By Matt Scully, Bloomberg News
The U.S. Securities and Exchange Commission isn’t planning to bring an enforcement action tied to Deutsche Bank AG’s losing nearly $550 million on mortgage-bond trades, after the lender’s own probe found no evidence of wrongdoing, according to people with knowledge of the findings.
A whistle-blower had told the SEC that a former top trader at the bank, Troy Dixon, had inflated the value of mortgage securities on his books in the years after the 2008 financial crisis and masked losses, Bloomberg reported last year. The trading losses came in 2013, after Deutsche Bank decided to scale down its exposure to the securities.
The lender’s internal probe found no evidence of inflated values and masked losses, the people said. Instead, they said, the bank determined that the red ink was caused by a failed hedging strategy and because, after Dixon left the firm, it decided to liquidate the bonds quickly. The U.S. agency is not formally closing its investigation, and may return to it if more information emerges, but it is not actively seeking more detail, the people said, asking not to be named because they aren’t authorized to speak publicly.
The decision was made inside an agency that has been facing possible budget cuts under President Donald Trump. The SEC has eliminated dozens of contractors who were hired to help root out Wall Street fraud. It also now has a new chairman, Jay Clayton, a former lawyer for Sullivan & Cromwell who was questioned during his nomination hearings about his Wall Street clients, which include Deutsche Bank. Clayton would have to recuse himself for a year from matters involving Sullivan & Cromwell and companies he represented.
In response to questions, Clayton told lawmakers that he was “100 percent committed to rooting out any fraud and shady practices in our financial system.”
Representatives for the SEC, Deutsche Bank, and Dixon declined to comment.
Valuing complicated securities like mortgage bonds has subjective elements, said Jaidev Iyer, chief executive officer of J-Risk Advisors and formerly a top risk manager for UBS Group AG and Citigroup Inc.
“In a crisis or in a liquidation scenario you may find that your valuations were too optimistic,” Iyer said. “You may be able to get out, but at prices that were much farther away than you wanted or thought.”
The results of Deutsche Bank’s internal probe may move the bank to the end of another chapter in its difficulties with its mortgage bond business. In 2015, the bank decided to quit trading residential mortgage bonds that were backed by the government, citing insufficient profits. In January, it finalized the terms of a $7.2 billion settlement with the U.S. Justice Department over the mortgage-backed securities it sold before the financial crisis.
The trades that the SEC was probing started around the 2008 financial crisis. Dixon bought securities backed by high-interest mortgages, betting that these homeowners would keep paying their loans at those high rates, and have a hard time refinancing amid the tumult. By 2009, his team had acquired $14 billion of the government-backed bonds, Bloomberg reported in June. At one point, the position was among the biggest on Deutsche Bank’s books anywhere in the world.
The trade’s returns were wildly volatile. In 2009, Dixon’s gains were about $467 million, according to an internal presentation. The next year, the trading desk lost $292 million, followed by another $109 million of profit in 2011, according to a document seen by Bloomberg.
By 2013, the positions had grown more problematic. As the Fed hinted it might start to taper some of its efforts to ignite growth, markets grew skittish. Investors also feared that new government policies might make it easier for homeowners to refinance the high-rate mortgages behind the investments. Preparing for new capital rules and stress tests was making it more expensive for the bank to hang onto the securities.
Disagreements broke out over how to value the bonds. Dixon and risk managers had shouting matches over the right prices, people who saw the fights said. One point of contention was whether the bank should assume the bonds would be held to maturity, or if it should instead assign valuations based on prices they would fetch if they were sold immediately.
The whistle-blower said that Dixon had been too slow to record losses on the bonds as markets grew volatile, and that at least $132 million of the hit that the bank took in 2013 on the positions should have been recognized sooner, according to the people with knowledge of the matter. But Deutsche Bank found that losses came in part because a hedge that was supposed to reduce its net exposure failed to do so, the people said. Also, after Dixon left in October, the bank elected to offload the positions quickly. Traders at other firms knew that Deutsche Bank had a big position in the securities, and that liquidating it wouldn’t be cheap, Bloomberg reported in June.
Dixon now runs hedge fund Hollis Park Partners, which gained 10 percent in 2016 and 3.5 percent in the first quarter.
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