Bank and how it played both sides of the subprime game. It’s good, but it could have been better.

Here’s how the WSJ describes what Deutsche did:

The bank, however, continued to build its mortgage-securities machine. It was a reliable assembly line, beginning with lenders like NovaStar, based in Kansas City, Mo. Deutsche agreed to provide a credit line to NovaStar in 2003, the year the home lender touted its “credit score override program.” A co-founder of the lender says that it sought “to underwrite loans with a focus on ensuring the borrower could repay his or her debt.”

As U.S. lenders churned out home loans, Deutsche bundled them into mortgage-backed bonds. It assembled these into CDOs, and built other CDOs out of derivatives that served as insurance on the bonds. Deutsche marketed the deals to conservative investors, such as insurers and banks, that had a positive view of the housing market.

Meanwhile, for hedge funds or other investors that wanted to bet on a housing downturn, Deutsche in 2005 and 2006 created a half-dozen deals that were collectively known as START.

Note that it’s the dumb money (banks and insurers) that gets the bum advice here and the smart money (hedge funds) that gets the good advice.

And there’s the nut of the problem. Deutsche began creating investments so they could be shorted. Now there’s nothing wrong with that per se. But when you’ve got one arm pitching shorts to certain investors while you’re hawking the other side of the same bet to other, less select buyers, you’ve got a potential problem. When you’re creating these shorts so you yourself can bet on them (despite Deutsche’s denials in the quote below) while selling the longs to the dumb money, you’ve got a potentially big problem. The ultimate question here is how the long bets were marketed.

Unfortunately, the Journal doesn’t have the knockout blow, which would be the marketing materials Deutsche used to pitch junk CDOs to the dumb money. Here’s as close as it gets (emphasis mine):

Deutsche took the bearish side of these deals and sought to sell the bullish side of them to U.S. and European investors. The bank says the instruments weren’t designed to enable it to short housing.

Not all investors who were pitched the bullish side were impressed. “My quick analysis of the portfolio suggests this is the biggest crock of s— I’ve seen yet!” one London trader who got the pitch responded by email to Deutsche. He added, “I won’t be spending any more time on it, but wish you luck in moving some paper.”

And:

During this time, Deutsche continued trying to get other investors to go “long” the housing market—that is, it continued trying to sell them products likely to prosper if housing did.

M&T, the bank that agreed during this time to invest in a new Deutsche mortgage deal, alleges in its suit that a week before the purchase, a Deutsche salesman told it by phone that the “underlying structures in these bonds are built to withstand” adverse conditions.

In late 2007, M&T wrote down the value of its $82 million investment to just $1.9 million, according to its suit.

Deutsche said documents for the product had clearly warned that the assets in the pool were of poor quality.

Deutsche says that, but did they really? We shouldn’t swallow Deutsche’s PR line, so it would have been nice for the Journal to give us an idea there of how true that is.

And I have to think that while it’s great that the Journal and others are zeroing in on the investor end of things, they’re still not really getting the better story: What Wall Street knew about the predatory lending it was bankrolling.

What’s surprising about the shortfalls of this story in particular is that some of the info that would have made this a home run (or at least a triple) is already out there—in a bestselling book. Michael Lewis wrote this in The Big Short about Steve Eisman, who would make a fortune shorting subprime. Note that Greg Lippman is mentioned here, and the emphases are mine:

He had no interest in listening to other people’s speeches. He had no interest in attending the panel discussion and hearing the potted remarks. He wanted private sessions with market insiders. Lippmann had introduced them to the people inside Deutsche Bank peddling CDOs to investors, and these helpful Deutsche Bank people had arranged for Eisman and his partners to meet the bond market’s financial intermediaries: the mortgage lenders, the banks that packaged the mortgage loans into mortgage bonds, the bankers who repackaged the bonds into CDOs, and the rating agencies that blessed the process at each stage. The only interested parties missing from the conference were the ultimate borrowers, the American home buyers, but even they, in a way, were on hand, serving drinks, spinning wheels, and rolling dice. “Vegas was booming,” said Danny. “The homeowners were at the fucking tables.” A friend of Danny’s returned from a night on the town to report he’d met a stripper with five separate home equity loans.
The Deutsche Bank CDO salesman—a fellow named Ryan Stark—had been assigned to keep an eye on Eisman and prevent him from causing trouble. “I started getting these e-mails from him, before the conference,” said Danny. “He was nervous about us. It was like, ‘I just want to clarify the purpose of the meetings,’ and ‘Just to be clear why we’re meeting …’ He wanted to make sure we knew we remembered that we were there to buy the bonds.” Deutsche Bank had even sent along the formal handouts intended for subprime buyers, as a kind of script for them to follow. “The purpose of the conference is to convince people it’s still OK to create and to buy this shit,” said Danny. “It was unheard of for an equity investor looking to short the bonds to come in and scope the place out for information. The only way we got these one-on-one meetings was by saying that we weren’t short. Deutsche Bank escorted us, to make sure we didn’t blow up their relationships. They put a salesman in the meeting just to monitor us.”

That’s a much more vivid and direct portrait of the conflicts of interest at work than what we get from the Journal.

Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.