The US Securities and Exchange Commission recently charged Deutsche Bank AG with sending it 'mis-stated' financial reports in 2008 that failed to take into account a weighty risk for potential losses thought to be in the billions of dollars.

DB paid $55 million as a settlement, signing a 'cease and desist' order which, as the recent history of American regulation shows, may or may not be worth the paper it is written on. DB neither admited nor denied the regulator’s findings in the order.

An investigation by the federal regulator found that Deutsche Bank overvalued a portfolio of derivatives consisting of 'Leveraged Super Senior' (LSS) trades through which the bank purchased protection against credit default losses. Because the trades were based on debt, the collateral posted for these positions by the sellers was only about 9% of the $98 billion total in purchased protection.

This created a 'gap risk' that the market value of Deutsche Bank’s protection could at some point exceed the available collateral, and the sellers could decide to unwind the trade rather than post additional collateral in that scenario. Therefore, the regulator has decided, Deutsche Bank was protected only up to the collateral level and not for the full market value of its credit protection. Deutsche Bank initially took the gap risk into account in its financial statements by adjusting down the value of the LSS positions.

According to the SEC’s order instituting a settled administrative proceeding, when the credit markets started to deteriorate in 2008, Deutsche Bank steadily altered its methods for measuring the gap risk. Each fresh realignment reduced the value assigned to the gap risk until Deutsche Bank eventually stopped adjusting for gap risk altogether. For financial reporting purposes, in other words, Deutsche Bank measured its gap risk at $0 and improperly valued its LSS positions as though the market value of its protection was fully collateralized. According to internal calculations not for the purpose of financial reporting, Deutsche Bank estimated that it was exposed to a gap risk ranging from $1.5 billion to $3.3 billion during that time period.

In addition to the $55 million penalty, the SEC’s order requires Deutsche Bank to cease and desist from breaking ss13(a), 13(b)(2)(A) and 13(b)(2)(B) Securities Exchange Act 1934 and Rules 12b-20, 13a-1, and 13a-16. Germany's BaFin and the United Kingdom's Financial Conduct Authority helped.