Odd Lots - 45: Why A Whistleblower Walked Away From Over $8 Million

Episode Date: September 12, 2016

Could you walk away from a reward of over $8 million? The guest on our latest episode of the Odd Lots podcast did just that. Eric Ben-Artzi was a risk officer at Deutsche Bank who concluded that his bank was mis-marking the assets of part of his derivatives portfolio to a significant degree. When he couldn't get his colleagues to reprice the derivatives he called a hotline and blew the whistle, ultimately leading to a huge reward. In this episode he explains what he saw that was wrong and why he ultimately didn't take the money.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a lot. It's a firm. It's a lot. It's a lot. It's a a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com

slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing Corporation Distributor. Put knowledge to work and grow your business with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. Hello and welcome to another edition of Oddlots. I'm Tracy Allaway, executive editor of Bloomberg Markets. And I'm Joe Wisenthal, managing editor of Bloomberg Markets. So Joe, on last week's episode, we were talking about money, and I rather glibly said that money was the thing that everybody wanted. But what if I told you today that we are going to speak with someone who turned down

$8.5 million? I wouldn't believe it. I wouldn't believe that such a person would exist or that a person would do such a thing. Well, we are going to talk to someone who turned down $8.5 million. That person is Eric Ben Artsy. You might remember him from some recent headlines. He used to work at Deutsche Bank as a risk manager and basically blew the whistle on the way the bank was accounting for a big position in derivatives. Since then, Deutsche Bank got fined by the Securities and Exchange Commission in the U.S., and part of that fine goes out to pay the whistleblowers. And Eric was just one of, well, I think in the end, there were two of them. So we're going to talk to him today about what it's like to be a whistleblower. and crucially why he turned down all that money.

This is so fascinating and surprising. I don't want to do any more intro. I think we should get right into it. All right. Eric, thank you so much for coming on the show today. Thank you for having me. So I guess to begin, maybe we should start with your career at Deutsche Bank, sort of ground zero for where this all started.

Tell us what you were doing at the bank. My job as a risk officer was to oversee the risk, the market risks in the trading portfolio. We oversaw many of the businesses that the bank was in both in New York and London. In particular, I was looking at the credit derivatives portfolio. And that's where the problems came up. So tell us it, when did you join Deutsche Bank in? What was your first indication that, in your view, something was wrong with the way derivatives were being priced internally? I joined Deutsche Bank in the summer of 2010, and I had quite a bit of experience before that in credit derivatives,

both through my work in Citibank and also at Goldman Sachs. So the assignment to the credit derivative of this portfolio was pretty natural, and I had experience with the models, with the products involved. You know, gradually, as I learned more and more about the portfolio at Deutsche Bank, I had more and more concerns. And as I raised those concerns with my managers, with accountants, and eventually I went to the hotline, the responses that I got were more and more of. alarming to me. So walk us through the problems that you discovered, because I know it can get a little bit complex, but there are some potentially big numbers involved here. And our listeners like complex details. You don't have to be afraid to get wonky. Okay, great. So essentially, the credit derivatives in question were synthetic credit derivatives. These were tranches on

portfolios of CDS. Initially, I was doing some stress testing, and I was tasked with assigning risk numbers to this portfolio. I wasn't quite aware of what the products underlying that were actually in the portfolio of what they were. My assumption was that these were regular tranches. And at some point, when I started asking questions, all of a sudden I realized that I was looking at leverage tranches, leveraged super seniors, as they were called. These were more exotic, more risky trades that were worth less. If you think of it as an insurance contract, then a

leverage tranche, if you buy insurance in a leveraged way, you have far less protection than if you have a regular tranche where you were protected for the entire amount of your portfolio. So one analogy that people seem to like is with parking lot full of cars. If you're a car dealer and you have a used car parking lot full of used kios. You could argue about what kind of values those used kios have. You can say they're worth $5,000 or $10,000, but you can't pretend that these are new Ferraris. And essentially I realized that this is what the bank was doing. It was misrepresenting the trade in its portfolio.

And I also began to realize just how huge this portfolio is. Essentially, Deutsche Bank owned the majority of this market. So as I was raising my concerns and getting answers that made less sense, I also got answers that made me more concerned about the amounts that we're talking about, the hidden losses or, if you will, the inflated valuations. So back in the deep, dark days of the financial crisis, and 2010 wasn't that far off from those, understating those potential losses would have meant a big, big flattering of Deutsche Bank's bottom line, right? Basically saving it on having to reserve lots and lots of extra

capital. In 2010, initially when I raised my concerns, I thought we were talking about about potentially hundreds of millions of dollars. And once I asked more and more questions, I realized that this was, you know, we're talking about billions. So, yes, these are very large numbers. I want to get to the part where you sort of blow the whistle and raise external issues.

But I just want to get a little more specific on the specific problem that you saw with the way that the derivatives were being priced. Because obviously pricing of the, derivatives and portfolio of derivatives is complex and people apply different models and techniques. But what was the fundamental difference in how you saw the products and how they should be valued versus how they were being valued by the bank? So I think that's a very good point that I wasn't arguing that a specific model should use. There are many, many models that could potentially be used and all of them had advantages and

disadvantages. So you could argue about what the actual value was of these trades. There's no doubt there, but you couldn't pretend like they, you couldn't pretend that they were not leveraged. The standard valuation, the correct sort of financial engineering valuation of a levered super senior or levered tranche is as a regular tranche minus an option. Essentially, you sold an option to the counterparty to walk away from the trade. That's really what the, what the, what the trade, the way to correctly value this trade. So what the value of this option is, you can argue over what that is. You can argue about, you can take different models that would give you different numbers. What Deutsche Bank did was it just said that these options were worth zero.

And other banks at the time were using the gap option, right? They were valuing it like they could lose all the collateral because the counterparties walk away. Definitely model being used in other banks and when when the issue is raised that you know that the models that there's no model that does a good job that all the models are unstable well the answer to that is if you can't if you can't value this option you have to apply the worst case not the best case especially when when you're looking at the underlying swap you're you are quite happy to take a maximal valuation in other words the leveraged super seniors their value is equal to the swap which is marked to market left the option, which is also market to market.

Deutsche Bank was happy to take the positive market to market on the swap, which is also derivative in itself, but it just said, well, I don't know how to value the option is hard, so I'm just going to market at zero. That was clearly dishonest. I should say that, you know, when I spoke with risk managers in other areas, this seems to be a consistent problem throughout the trading book. as I was raising concerns about this particular portfolio, which was probably the largest,

I also began to realize that there was something more widespread, more systematic here, that it seemed as though the bank was really operating on little or no reserves for many trades that should have been reserved for, and it seemed as though it was trying to sort of inflate its financials. That was my impression. So after you start looking at the book and talking to other people, walk us through exactly what happened when you brought this to the attention of your managers. You mentioned making the call on the hotline. I imagine there was quite a process that you had to go through before you got to the hotline part or the SEC part. Yes, I talked with the line of command and within the risk management department.

I went to the, I spoke with managers in other adjacent areas, model validation, so other gatekeepers, if you will. I ended up going to the accountant, the finance division, so these are the people ultimately responsible for the financials for the statements. And that's really where, you know, I was expecting throughout this process that somewhere down the line, somebody is going to adjust for this leverage. Somebody's going to adjust for the fact that, you know, Deutsche Bank's. sold options on a huge portfolio that were being valued at zero. Somewhere there's going to be some accounting for that. And the accounting was just, it seemed as eventually when I talked to the accountants, they said, no, it's just valued as a regular swap. And that's when I went to

the hotline. So how did the conversations actually go? Because I can imagine it must be pretty awkward if you go up to people and you say, hey, I think that Deutsche Bank's potential losses on its LSS portfolio could be massively, massively bigger than we're in. accounting for? Yeah, so absolutely. The answers were invasive. Some people didn't want to talk about it. Others gave answers that were just wrong.

I think maybe just because they didn't know. Because these trades are pretty complex, anybody who didn't really specialize in it could easily misunderstand and you could tell them that you could run into a situation where they don't really understand what they're talking, how to value these trades.

So some of the answers I got, I assume were just uninformed answers rather than attempts to hide. But when I talked to people who did understand, the answers were clearly evasive and, you know, was like political, were used when I asked about it. So all of these red flags to me. All right. I want to get to the point where you begin the process of calling the hotline and becoming a whistleblower. First, I want to take a quick moment for a word from our sponsor. Put knowledge to work and grow your business with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing,

and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. And we're back with Eric Ben Arzzi, a former risk analyst at Deutsche Bank and a whistleblower. So walk us through the process. You talk about calling the hotline when you see that there's this major unresolved issue with the valuing of these derivatives. How does that actually work? Walk us through what the process is like becoming a whistleblower, essentially.

So the hotline, there's a number. You call the number, and it's supposed to be operated by third party, external to the bank, I believe. So to the best of my memory, I talked to somebody outside of the bank. and they just take down your concerns. That's it. You don't really, you have to express, you know, a fairly complex issue to somebody who doesn't really understand what it is, and then hope that somebody will get back to you.

It felt a little bit like kind of screaming into the dark. But eventually, actually pretty quickly, I was contacted by the legal department, by the compliance department. So that part of it worked pretty. well. And when did you go to the SEC? Because I imagine once you made that hotline call, you were probably already at least a little bit worried about your job at Deutsche. Yeah. So my strategy there was to go in parallel, essentially to be safe. And I wasn't sure whether I would be instantly fired after going to the hotline. There was always that concern. So I made sure to go almost simultaneously to the SEC with

information that I had and to the hotline at the same time. So effectively it was as though these two, you know, we're talking about March 2011, these two things were being raised and I later realized that there were ongoing investigations both inside the bank and the SEC, you know, a year prior. But at the time I thought I was starting investigations in both. There were other whistleblowers. Yes. As far as I understand it, I've never spoken to.

Matthew Simpson, who I believe he is the other whistleblower. And apparently there was yet another whistleblower before that. So we know of at least three people who raised concerns there. And you all were identifying the same thing? Apparently. I've ever seen the concerns that Matthew Simpson or the third person raised. And I believe there might have been other whistleblowers as well. They might have raised issues that are related or similar.

These businesses are very complex. There were lots of different risks that you can look at. The trades were, you know, I'm going to be a little bit technical here. These were bespoke leverage super senior trades, which is an animal that I didn't really think existed before I joined Deutsche Bank. So there were different kinds of risks there. And so I wouldn't be surprised this other whistleblowers raised concerns over other valuation issues such as quanto.

I've heard that that was an issue which I did not raise. I talked specifically about the gap option, but there were other issues with this portfolio. Also, there are other portfolios that were kind of related and might have been similar, maybe CDS portfolios or other CDO portfolios that had similar issues in them possibly. So this is all speculative. I don't really know what the other whistleblowers raised what concerns they raised, but presumably since Matthew Simpson, the whistleblower, assuming he's worth of Matthew Simpson was also given a whistleblower award, they also contributed to the investigation.

So it's March of 2011. You've just gone to the SEC. I'm going to be slightly facetious. How quickly were you shown the door at Deutsche Bank? Well, it took a few months, actually. So I was fired in 2011. And in between that, I was actually, you know, I became, I was introduced to the head of compliance regulatory affairs at the bank in New York, Robert Rice, and he was the one who was handling the investigation. There was also an outside law firm, Freed Frank, that was, so I guess they were formally in charge of the investigation and cooperation with the compliance department. I'm not quite sure what that means in terms of what the regulatory requirements are in terms of an outside law firm. investigating this. But in the court, during these next few months, Robert Rice, the compliance department introduced me to a number of other executives,

mostly in the finance division, so mostly accountants, to explain, or at least they claimed it was to explain to me what was being done inside the bank. In fact, those meetings were more, I felt more a way of trying to glean what I understood, what I knew, and to help them get a leg up on the SEC investigation, and also to prevent me or to discourage me, implicitly discourage me from going to the SEC. That's how I interpret those meetings. I certainly was not satisfied with the answers that I was given, and I don't think that was, I don't think an investigation that protecting shareholders

would have been conducted differently, completely, and 180 degrees, instead of trying to download the information and trying to essentially blunt my concerns, we should have gone along and gone to the bottom of it and corrected the role of what was wrong. And I'm pretty sure they When you were fired, what did they say the reason was? They just said that my job was being moved to Berlin. In fact, Deutsche Bank was opening a Kwan Center for its service department in Berlin. And I had previously, before I blew the whistle, I'd been offered a job there, and I expressed interest in moving to Berlin. So this was clearly just an excuse.

But nobody ever said anything about conduct. I had the reviews that I had were positives in the time that I spent at Deutsche Bank. So there was really no reason other than I can see no reason other than my whistle blowing. Did you regret going to the SEC at that point? I know. I thought I did the right thing, and I thought that the right thing would happen, that justice would be served there. Well, let's skip ahead then, because you were just in the news at the end of last month, because there was this huge whistleblower award for you and your fellow whistleblowers. And you were offered several million dollars as a reward for shining a light on this, and you didn't accept it. explain to us how that award came about and whether you're surprised by that and how you made this

decision that, as we said in the beginning, seems almost unfathomable for a person to make. During the years since, you know, I started, I blew the whistle in spring 2011, really I blew the whistle before that because I started raising the concerns months before that. I gradually became not only attached to the case, but also attached to the idea of seeing justice carried out. And after I was fired, this case was also the case of my career. So you could say that my life became completely, I wouldn't say dependent, but it became very, very much attached to this case. And so in the next few years, I pushed the SEC along at some points.

You know, there was a point where we heard that the case is about to be closed, 2000-12, and so we went and worked with the Financial Times to get the story out. And that really kind of gave new life to this case. So I know a lot to the Financial Times reporter in this case, who did a great job. And ultimately, over these years, I became, you know, I also became familiar with the lawyers, The Deutsche Bank lawyers went in and out of the SEC. I was forced to follow their career paths. I read Matt Taibi's piece in 2011 about the SEC's internal whistle, Darcy Flynn.

That's a story that I think hasn't gotten the attention that it deserved, in which he blew the whistle to Robert Cusami, who was head of enforcement and the SEC previously was Deutsche Bank's stuff. general counsel, I believe, from North America. At the same time, I followed, you know, Robert Rice was appointed, you know, went from being the head of compliance to being the chief counsel at the SEC. So I realized the evolving door was working against me and really was working against the rule of law in the United States.

So the decision not to take the award was essentially a protest against this revolving door concept between the SEC and Deutsche Bank. But that kind of throws up a question. Do you think that there's a problem with whistleblowing in general, or is it something specific because Deutsche had so many people at the securities watchdog? So I think I do think that the revolving door problem, and maybe I shouldn't use the word revolving door. I think the justice for sale problem is widespread.

It goes beyond just Deutsche Bank. It was especially bad here, but I think it happens quite, unfortunately, it happens quite a bit today. So it's not a problem necessarily with whistleblowing. It's a problem with the justice system. I think justice and money don't mix very well. And there were too many loopholes to which it makes its way into the system, not just in securities law. But in securities law, it's especially bad. So I think my case was especially bad.

it was especially blatant, the fact that the victims were clearly the shareholders. There was no third party. You know, there was no way to, I can't see any way to argue that the shareholders benefited from the inflation of this portfolio. I think this is like Enron. The shareholders are clearly, to me, the primary victims. I was just going to say there is a devil's advocate type argument where you could say, well, all right, so Deutsche Bank didn't value the gap risk in the way.

that it should have, but it ended up not suffering catastrophic losses anyway, right? So it made it through, and its assumptions about the gap risk turned out to be correct, and in effect it saved its shareholders a lot of pain. Again, that's just a devil's advocate argument for you, but it does get to the heart of the point that Joe made earlier, which is these are really complex things, and you're making a lot of assumptions about them, and right and wrong aren't always that clear cut. Yeah, so I think this devil's advocate. argument is very important, and I've heard it a number of times, and I think the answer to it

is you can see the answer in the stock price. So the stock price was in 2010, after the financial crisis was north of $70, and now it's, you know, it reached something like 12 or 13. I'm not sure where it is today, but, you know, the rumors about Deutsche Meck may possibly requiring a bailout. So it's hard to argue that Deutsche Bank didn't take some of those losses and just spread it out over subsequent years. And in those years that it hid those losses, the executives took large bonuses at the expense of the shareholders. So you're arguing that the ill fortunes we've seen of Deutsche Bank in recent years and the stock price is down about 90 percent from its pre-crisis peak is not just some secondary result of poor conditions for European banking, but also to

to some extent, a direct function of what you see, you saw as the behavior of the people internally to, as you say, misstate the value of the assets on the books? Absolutely. I think that's not the only, obviously, you know, this gap risk was just one of many things. And yes, the weakness in the European economy, I'm sure, did not help Deutsche Bank. But if you look at some of the other banks, the U.S. banks, for example, they didn't suffer the same kind of losses over the subsequent quarters. Deutsche Bank has a big presence in North America, the global bank. So you wouldn't expect that it should just be exposed only to Europe.

Also, I want to address one point that Tracy brought up, which is, well, you know, those losses that Deutsche Bank was correct in assessing that the gap risk losses are going to go away. Well, another way of thinking at this is to say that the value of the swaps was not, was inflated. In other words, if you say that the gap option was worthless, was worth zero, and it was just a temporary fluke around 2009 and 10 or 8, 9, 10 that its value was very high, you have to say the same thing about the swap itself. So the swap and the option go hand in hand. So you can't make an argument about one without making the same argument about the other.

What I see as having happened at Deutsche Bank in those years is that they invented quite a bit of capital on the balance sheet, in that capital that they invented, they dissipated it over the subsequent quarters. How much was the Deutsche Bank scandal that you identified to do with the complexity of these leveraged super senior positions and how much of it had to do with a cultural problem at the bank? I guess what I'm asking is could we get a scandal on the same sort of level for something like a certificate of deposit or like a much simpler type of product? or is this something that you think could only happen in the deep, dark realms of the derivatives world? I think certainly it's easier to hide losses when you have something that nobody really understands. So certainly when you have these level three assets with very complex models that understanding what the contract itself is very complicated, it's easier to inflate the valuation.

It's a lot harder to say that, you know, some, the stock of company XYZ, which is trading at $20, it's harder to market at $40. So what are you doing now? So you've renounced this reward. Do you feel that you've made the statement that you tried to make by not accepting this money that the punishment of Deutsche Bank shouldn't fall on the shareholders? Do you feel like you've made that statement? And where to next for you?

I think it's not so much a statement as much as it just a real. refusal to be part of that. So I just don't want to, you know, if you saw, you know, if you saw the analogy that I like to give is if you, if you saw somebody getting mugged in the street in New York, and then you call the cops, and then the cop shows up and the cop is actually the guy who just, who just mugged the victim, and he mugged the victim again, and then throws you a couple dollars out of the wallet so that you shut up, you probably wouldn't do that. And so I don't think what I did is so extraordinary. I think if people, if you see this, see it the way I do, which is as, you know, the victim being robbed again and the award money

being sort of hush money, then it's, what I did is really not, not extraordinary at all. In terms of the impact or the outcome, you know, I think it's, you know, the fight to get the justice system cleaned up, if you will, to have, you know, to have the same kind of justice for the powerful and connected as everybody else. I think that's a really long-term struggle. So I don't think I'm going to make, by myself, I'm not going to make a difference, but I do think that they make a small difference,

and hopefully there will be more people like me, and then hopefully we will make a difference together. What's next for me? You know, I've rebuilt my career in a fintech company. I'm very proud of the work we're doing. The name of the company is Bond IT. We are a product aims to improve the world of investing, bond investing, specifically. So we work with some of the major financial institutions in the world

to help construct smart portfolio, smart bond portfolio, retail and private banking customers. Would you ever return to Wall Street? Could you ever return to Wall Street? You know, I think the answer is yes, I would, and I also think, yes, I could. I just think that, you know, it's a matter of a change in culture and perception. I think the fact that what I didn't seem extraordinary, it's conceivable that it could happen, that the culture and the management in some of these major financial institutions would be more aligned with that, more aligned with the shareholders, more aligned with working again on Wall Street.

It may sound like, you know, like a dream when I'm saying it now, but I think, you know, stranger things have happened. All right. Let's leave it there. Eric, thank you so much for joining us today. Thank you. I appreciate you. I'm having you again.

So, Joe, I thought that was a really fascinating story. And I think the thing that emerges the most from it is probably the courage of a guy who kind of knew he was probably going to lose his job by blowing the whistle. on this and then the idea that he gave up millions of dollars on principle. I like to think I would do the same thing, but let's be realistic how many of us actually would. Yeah, you know, he said he didn't think that that was a really extraordinary thing. And I did like his framing that essentially, if you consider what he blew the whistle on to be deleterious to shareholders and his whistleblower reward would also come from shareholders, that he was, as he put it, participating in the theft. I still think that is a way of framing it that is quite extraordinary that very few people would

get to that way of thinking about it when given the opportunity to collect so much money. The other thing that struck me is, you know, it warms my heart to talk about all these financial crisis relics like Leveraged Super Seniors and Quanto Risk and correlation books and things like that. But it throws up this question, you know, many years after the financial crisis, it feels like we've gone some way towards tackling some of the complexity in banking, but I'm not sure we've done that much to actually fix some of the cultural problems that people like Eric have identified. I totally agree with that. One of the thing I thought was interesting was this kind of reminds me a little bit of the discussion that we had several weeks ago with the professor who say

Lehman could have been saved. And when we go back to these stories, a common thread, of course, is that during periods of extreme volatility and with these complicated financial products, there's often some debate about how they're valued at any given moment. So I like the way he clarified his take, which was that this was not really in his view a debate about which model to use. And of course, have disagreements about that, but sort of fundamentally the building blocks of the model, just acknowledging what you, sort of like agreeing on a common set of facts to go into the model. And so being a little bit, in his view, more clear than mere sort of disagreement about what model is. Or deconstructing your conclusion, right?

Right, right. All right. Well, on that happy note, shall we deconstruct this conversation? Sounds good. All right. This is another episode of Oddlots. I'm Tracy Allaway. You can find me on Twitter at Tracy Allaway. And I'm Jill Wisenthall. You can follow me at the stalwart. Thanks for listening. Put knowledge to work and grow your business with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses.

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