NEW YORK, March 12 (Reuters) - In the weeks leading up to the U.S. Federal Reserve's annual stress test of major banks, a former risk executive of Deutsche Bank AG repeatedly warned senior managers of the German bank's U.S. unit that they were painting a far too rosy picture of the bank's health.
The warnings weren't about this year's stress test. They were written by William Broeksmit in December 2013 and January 2014 as the bank was preparing its Fed-mandated, internally run stress test. At the time, Broeksmit was serving as a director of the U.S. unit.
The bank needed to "stress harder," Broeksmit wrote in one email to senior managers. The bank's forecasts were "way too optimistic," he wrote in another. In others, he said that forecast losses were "way too small compared to history," and that the full board had to be briefed on the discrepancies, which were "way too important" to be glossed over.
Deutsche Bank's senior U.S. managers rebuffed Broeksmit's warnings, according to the emails, copies of which were reviewed by Reuters.
Deutsche Bank was exempted last year from submitting its portfolio to a Fed-run stress test, but it was still required to run its own assessment using the same scenarios as other banks.
Broeksmit was found hanged in his London home on Jan. 26 last year. After a coroner's inquest, his death was ruled a suicide.
On Wednesday, the Fed validated many of Broeksmit's concerns when it said the U.S. unit failed the regulator's latest test of banks' risk-management capabilities. "In its evaluation, the Federal Reserve identified numerous and significant deficiencies across Deutsche Bank Trust Corporation's risk-identification, measurement, and aggregation processes; approaches to loss and revenue projection; and internal controls," the Fed said in announcing the stress test results.
Deutsche Bank spokeswoman Michele Allison said Broeksmit's warnings did not reflect disagreement within the bank, but were part of a routine discussion process. "Bill's colleagues on the board of Deutsche Bank Trust Company of the Americas held him in high regard and valued his advice," she said in a statement. "He deeply influenced their thinking and actions."
Deutsche Bank last week passed the first part of the Fed's stress test. That part assessed whether banks have enough capital to survive a severe economic crisis. This week's second part, which Deutsche Bank failed, assessed banks' ability to measure risk and fund capital plans, and carries stiffer consequences for those that fail.
For Deutsche Bank, it means the bank's U.S. unit will be unable to distribute capital to its parent company until it makes "substantial progress" toward fixing issues identified by the Fed. If the bank's problems persist, the Fed could bring enforcement actions against it, such as fines, or, in an extreme case, issuing a cease-and-desist order.
Among those who dismissed Broeksmit's concerns were Chief Financial Officer Eric Smith; Angelo Del Giudice, who headed Deutsche Bank's preparations for the stress test and now has a similar role at Barclays; Mark Cohen, head of restructuring, corporate banking and securities; and David Waill, the bank's global head of leveraged loan management.
Smith, Cohen and Waill declined to comment, according to spokeswoman Allison. Del Giudice declined to comment, according to a spokeswoman for Barclays.
These executives belonged to the bank's "Center of Excellence," a senior management committee established in late 2013 to review the bank's stress test results. The committee met many times in December 2013 and January 2014 as members prepared the bank's test results.
In a Dec. 17, 2013, email to the committee, Broeksmit criticized the group for ignoring the bank's portfolio performance from 2001 to 2004. During that period, many of the bank's collateralized debt obligations and other structured financial products had struggled. But in their stress test calculations, Broeksmit said, bank staff seemed to be cherry-picking historical data to support optimistic forecasts.
"Given how much lower our stress loan losses are versus peers we have to either explain why we disregarded this historical episode in establishing stress losses or, better yet, sharply scale up our losses to impose more stress," Broeksmit wrote.
The following day, Del Giudice wrote back, telling Broeksmit that after "a lot of discussion," the committee had decided not to stress their portfolio any harder and would not be discussing the issue with the full board of the bank.
Broeksmit was already well-known as an innovator in complex structured financial products and as a prescient analyst of risk.
While head of Merrill Lynch's U.S. fixed-income derivatives business in the early 1990s, he warned that Orange County, California, was taking on far too much risk by investing in certain debt instruments - products he himself had helped create. He was ignored. In 1994, Orange County, with $1.6 billion in investment losses, became the largest U.S. municipality to date to file for bankruptcy.
Broeksmit was close to Deutsche Bank AG co-Chief Executive Officer Anshu Jain from their time working together at Merrill Lynch. Jain tapped Broeksmit to join the bank's global management board as head of risk in 2012. But German regulators blocked the appointment, saying the executive lacked experience leading large teams.
In late 2013, Broeksmit continued to insist that Deutsche Bank management was making a mistake in preparing its stress test and that the board must be briefed in full. CFO Smith "should raise the topic ... at Board meeting. ... We have to explain why our stressed loan losses are much smaller percent of outstandings than out peers," he wrote in a Dec. 19, 2013, email. "This topic is way too important to speed past."
The "Center of Excellence" committee met and suggested in an email that Broeksmit present the group's findings to the full board, even though Broeksmit disagreed with many of the team's conclusions. Broeksmit bristled at the suggestion.
"Who is recommending that I do this?" he asked. "I am supposed to be an independent director and this puts me further into a role aligned with management. ... Also, as you can tell from my comments, I believe our stress credit losses are so low relative to peers that we will be open to criticism that our models are too generous."
The committee agreed to have someone else brief the board.
Broeksmit also fretted over the bank's loans to businesses. This sector has emerged as one of the frothiest post-crisis credit markets. Many business loans have been packaged into securities similar in structure to the mortgage-backed securities that played a big role in the financial crisis.
The Fed's test this year put particular emphasis on these types of loans, with a hypothetical "severely adverse" scenario that included a high rate of corporate defaults.
Broeksmit warned that rival Morgan Stanley had taken a far more conservative approach to risk calculations in business lending. The Morgan Stanley math "maybe points to our method being too optimistic," he wrote in a Dec. 5, 2013, email.
Waill, the bank's global head of leveraged-loan management, played down Broeksmit's concerns. While "conceivable that your ballpark may be right," he responded, Morgan Stanley's business-loan book "may be weaker." Morgan Stanley declined to comment.
Undeterred, Broeksmit fired off more warnings the following day. The team's forecast loan losses on another segment of the portfolio "look to be microscopic," he warned. "Maybe we are being too optimistic," he wrote. "I think we should stress harder." The bank's "severely adverse scenario losses in 2014 and 2015 look way too small compared to history," he wrote in the Dec. 6 email.
Twenty-five minutes later, he sent another warning to the senior management team, identifying other oddities in their earnings forecasts. "This doesn't sound right," he warned. "I don't think any has ever achieved those results."
Susan Skerritt, head of Deutsche Bank's global transaction banking division in its U.S. unit, responded: "The business has grown significantly over the past 5 years, which may account for some of the difference," she wrote. "But, I appreciate both of your questions and we will come back to you next week with a full explanation and potential revisions."
Reuters could not determine whether that follow-up email was ever sent. Deutsche Bank declined to make Skerritt available for comment. (Edited by John Blanton)