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Is Deutsche’s CDO business out of control?

The Euromoney February 2006 issue has an article that publicly asks what several investment professionals have been asking lately: Is Deutsche Bank’s CDO business out of control? Toomre Capital Markets first wrote of the Deutsche Bank’s CDO business here noting the curious fact that Mark Stainton left as the head of Deutsche Bank’s collateralized debt obligation trading desk to join Citadel Investment Group as the head of its energy trading group. While credit risk issues dominate the energy trading business, particularly with OTC derivative contracts that are a mainstay for longer-dated contracts, TCM found it odd that the trading desk head of such a leading market maker would leave before year-end bonuses were paid, especially to head a business that has other issues beside just credit. (Perhaps volumetric risks and contingent options were not discussed in the interview process?)

With the subsequent news that Anshul Rustagi, the trader disciplined for allegedly overstating his trading profits by 30 million pounds, was fired in January 2006 for gross misconduct following an investigation into supposed discrepancies that came to light in mid-December 2005, one wonders about what really was going on in the Deutsche Bank CDO trading business. As the Euromoney article states, “To outsiders, it looks as if Rustagi was attempting to boost his book’s value heading into the bonus round. It is not entirely clear how this happened but traders were surprised and alarmed that a trader on a flow product, which has easily available broker prices, could get past his risk managers, whether deliberately or not. This suggests problems with appropriate control systems at the German bank. If Rustagi did manage to mark up his book into the year-end, Deutsche’s procedures must have failed.”

The article goes on to detail information about the CDO correlation book at Deutsche Bank

Although Stainton was a highly regarded and sharp young trader, his correlation book took a significant hit when the tranched credit market blew up in May, in the wake of the Ford and GM downgrades, as did those of all the big players in CDOs. These included JPMorgan, Citigroup, Goldman Sachs and newer players such as RBS, as well as leading French derivatives houses such as BNP Paribas and SG.

There have been persistent, but unsubstantiated, rumours that Deutsche Bank lost as much as $200 million in the May unwind and that since then the correlation desk has been unsettled. Stainton’s departure, coinciding with the disciplinary move against Rustagi, has provided the conspiracy theorists with a field day. It is unusual for a senior banker to leave a firm ahead of the bonus round, but Citadel was keen to get Stainton on board quickly and probably paid up to achieve this.

But where does it all leave Deutsche? Since the departure of co-head of the CDO group, Brian Zeitlin, 18 months ago, there has been a high degree of turnover in one of the most active structured credit derivatives operations in the market. Perhaps that explains the biggest surprise of all – that Rustagi’s trade became public knowledge. A £30 million loss hurts, but it’s a small wound in the context of Deutsche’s wider trading positions. Only a Deutsche banker could have leaked details of the Rustagi situation. The implication is obvious: not everyone at Deutsche Bank is pulling in the same direction.

The other implication is that the markets have not heard the last of this Deutsche Bank story. Comments andthoughts are welcome.