Deutsche Bank, one of the world’s very largest banks, sold a lot of bad securities that ended up contributing to the 2008 Great Recession. Now, the Wall Street Journal reports that the US government is trying to hold the German bank accountable, demanding it pay $14 billion in settlements for its alleged malfeasance.
That sounds like a lot of money. And it is — it’s enough to create a serious problem for Deutsche Bank, which doesn’t have nearly as much money on hand as the Federal Reserve thinks it should for safety against major risk (uh-oh).
That being said, there’s a real chance settlements like these might not help deter similar malfeasance in the future. And Deutsche Bank may not end up paying anywhere near the $14 billion the US government wants regardless. Ironically, Deutsche Bank’s weak financial position may actually give it some extra bargaining power, since regulators won’t want to risk levying such a big fine that it creates a risk of another financial meltdown.
This is about Deutsche Bank paying up for the financial crisis
The German company is one of many banks the US government has gone after on related issues. JP Morgan paid $13 billion to settle a similar case with the US government in 2013; Bank of America paid out the largest sum, $16.65 billion, in 2014.
The core dispute here is responsibility for the financial crisis.
Here’s how it went down: Banks sold investors residential mortgage-backed securities (RMBS), basically packages of mortgages. A lot of these mortgages were “subprime” — that is, mortgages given to people with low credit scores or other financial challenges, and therefore less likely to pay them back.
When home prices collapsed after 2007, it became clear that many of these people could not pay their mortgages — which meant the people who owned the securities, banks and investors alike, were on the hook for huge sums. The banks were too heavily leveraged — meaning they didn’t have very much capital relative to the money they had loaned out — so the mortgage losses put them under water.
This is what caused the financial crisis, and ultimately the Great Recession.
In the Deutsche Bank case, the US government is saying that Deutsche, like its competitors, sold these RMBS without sufficiently warning investors of the risk. Essentially, they lied and put other people on the hook for their lies.
“The US government is making all of the major investment banks make a settlement for their involvement in the securitizations that went awry,” John Coffee, a law professor at Columbia University who studies securities, tells me.
The problem, according to Coffee, is that this kind of punishment is not enough to deter bankers from doing something similarly shady in the future.
“The only thing that will effectively deter wrongdoing is focusing on individuals,” he says.
Coffee’s argument is straightforward: Big fines leveled at corporations affect the company and its shareholders — but it’s individual bankers and executives who knowingly sold the bad products. If you want to stop individuals from doing shady stuff, you need to make it unprofitable or otherwise too risky for them to do it. Leveling penalties at the corporate level doesn’t do that.
At least some officials in the Department of Justice agree this. A year ago, Deputy Attorney General Sally Yates put out a memo — now called the Yates Memorandum — arguing that US policy needed to go after individuals before it settled corporate cases. “Both criminal and civil corporate investigations should focus on individuals from the inception of the investigation,” she wrote.
This effort to go after Deutsche Bank, however, doesn’t really do that. So if Coffee is right — and he may not be — then the payment won’t end up mattering that much.
“The Department of Justice keeps saying it wants to identify individual wrongdoers, but it gets into these settlements and the names of individuals disappear,” Coffee explains.
Could a large settlement create new risks?
That being said, this sum would be a quite a problem for Deutsche Bank.
“The unique problem, if you focus a little on Deutsche Bank, is that it’s more financially troubled than many of its peers,” Coffee explains.
Banks need to keep a certain amount of capital in reserve in order to pay back loans. (The amount varies relative to the amount of the bank’s assets.) This is called a “capital ratio,” because it’s the ratio of the amount of capital the bank has or could get quickly to its own liabilities.
The Federal Reserve and European authorities are especially sensitive to this after the financial crisis. Back then, a lot of banks needed to be bailed out because they didn’t have enough capital to pay for the losses created by the housing crash.
Deutsche Bank already has a dangerously low capital ratio, which means it would be at risk in the event of another big downturn. The BBC’s Simon Jack named it “the most dangerous bank in the world” after a report by the International Monetary Fund found that Deutsche was the bank most likely to trigger another financial collapse.
This creates an issue for the settlement, then: The more the Department of Justice bleeds Deutsche, the less capital the bank has in case something goes wrong in the market and they have to pay up. The Wall Street Journal’s Jenny Strasburg reports that even a $4 billion settlement with the US government would strain the bank.
Ironically, then, the Department of Justice’s attempt to hold Deutsche Bank accountable for the financial crisis could actually generate more risk.
“There’s a real tension here between what government enforcers want … and the need to not diminish [Deutsche’s] equity capital,” Coffee says. “The goals of the Federal Reserve and the Department of Justice are at cross purposes.”
Deutsche, for its part, is flatly rejecting the $14 billion price tag. “Deutsche Bank has no intent to settle these potential civil claims anywhere near the number cited,” it said in a statement. A source told the Journal that it expected to pay somewhere closer to $1.9 billion.
Another possibility, which Coffee warned me not to discount, is that Deutsche is simply waiting for the US election to end — on the hope that a Donald Trump presidency, unlikely as it may seem, might drop the case entirely.