PART 13

negative view of RMBS securities was based primarily on his view that moderating home prices

would cause subprime mortgage defaults and was not dependent upon the quality of the

subprime loans.1299

In the fall of 2005, Mr. Lippmann said that he approached his supervisor Richard

D’Albert, Global Head of the Structured Products Group, for permission to enter into CDS

agreements to short RMBS securities totaling $1 billion.1300 He said that he explained at the time

that a cost benefit analysis favored a short RMBS position, because the bank would pay a

relatively small amount of CDS premiums per year in exchange for a potentially huge payout.

Mr. Lippmann said that he estimated at the time that, when the costs were compared to the

potential payout if the BBB securities defaulted, the proposed short position offered a potential

payout ratio of 8 to 1.

Mr. Lippmann also developed a presentation supporting his position entitled, “Shorting

Home Equity Mezzanine Tranches.” It made the following points:

• “Over 50% of outstanding subprime mortgages are located in MSAs [metropolitan

statistical areas] with double digit 5 year average of annual home price growth rates.

• There is a strong negative correlation between home price appreciation and loss

severity.

• Default of subprime mortgages are also strongly negatively correlated with home

price growth rates.

1296 Subcommittee interview of Greg Lippmann (10/18/2010). When asked if the position was a proprietary

investment by the bank, Mr. Lippmann told the Subcommittee that it was. Id. Deutsche Bank acknowledges in a

20-F filing with the U.S. Securities and Exchange Commission that it conducts proprietary trading, in addition to

trading activity that facilitates customer business. Deutsche Bank stated that it trades for its own account (i.e., uses

its capital) to exploit market opportunities. See Deutsche Bank Aktiengesellschaft’s Form 20-F filed with the

Securities and Exchange Commission on March 26, 2008, at 24.

1297 Subcommittee interview of Greg Lippmann (10/18/2010).

1298 Subcommittee interview of Greg Lippmann (10/18/2010).

1299 Id.

1300 Id.

343

• Nearly $440 billion subprime mortgages will experience payment shocks in the next 3

years.

• Products that may be riskier than traditional home equity/subprime mortgages have

become popular.” 1301

Mr. Lippmann told the Subcommittee that Mr. D’Albert approved his taking the short

position in or around November 2005, but said the trade was so big and controversial that Mr.

Lippmann also had to get the approval of Rajeev Misra, Global Head of Credit Trading,

Securitization and Commodities, who was based in London.1302 Mr. Lippmann said that, in or

around November 2005, Mr. Misra reluctantly gave his approval for the short position, even

though Mr. Misra believed mortgage related securities would continue to increase in value over

time.

Building the Short Position. Mr. Lippmann told the Subcommittee that he used some

existing short positions that had been undertaken as hedges to begin building his position.1303 He

said that, throughout 2006, he gradually accumulated a larger short position, which eventually

reached $2 billion. According to Mr. Lippmann, Deutsche Bank senior management reluctantly

went along.1304 He told the Subcommittee that, at one point in 2006, Boaz Weinstein, who

reported to Mr. Misra, told him that the carrying costs of his position, which required the bank to

pay insurance-like premiums to support the $2 billion short position, had become so large that he

had to find a way to pay for them. According to Mr. Lippmann, the bank’s senior management

asked him to persuade them that he was right by demonstrating that others were willing to

“short” the market as well. Mr. Lippmann told the Subcommittee he was then motivated to

convince his clients that they ought to short the mortgage market, arrange the shorts for them,

and make enough in fees from those transactions to pay for the costs of his multi-billion-dollar

short.1305

Mr. Lippmann told the Subcommittee that he spent much of 2006 pitching his clients to

short the mortgage market. He said that he often made presentations to prospective clients

sharing with them his “strategy on how to cash in on a slowing housing market.”1306 He said

that, in early 2006, he expended approximately 200 hours trying to convince AIG to short single

name RMBS, but was unsuccessful. He told the Subcommittee that he also believed that his

presentations helped convince AIG to stop buying RMBS and CDO securities and stop selling

CDS protection for those deals. In an August 2006 email, Mr. Lippmann wrote: “In 05 for a

time, we sold EVERY single one to AIG. They stepped out of the market in March of 06 after

speaking with me and our research people (and I don’t doubt other dealers).”1307

1301 9/2005 “Shorting Home Equity Mezzanine Tranches, A Strategy to Cash in on a Slowing Housing Market,”

DBSI_PSI_EMAIL00502892-29.

Mr. Lippmann

1302 Subcommittee interview of Greg Lippmann (10/18/2010).

1303 Id.

1304 Id.

1305 Id.

1306 Id.

1307 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236.

344

told the Subcommittee that Mr. Lamont, who co-led Deutsche Bank’s CDO Group, was not

pleased that Mr. Lippmann had convinced AIG, a very large purchaser of long interest in RMBS

and CDO securities, to stop buying them.

The documents indicate that Mr. Lippmann and his trading team were aware at the time

that the CDO Trading Desk was expected to promote rather than discourage client interest in

purchasing Deutsche Bank’s CDO securities. One of Mr. Lippmann’s top traders, Rocky Kurita,

put it this way in mid-2005: “[W]e have to make money. Customer happiness is a secondary

goal but we cannot lose sight of the trading desk[’]s other role of supporting new issue and the

customer franchise.”1308 In a 2007 email to a client, Mr. Lippmann wrote: “[P]lease please do

not forward these emails outside of your firm. … I do not want to be blamed by the new issue

people for destroying their business.”1309

Although Mr. Lippmann was unsuccessful in convincing AIG to short RMBS and CDO

securities, he did convince some of his other clients, usually hedge funds, to undertake such

shorts, primarily by purchasing single name CDS contracts referencing specific RMBS

securities. Those trades generated substantial sums for the ABS Correlation Trading Desk which

acted as a market maker in the CDS market for those clients. Mr. Lippmann told the

Subcommittee that the shorts executed by his clients ultimately generated about $200 million in

revenues for his desk in 2006.1310

Defending the Short. According to Mr. Lippmann, in December 2006, he met in

London with a senior bank official, Anshu Jain, Head of Global Markets at Deutsche Bank, and

suggested that Deutsche Bank’s long positions in mortgage related securities created too much

exposure for the bank and should be reduced.1311 Mr. Lippmann recommended that the bank

hedge its risk using his short strategy. His suggestion was not acted upon, but as the market

grew more volatile in late 2006 and early 2007, Mr. Lippmann’s short position began to gain in

value and caught the attention of senior management at the bank.

Mr. Lippmann told the Subcommittee that, in January 2007, he met with Mr. Jain, Mr.

Misra, and Mr. D’Albert at a hotel in Lisbon, where all three again challenged him to defend his

short position by noting that it had required him to pay out $20 million in CDS premiums during

2006.1312 Mr. Lippmann told the Subcommittee that he countered by pointing out, while he had

paid out $20 million, his desk made $200 million from trading in RMBS and CDO shorts for his

clients. He said that the three concluded he could keep his short position.1313

1308 5/12/2005 email from Rocky Kurita to Greg Lippmann, DBSI_PSI_EMAIL00054826.

According to Mr.

Lippmann, in February 2007, Mr. Jain met with him again to discuss whether or not to keep his

short position, because it had gained in value and Deutsche Bank could cash in the position and

1309 2/1/2007 email from Greg Lippmann to Wyck Brown at Braddock Financial, DBSI_PSI_EMAIL01969867.

1310 Subcommittee interview of Greg Lippmann (10/18/2010).

1311 Subcommittee interview of Greg Lippmann (10/18/2010).

1312 Subcommittee interview of Greg Lippmann (10/18/2010).

1313 Subcommittee interview of Greg Lippmann (10/18/2010).

345

take the profits at that time. Mr. Lippmann said that the result of the meeting was that, once

again, his position was left in place.

While defending his position within the bank, Mr. Lippmann continued to speak with his

outside clients about his negative views of the market, continued to make presentations to

potential clients about shorting the market,1314 and continued to execute shorts for them, while

building his desk’s proprietary short position.

According to Mr. Lippmann, in late February or early March 2007, as the ABX Index

showed subprime RMBS securities losing value and subprime mortgages continued incurring

delinquencies at record rates, an ad hoc meeting of Deutsche Bank’s executive committee took

place in London to discuss the bank’s risk exposure in mortgage related securities. According to

Mr. Lippmann, he happened to be in London at the time and was invited to attend. He estimated

that ten to twelve persons were at the meeting in person, and another two to four persons

participated by telephone. He said that, at the meeting, Deutsche Bank executives discussed

whether the recent market volatility reflected short term or longer term trends and whether the

bank should make any changes in its holdings.1315 At that time, Mr. Lippmann held the only

large short position on behalf of the bank, then about $4 to 5 billion in size.1316 In contrast, the

Deutsche Bank mortgage group held $102 billion in long RMBS and CDO securities, and

Winchester Capital, Deutsche Bank’s hedge fund affiliate, held a net long position of $8.9

billion.1317 Mr. Lippmann told the Subcommittee that he was the only person at the meeting who

argued for the bank to increase its short position.1318

At the time of the London meeting, Mr. Lippmann’s position was showing a significant

profit. Mr. Misra brought up the alternative of cashing in his position while RMBS prices were

down, because he thought prices were in a short term dip and the profits might disappear later

on. Mr. Lippmann contended that the bank should not only keep his short position, but increase

it, but more senior voices disagreed with him. He told the Subcommittee that the decision at the

end of the meeting was for all parties to keep their positions unchanged, including Mr.

Lippmann.1319

Cashing In the Short. In July 2007, the major credit rating agencies began issuing

downgrades of RMBS and CDO securities, in particular those that incorporated or referenced

subprime mortgages. The value of those securities began to plummet. By the end of the summer

of 2007, Deutsche Bank initiated efforts to sell off the long positions held by Winchester Capital

and other Deutsche Bank entities, reflecting a shift in the bank’s strategy, but its sales force had

1314 See, e.g., 2/2007 presentation, “Shorting Home Equity Mezzanine Tranches,” prepared by Mr. Lippmann,

DBSI_PSI_EMAIL01988773-845.

1315 Subcommittee interview of Greg Lippmann (10/18/2010).

1316 2/23/2007 email from Greg Lippmann to Anshu Jain, DBSI_PSI_EMAIL02383117-18.

1317 3/2/2011 letter from Deutsche Bank’s counsel to the Subcommittee, PSI-DeutscheBank-31-0004-06.

1318 Subcommittee interview of Greg Lippmann (10/18/2010).

1319 Id.

346

difficulty due to the lack of customers willing to buy long.1320 During 2007 and 2008, at the

direction of senior management, Mr. Lippmann gradually cashed in his short position, obtaining

a total return of about $1.5 billion, which Mr. Lippmann told the Subcommittee he believes was

the largest profit obtained from a single position in Deutsche Bank history.1321

Despite the gain from Mr. Lippmann’s short position, Deutsche Bank told the

Subcommittee that, overall in 2007, it had a long position in mortgage related holdings, with a

face value of about $128 billion and a market value of more than $25 billion. Deutsche Bank

told the Subcommittee that, despite the size of these holdings and their declining value, it lost

only about $4.5 billion on those mortgage related holdings for the year.1322 Deutsche Bank also

filed a 2007 annual report with the SEC claiming a 2007 profit of €7.2 billion.1323 When asked

why its large long position in mortgage holdings did not lose more value, Deutsche Bank told the

Subcommittee that it had placed large hedges, using U.S. Treasury bonds, which reduced its

losses.1324

(4) The “CDO Machine”

From 2006 to 2007, Mr. Lippmann repeatedly cautioned his colleagues and clients that

the mortgage market was headed for a downfall, convinced a number of his clients to short

RMBS and CDO securities, and built his $5 billion short position on behalf of Deutsche Bank.

Meanwhile, the “CDO machine,” as he described it, continued issuing new CDO securities

through the end of 2007. The reasons for this continuing CDO activity, despite a deteriorating

mortgage market and waning investor interest, are key to understanding how these complex, high

risk, structured finance products ended up in multiple financial portfolios throughout the U.S.

financial system.

Mr. Lippmann was frequently asked why, given his negative views, the CDO market was

continuing to operate. He pointed to investment bank fees, prestige, and pressure to preserve the

CDO jobs involved. In August 2006, for example, Mr. Lippmann wrote:

1320 Subcommittee interview of Jordan Milman (10/22/2010). Mr. Milman, one of Mr. Lippmann’s top traders,

stated that the market first weakened in February 2007, stabilized until June or July 2007, and then it was a “one

way train” down from then through 2008. Id.

1321 Subcommittee interview of Greg Lippmann (10/18/2010). See Net Revenues from ABS Products Backed by

U.S. Residential Mortgages, DB_PSI_C00000003.

1322 According to a chart prepared by Deutsche Bank for the Subcommittee, in 2007 and 2008, its RMBS holdings

lost about $3.4 billion; the CDO Group lost about $1.0 billion; Winchester Capital lost about $1.1 billion; and two

other trading desks lost nearly $650 million. These losses were offset by the $1.5 billion gain from the bank’s short

position, for total mortgage related losses of about $4.5 billion. Net Revenues from ABS Products Backed by U.S.

Residential Mortgages, DB_PSI_C00000003.

1323 Deutsche Bank stated in its annual report filed with the SEC that it ended 2007 in the black, due to gains in other

areas of the bank, including its Corporate and Investment Bank which reported a pre-tax profit of €5.1 billion and its

Private Clients and Asset Management division which reported a pre-tax profit of €2.1 billion. See Deutsche Bank’s

2007 annual report filed with the SEC, in particular the Executive Summary of Deutsche Bank’s Annual Report and

the letter from the Chairman of the Board.

1324 Subcommittee interview with Deutsche Bank’s counsel (3/7/2011). See also 3/21/2011 letter and accompanying

chart from Deutsche Bank’s counsel to the Subcommittee, PSI-Deutsche_Bank-32-0001-04.

347

“Why have we done this? It is not without reluctance and we are looking for ways to get

out of this risk, but for now the view has been, we like the fees and the league table credit

(and dammit we have a budget to make).”1325

In January 2007, after a trader asked Mr. Lippmann why the CDO market hadn’t imploded, Mr.

Lippmann responded: “league table, fees, never has one blown up yet.”1326 The reference to

“league table credit” indicates that investment banks considered it prestigious to be listed as the

leading producer of a complex structured finance product like CDOs, and used their standing in

the tables that tracked total origination numbers as a way of burnishing their reputations,

attracting top talent, and generating new business. An October 2006 “Progress Report” on its

CDO business, for example, which was prepared internally by the bank, included a slide entitled,

“CDO Primary Revenue Forecast and League Tables,” in which a chart ranked Deutsche Bank

third in CDO issuance, behind Merrill Lynch and Citigroup.1327 The slide indicated that

Deutsche Bank had completed 38 CDOs to date, had a 7% share of the CDO market, and

“expected to close 50 deals by year end,” with the “pipeline for Q1 and Q2 2007 building.” The

final page of the presentation, providing a chart listing the top 20 Deutsche Bank CDO

salespersons by region, together with their individual sales credits, identifies some of the bank

personnel invested in the continuation of the CDO business.

On the issue of fees, the head of Deutsche Bank’s CDO Group Michael Lamont told the

Subcommittee that he estimated the bank received 40-200 basis points for each CDO created,

depending upon the complexity of the CDO.1328 He indicated those fees translated into about $5

to $10 million per CDO.1329 When asked what he meant by saying “we have a budget to make,”

Mr. Lippmann explained that new CDO deals had to be completed continuously to produce the

revenues needed to support the budgets of the CDO desks and departments involved with their

creation.1330

1325 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236-42.

On August 1, 2006, Mr. Lippmann wrote to Mr. Milman, “who has all this crap and let me know which ones to look

at looks like a lot of crappy deals.” 8/1/2006 email from Greg Lippmann to Jordan Milman,

DBSI_PSI_EMAIL01510643. Mr. Lippmann’s negative views were shared by his traders. In an email originally

sent by one of the traders on his desk, Rocky Kurita, the CDO business is set to a song, “CDO Oh Baby,” by Vanilla

Ice with the following lyrics: “Yo vip let’s kick it! CDO oh baby, CDO oh baby. All right, stop, collaborate and

listen. Spreads are wide with a technical invasion. Home Eq Subs were trading so tightly. Until Hedge Funds Bot

Protection daily and nightly. Will they stop? Yo I don’t know. Turn up the Arb and let’s go. To the extreme Macro

Funds do damage like a vandal. Now, BBs are trading with a new handle. Print, even if the housing bubble looms.

There are never ends to real estate booms. If there is a problem, yo, we’ll solve it. Check out the spreads while my

structurer revolves it. CDO oh baby, CDO oh baby.” 11/8/2005 email from Jordan Milman to Greg Lippmann,

DBSI_PSI_EMAIL00686597-601 (forwarding an 11/8/2005 email from Rocky Kurita at Deutsche Bank).

1326 1/5/2007 email from Greg Lippmann to Chris Madison at Mast Capital, DBSI_PSI_EMAIL02333467-68.

1327 10/2006, “CDO Primary Update Progress Report,” DBSI_PSI_EMAIL03970167-72, at 68.

1328 Subcommittee interview of Michael Lamont (9/29/2010).

1329 Id.

1330 Subcommittee interview of Greg Lippmann (10/18/2010).

348

A similar view as to why the CDO business continued to operate despite increasing

market risk was expressed by a former executive at the hedge fund Paulson & Co. in a January

2007 email exchange with another investor. The Paulson executive wrote:

“It is true that the market is not pricing the subprime RMBS wipeout scenario. In my

opinion this situation is due to the fact that rating agencies, CDO managers and

underwriters have all the incentives to keep the game going, while ‘real money’ investors

have neither the analytic tools nor the institutional framework to take action before the

losses that one could anticipate based [on] the ‘news’ available everywhere are actually

realized.”1331

At the end of September 2006, the head of Deutsche Bank’s sales force, Sean Whelan,

wrote to Mr. Lippmann expressing concern that some CDO tranches were getting increasingly

difficult to sell: “[T]he equity and the AAA were the parts we found difficult to place.”1332 Mr.

Lippmann told the Subcommittee that once firms could not sell an entire CDO to investors, it

was a warning that the market was waning, and the investment banks should have stopped

structuring new ones.1333

“As the housing boom began to slow in mid-2006, investors became skittish about the

riskier parts of those investments. So the banks created – and ultimately provided most

of the money for – new CDOs. Those new CDOs bought the hard-to-sell pieces of the

original CDOs. The result was

Instead of getting out of the CDO business, however, he said, a new

source of CDO demand was found – when new CDOs started buying old CDO securities to

include in their assets. One media report explained how this worked:

a daisy chain that solved one problem but created another:

Each new CDO had its own risky pieces. Banks created yet other CDOs to buy

those.”1334

Research conducted by Thetica Systems, at the request of ProPublica, found that in the

last years before the financial crisis, CDOs had become the dominant purchaser of high risk

CDO securities, largely replacing real money investors like pension funds, insurance companies,

and hedge funds. The CDO market analysis found that, by 2007, 67% of the high risk mezzanine

CDO securities had been purchased by other CDOs, up from 36% in 2004.1335

1331 1/14/2007 email from Paolo Pellegrini at Paulson to Ananth Krishnamurthy at 3a Investors, PAULSON

ABACUS 0234459.

1332 9/27/2006 email from Sean Whelan to Greg Lippmann, DBSI_PSI_EMAIL02255361-63.

1333 Subcommittee interview of Greg Lippmann (10/18/2010). Mr. Lippmann told the Subcommittee that he thought

Mr. Lamont’s CDO Group at Deutsche Bank had too many CDOs in the pipeline in the spring of 2007, when it

could not sell all of its CDO securities. He reported that he told Mr. Lamont that defaults would increase.

1334 “Banks’ Self-Dealing Super Charged Financial Crisis,” ProPublica, (8/26/2010),

http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis.

1335 Id. ProPublica even found that, from 2006 to 2007, nearly half of all the CDOs sponsored by Merrill Lynch

bought significant portions of other Merrill CDOs.

349

Mr. Lippmann told the Subcommittee that he considered it a “shady” practice when, in

2006, difficult-to-sell BBB CDO tranches began to be placed in new CDOs.1336 In a June 2007

email to Mr. Lippmann, Richard Kim, a Deutsche Bank Managing Director, described placing

unsold CDO tranches into a new CDO to be sold to investors as a “CDO2 balance sheet

dump.”1337

In addition to placing unsold CDO securities in newly issued CDOs, investment banks

turned increasingly to non-U.S. investors to keep the CDO machine going. In August 2006, Mr.

Lippmann noted that European and Asian banks were being targeted to buy CDOs:

“Hear what you are saying and in a normal market your logic would be inarguable, but

the demand for this crap is virtually entirely technically driven, all cdos. And each

person at the cdo table thinks someone else is the fool- cdo equity, ostensibly only two

buyers one mutual fund in Australia, and one hedge fund in Chicago, who is actually

putting on a bearish correlation trade: bbb sold mostly ponzi-like to other cdos with

limited distribution in Europe. AA and Junior AAA sold mostly to high grade cdos and

to a certain extent European and Asian banks and lastly the senior AAA, this may

ultimately break the cdo market.”1338

In a December 2006 email, Mr. Lippmann wrote to a client: “[W]ho owns the cdos…insurance

company and german and asian banks…and high grade cdos (can you say ponzi scheme)[?]”1339

In early 2007, he wrote:

“[T]he other side is all cdos..so it is the cdo investors who r on the other side who buys cdos:

aaa-reinsurance, ws [Wall Street] conduits, European and Asian banks, aa-high grade cdos,

European and Asian banks and insurers..some US insurers, bbb other mezz [mezzanine] abs

[asset-backed security] cdos (i.e. ponzi scheme), European banks and insurers, equity some US

hedge funds, Asian insurance companies, Australian and Japanese retail investors through

mutual funds.” 1340

In February 2007, when an investor wrote to Mr. Lippmann inquiring about the status of

the “CDO machine,” Mr. Lippmann responded: “[G]etting slower but not dead yet[.] … 2-5

ramping a day instead of 10-15[.] … [H]earing of many investors in asia especially shutting

down … but the window is not completely shut yet.”1341 Deutsche Bank emails demonstrate

that, in 2007, like other investment banks, it was actively trying to sell CDOs in Asia.1342

1336 Subcommittee interview of Greg Lippmann (10/18/2010).

1337 6/14/2007 email from Richard Kim at Deutsche Bank to Greg Lippmann, DBSI_PSI_EMAIL02202920.

1338 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236.

1339 12/4/2006 email from Greg Lippmann to Deutsche Bank employee, DBSI_PSI_EMAIL01867147-49.

1340 2/27/2007 email from Greg Lippmann to Fabrizio Wittenburg at Deutsche Bank, DBSI_PSI_EMAIL02027053-

55.

1341 2/20/2007 email from Greg Lippmann to David Homan at Moore Capital, DBSI_PSI_EMAIL02006853-54.

1342 See, e.g., “I would like these guys to push Asia sales on this…, but also as Ilinca said, the question arises why

weren’t they working on this thus far?” 2/21/2007 email from Abhayad Kamat at Deutsche Bank to Michael

Lamont and others at Deutsche Bank, DBSI_PSI_EMAIL04056326-36.

350

Mr. Lippmann had an unrelentingly negative view of the RMBS and CDO securities he

traded. He believed the securities would ultimately lose value, but he also believed investment

banks would do all they could to sustain the CDO market for as long as possible due to the CDO

fees, prestige, market share, and jobs at stake.

(5) Gemstone

To understand how one investment bank, Deutsche Bank, continued to develop and

aggressively solicit its clients to purchase CDO securities even as mortgage related securities lost

value and the CDO market began collapsing, the Subcommittee examined in detail Gemstone 7,

a $1.1 billion CDO. Gemstone 7 was assembled and marketed by Deutsche Bank, as sole

placement agent, from October 2006 to March 2007.1343 Gemstone 7 was the last in a series of

CDOs sponsored by HBK Capital Management (HBK), a large hedge fund.1344

Deutsche Bank issued the Gemstone 7 securities in March 2007. Six out of Gemstone’s

seven tranches received investment grade ratings, including AAA ratings for the top three

tranches. Two months later, in July 2007, the major credit rating agencies issued mass rating

downgrades of RMBS and CDO securities, including 19 of the 115 RMBS securities included or

referenced in Gemstone 7. In November 2007, the credit rating agencies began to downgrade the

Gemstone 7 securities. Today, all seven tranches have been downgraded to junk status, and the

Gemstone 7 securities are nearly worthless.

(a) Background on Gemstone

Gemstone 7 was a $1.1 billion hybrid CDO whose assets consisted predominantly of high

risk subprime RMBS securities. Nearly 90% of its assets were mid and subprime RMBS

securities with 33% carrying non-investment grade ratings.1345 Of the remaining assets, 4.5%

were CDO securities; 3.3% were commercial mortgage backed securities; and 3.5% were

securities backed by pools of student loans.1346 When the deal closed in March 2007, Gemstone

7 had about $476 million in cash RMBS assets as well as $625 million in synthetic assets.1347

1343 In the Gemstone 7 offering circular, Deutsche Bank is described as the placement agent: “The Notes purchased

by the Initial Purchaser, if any, will be privately placed with eligible investors by the Initial Purchaser” where the

Initial Purchaser was Deutsche Bank. Gemstone 7 Offering Circular, GEM7-00000427-816 at GEM7-00000640. In

contrast, other documents produced by Deutsche Bank indicate that the bank was acting as an underwriter in the

Gemstone 7 transaction. See, e.g., 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71 and

undated Gemstone 7 Securitization Credit Report, MTSS000011-13. For ease of reference but without making a

judgment on the matter, this Report uses the term “placement agent” when describing Deutsche Bank’s role in

Gemstone 7.

Gemstone 7 was constructed as a “partially static” CDO, meaning that while some of its assets

were set and could not change, others could be replaced by the collateral manager, HBK.

1344 Subcommittee interview of HBK Managing Director Jamiel Akhtar (9/15/2010).

1345 The intended portfolio composition of Gemstone 7 was disclosed to investors in a Debt Investor Presentation.

See 2/2007 Gemstone 7 Debt Investor Presentation, GEM7-00001687-1747 at 1695.

1346 Id. at 1691.

1347 9/14/2010 Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03.

351

HBK is a Dallas based hedge fund that was founded in October 1991, and by 2007,

managed approximately $12 billion in capital.1348 According to HBK, its Structured Products

Group, one of its 21 business units, was “one of the leading purchasers and long-term investors

in credit sensitive mortgages … including RMBS and ABS, a component in HBK’s overall

strategy since 2002.”1349 Deutsche Bank told the Subcommittee that HBK had a reputation as a

competent manager of mortgage related assets.1350 HBK had acted as the collateral manager for

seven previous CDO deals (six named Gemstone), choosing to alternate the mandate for the

deals between Lehman Brothers and Deutsche Bank.

In October 2006, HBK retained Deutsche Bank to act as the placement agent for

Gemstone 7. Under the agreement, HBK was to receive 30 basis points, or 0.3%, per year of the

notional amount of Gemstone 7 (approximately $3.3 million) in return for serving as the

collateral manager. Deutsche Bank was slated to receive $6.79 million in “underwriting fees,”

but because the deal did not sell completely, Deutsche Bank ultimately received a lesser amount

of $4.7 million.1351

On October 25, 2006, HBK and Deutsche Bank signed an agreement outlining the terms

of Gemstone 7. HBK told the Subcommittee:

“The collateral purchased under the warehouse arrangement was selected by HBK and

subject to Deutsche Bank’s right of approval. The warehouse documents originally

contemplated a total collateral pool of $750 million, which was increased to $1.1 billion

in late December 2006.”1352

On October 24, 2006, Deutsche Bank opened a warehouse account to store the assets that would

serve as the collateral for the CDO when it closed.1353

1348 1/2007 Gemstone 7 Debt Investor Presentation, at 17, DBSI_PSI_EMAIL01980000-60.

Deutsche Bank and HBK shared the risk

1349 Id.

1350 Subcommittee interview of Sean Whelan, co-head of Deutsche Bank sales force (9/22/2010).

1351 See 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71; undated Gemstone 7

Securitization Credit Report, MTSS000011-13; 3/15/2007 Gemstone CDO VII Ltd. Closing Memorandum,

DB_PSI_00133536-41. According to the Gemstone Offering Circular, HBK was to receive “0.30% per annum on

the Quarterly Amount payable in arrears on each distribution date.” 3/15/2007 Offering Circular for Gemstone

CDO VII, Ltd., GEM7-00000427-816, “The Management Agreement,” at 168. As opposed to an upfront fee, which

Deutsche Bank received, the fee to HBK was paid quarterly. Thus, 0.30% of $1.1 billion translates to a fee of

approximately $3.3 million for HBK. See 7/11/2007 email from Chehao Lu at Deutsche Bank to Marco Lukesch at

HBK, GEM7-00003568. See also email noting HBK’s quarterly collateral management fee of $826,067.88 as of

September 11, 2007. 9/11/2007 email from Eric Martel at HBK to Jamiel Akhtar at HBK, GEM7-00006900.

1352 8/20/2010 letter from HBK’s counsel to the Subcommittee, at 2.

1353 See chart, “Assets Purchased by Gemstone VII CDO during Warehouse Period,” GEM7-00001831-33 (showing

assets purchased during the warehouse period). According to Credit magazine, “The financial press will often make

its first mention of a ‘new’ CDO on or around the time of its closing – with the closing date generally the day on

which the CDO issues tranches of debt and equity to investors. Prior to that day, however, there will have been a socalled

pre-closing or ‘warehousing’ period, typically lasting between three and six months. During that period the

asset manager will have acquired (or ‘warehoused’) assets to act as collateral for the securities to be issued by the

CDO … on the closing day.” See “CDO Guide: recovery rates,” Credit (May 2004),

http://db.riskwaters.com/public/showPage.html?page=133193.

352

for any change in value of the warehoused assets if the deal failed to close. Pursuant to the risk

sharing agreement, if the deal failed to close, HBK would incur the risk for the first $80 million

in losses, and Deutsche Bank would bear the remaining risk.1354

Deutsche Bank CDO Group. Several departments and desks at Deutsche Bank were

involved in designing, marketing, and selling the Gemstone 7 securities. The CDO Group, coheaded

by Michael Lamont and Michael Herzig, was responsible for designing its structure,

monitoring the purchasing and warehousing of its assets, obtaining its credit ratings, preparing

the legal documentation, establishing its administrative structure, obtaining underwriting

approval of the deal, designing the marketing materials, and overseeing the issuance of the CDO

securities.1355 Abhayad Kamat within the CDO Group was assigned lead responsibility for

structuring Gemstone 7.1356 The CDO Trading Desk, headed by Greg Lippmann, participated in

the CDO approval process once HBK selected assets. The CDO sales force, headed by Sean

Whelan and Michael Jones, was responsible for selling the Gemstone 7 CDO securities.

To issue the CDO securities, Deutsche Bank established an offshore corporation in the

Cayman Islands called Gemstone CDO VII, Ltd.1357 To administer the corporation, Deutsche

Bank appointed its Cayman Island affiliate, Deutsche Bank Cayman, which is a licensed trust

company.1358 As administrator, Deutsche Bank Cayman provided Gemstone 7 with the

administrative services needed to operate the CDO securitization, including but not limited to,

providing office facilities and secretarial staff, maintaining the books and records required by

Cayman law, naming at least two Cayman directors, and acting as the Share Registrar for

Gemstone shares.1359

HBK’s Long Investment in Gemstone. HBK routinely purchased the equity

tranche,1360 also known as the residual interest, in all of its Gemstone deals, including Gemstone

7.1361

1354 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71.

HBK told investors in its sales presentation that “HBK has retained 100% of the equity

1355 Subcommittee interview of Michael Lamont (9/29/2010).

1356 Subcommittee interview of Abhayad Kamat (10/8/2010).

1357 Gemstone CDO VII Ltd. Certificate of Incorporation and Memorandum and Articles of Association of

Gemstone CDO VII Ltd., DB_PSI_00236844.

1358 Deutsche Bank International Limited is a wholly owned subsidiary of Deutsche Bank AG. It currently has

several offices around the world, including one in the Cayman Islands, Deutsche Bank (Cayman) Limited (“DB

Cayman”), that was opened in 1983. “Deutsche Bank International Ltd.,” Bloomberg Businessweek,

http://investing.businessweek.com/research/stocks/private/snapshot.asp?privcapId=884191; “Deutsche Bank in the

Cayman Islands,” Deutsche Bank, http://www.dboffshore.com/page.php?title=cayman_islands. DB Cayman is a

licensed trust company incorporated in the Cayman Islands. Preference Share Paying Agency Agreement, GEM7-

00001089-1030, at 1092.

1359 Amended and Restated Administrative Agreement, GEM7-00001223-31; Preference Share Paying Agency

Agreement, GEM7-00001089-1130 at 1095-96.

1360 An equity tranche is the tranche in an RMBS or CDO structure that is designed to be the first to incur any losses

from the securitization. Since it is expected to incur at least some level of losses, the equity tranche is usually not

given a credit rating and is often retained by the originator of the securitization. See American Banker definition,

http://www.americanbanker.com/glossary/e.html.

1361 According to HBK, “HBK’s investment process integrates expertise in capital markets, structural analysis,

collateral and loan level analysis, due diligence, and in house surveillance. HBK is seen as not as a trader but as a

353

from CDO transactions resulting in strong alignment of interests between HBK and

investors.”1362 According to Kevin Jenks, HBK’s collateral manager, HBK had a “buy and hold”

approach to all of its Gemstone CDOs.1363 HBK also told the Subcommittee that it participated

in Gemstone 7 with “the objective of obtaining long exposure to the CDO’s collateral, on a

leveraged basis, through ownership of the Residual interest.”1364

HBK deals were known for containing above average concentrations of BB or lower

rated assets, but HBK prided itself on its ability to run in-depth analysis and accurate stress tests

on assets it selected for its CDOs.1365 HBK expected to receive a 15% return on its investment in

the equity tranche.1366 In its investor presentation, HBK stated: “The firm strives to provide

superior risk-adjusted rates of return with relatively low volatility and relatively low correlation

to most major market indices.”1367 HBK’s presentation also claimed that, as of January 2007, it

had only three downgrades in its asset backed security portfolio, and that its upgrade to

downgrade ratio was 23 to 3.1368 Investor M&T Bank, who later purchased Gemstone 7

securities, told the Subcommittee that it had relied on HBK’s assertions when choosing what it

thought was an investment with “minimal risk.”1369

HBK informed the Subcommittee that it had never shorted any of the assets in its seven

Gemstone CDOs, that its CDO trade book was evenly matched with long and short CDO assets

during the 2006-2007 period,1370 and that it lost over $700 million in its Structured Credit

business unit during 2007.1371

(b) Gemstone Asset Selection

As the collateral manager, HBK selected the assets for Gemstone 7, subject to approval

by Deutsche Bank’s structuring and trading groups before each asset could be placed in the

Deutsche Bank warehouse account for the CDO.1372

vigilant investor that maximizes value through intensive analysis and surveillance.” 1/2007 Gemstone 7 Debt

Investor Presentation, DBSI_PSI_EMAIL01980000-60 at 23.

According to HBK and Deutsche Bank

1362 Id.

1363Subcommittee interview of Kevin Jenks (10/13/2010). Also see 1/2007 Gemstone 7 Debt Investor Presentation,

DBSI_PSI_EMAIL01980000-60 at 25.

1364 8/20/2010 letter from HBK’s counsel to the Subcommittee.

1365 Subcommittee interview of Abhayad Kamat (10/8/2010). Mr. Kamat was the individual at Deutsche Bank who

was primarily responsible for structuring Gemstone 7.

1366 Subcommittee interview of Jamiel Akhtar (9/15/2010).

1367 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 at 17.

1368 Id. at 25.

1369 Subcommittee interview of M&T (9/20/2010).

1370 According to HBK, “HBK never had a short position in any securities issued by the Gemstone 7 CDO.” HBK

also told the Subcommittee staff that it had approximately $350 million of long exposure in Gemstone 7 and another

$800 million of “additional long exposure to the same assets underlying collateral outside the CDO.” 8/20/2010

letter from HBK’s counsel to the Subcommittee. HBK told the Subcommittee that it did at times take short

positions in certain mortgage backed securities unrelated to the Gemstone transactions.

1371 8/20/2010 letter from HBK’s counsel to the Subcommittee, and exhibit to letter, HBK’s exposure to Gemstone

VII Notes, GEM7-00000001-10.

1372 Subcommittee interview of Abhayad Kamat (10/8/2010).

354

personnel, the approval process worked in the following manner. First, HBK identified the

RMBS, CDO, and other securities it wanted to include or reference in the CDO. HBK then sent

an email to Mr. Lippmann or his traders at Deutsche Bank requesting that the identified assets be

placed in the warehouse account for Gemstone 7. Deutsche Bank traders, sometimes in

consultation with Mr. Lamont’s structuring group, would then either approve or voice concerns

regarding the proposed assets. If they had concerns, the traders would work with HBK personnel

to resolve them. For example, on January 9, 2007, HBK’s Jason Lowry sent an email to Mr.

Lippmann and his trader, Jordan Milman, with a list of RMBS securities proposed for inclusion

in Gemstone 7, and asked: “This is the last BB list for approval. Could you take a look?” On

the same day, Mr. Milman wrote back: “approved contingent upon first pay defaults getting

bought back on the 2 heat bonds.”1373

Although the Gemstone 7 offering circular did not describe Deutsche Bank’s role in the

asset selection process, the private engagement agreement between HBK and Deutsche Bank

did.1374 According to the terms of the engagement agreement, Deutsche Bank agreed to provide,

among other items, the following service: “advising the Issuer [Gemstone 7] and the Company

[HBK] on the selection and acquisition of the Underlying Assets” and “the scope of due

diligence for the Underlying Assets.”1375 Under both the engagement agreement and a separate

risk sharing agreement, Deutsche Bank also had the right to reject assets selected by HBK for the

Gemstone warehouse account.1376 When asked about Deutsche Bank’s obligations under these

agreements, Mr. Lippmann told the Subcommittee that he viewed Deutsche Bank as having an

obligation to the entity, Gemstone 7, to price the assets accurately as they were purchased, which

included comparing the price of each security or CDS contract on the date it went into the

warehouse account to its market price and ensuring that the CDO did not overpay for the assets it

purchased.1377 Mr. Lippmann’s trader, Mr. Milman, and Mr. Kamat, of Mr. Lamont’s CDO

Group, agreed with that assessment.1378 All three also stated that the engagement agreement did

not require Deutsche Bank to analyze the quality of the assets being purchased or how those

assets were expected to perform.

On the other hand, documents reviewed by the Subcommittee indicate, in at least a few

instances, that Deutsche Bank personnel voiced concerns about an RMBS security being placed

in the deal due to performance concerns in addition to price. For example, Mr. Kamat, who also

assisted Mr. Lippmann’s trading desks, wrote to Mr. Jenks about the quality of an asset being

1373 See, e.g., 1/9/2007 email from Jason Lowry to Greg Lippmann, GEM7-00002154; and 12/11/2006 email from

Greg Lippmann to Kevin Jenks, GEM7-00002805. The term “heat” refers to an RMBS security issued by Home

Equity Asset Trust.

1374 The Gemstone 7 offering circular states that with regard to the purchase of underlying assets: “The Issuer

[Gemstone 7] will acquire Underlying Assets from a warehouse facility (the ‘Warehouse Facility’) provided by an

affiliate of DBSI [Deutsche Bank Securities, Inc.], which provides for the purchase of Asset-Backed Securities at the

direction of the Collateral Manager [HBK] on behalf of the Issuer prior to the Closing Date.” Gemstone 7 Offering

Circular, GEM7-00000427-816 at 494.

1375 10/25/2006 signed letter agreement between HBK and Deutsche Bank, GEM7-00000071-89 at 72.

1376 10/25/2006 signed letter agreement between HBK and Deutsche Bank, GEM7-00000071-89 at 72; and

10/24/2006 Risk Sharing Agreement, GEM7-00000090-99 at 91.

1377 Subcommittee interview of Greg Lippmann (10/18/2010).

1378 Subcommittee interview of Jordan Milman (10/22/2010) and Abhayad Kamat (10/8/2010).

355

considered for Gemstone 7. Mr. Kamat wrote: “MLMI 2005-HE1 B3 [is] on credit watch – do

you want to move this out of the portfolio – investors might question/resist[.]” Mr. Jenks

responded: “[N]o let’s leave it in[.]”1379

On another occasion, Mr. Jenks from HBK exchanged several emails with Mr. Lippmann

about several RMBS securities that Mr. Jenks wanted to include in the Gemstone 7 warehouse

account. Mr. Jenks sent the list to Mr. Lippmann and wrote: “please approve.” Mr. Lippmann

responded: “ok approved but would like to lower these 2 pts each given recent press on fhlt and

significant widening in the baa3 cds. Is that cool?” The term “fhlt” referred to RMBS securities

issued by Fremont; by saying he wanted to “lower these 2 pts,” Mr. Lippman indicated he

wanted to assign them a lower value for warehouse purposes. Mr. Jenks replied: “Greg,

Fremont overall is really not trading badly just the ones on downgrade watch,” to which Mr.

Lippmann responded: “we have seen the fhlt 05-d bbb-trade wide …. please work with me on

this. … I am trying to work with you.” Mr. Jenks replied:

“Greg, I have been trying to work with you. Doing trades just with you and not on bid

lists. But we play in the higher quality part of the market, I really expected you to

approve the list as is. We still have several hundred million of bonds to do in cds form to

do [sic].”1380

This exchange shows that Mr. Lippmann was cognizant of the quality of the assets being

included in the CDO, and pushed for lower prices when he thought the assets were of poor

quality.

HBK told the Subcommittee that it selected good quality bonds using a very complex

model to analyze them.1381 It told investors that it “analyze[d] every bond in the market,

providing for a vast range of data …. [F]rom this data, trends can be observed early regarding

the bonds themselves as well as the general economy and the implications on future

issuance.”1382 HBK provided this description for the Subcommittee regarding the tools it used in

the asset selection process:

“HBK used a statistically driven mortgage behavior model to help make trading decisions

and select assets for inclusion in the Gemstone VII CDO. Three separate database tools

were utilized in this process. First, HBK licensed a commercial database called LP

Database, which contained detailed information and performance history for millions of

non-agency mortgages. The LP Database was a robust dataset comprising close to 80%

of the market, back to the 1996 vintage. Utilizing the data acquired from the LP

1379 1/5/2007 email from Abhayad Kamat to Kevin Jenks, GEM7-00001977.

1380 12/8/2006 and 12/11/2006 emails between Mr. Lippmann and Mr. Jenks, DBSI_PSI_EMAIL01886779-80.

1381 See 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 (“HBK’s investment

model utilizes proprietary default, prepay and severity loan level models to make investments in the residential

market. ... Transaction performance is tracked monthly via trustee surveillance reports and ongoing loan level

information to monitor and analyze parameters such as collateral yields, delinquency and default trends, recoveries,

prepayments, and available credit enhancement.”).

1382 Id. at 42.

356

Database, HBK then developed a proprietary system called the Loss Model that

forecasted the likelihood of default, prepayment, delinquency, or timely payment for an

individual mortgage monthly over a ten-year time horizon. The Loss Model made these

forecasts based on a series of 50 loan characteristics, including whether the mortgage was

a first or second lien mortgage, the type of mortgage (e.g., fixed or ARM), its geographic

location, FICO score, loan-to-value ratio, and level of documentation, and projections of

home price appreciation and unemployment rates.

Finally, HBK merged the information from the Loss Model into a Bond Evaluation

Engine, which was based on software licensed from Intex Solutions. The Bond

Evaluation Engine provided information that assisted HBK traders in pricing mortgage

bonds and evaluating how the bonds might perform under certain stresses. … This

portion of the analysis focused on the structure and enhancements of the RMBS and how

those structures would contribute to bond performance.”1383

Mr. Jenks of HBK told the Subcommittee that HBK “never had a bond that we thought

was bad that was put in a CDO.”1384 Mr. Jenks also told the Subcommittee that he had frequent

conversations with Mr. Lippmann, was aware of his “negative housing view,” but disagreed with

the magnitude of Mr. Lippmann’s negative views.1385 Mr. Lippmann told the Subcommittee that

although he occasionally suggested bonds to Mr. Jenks for Gemstone 7, and Mr. Jenks at times

purchased them, Mr. Jenks had strong views on the assets that should be included in the CDO

and was not required to listen to him. HBK and Deutsche Bank emails confirm that Mr.

Lippmann or his traders offered at times to sell certain bonds to HBK, which occasionally

purchased them.1386 Deutsche Bank sold five bonds from its inventory, with a value of more

than $27 million, to HBK for inclusion in Gemstone 7.1387 According to Mr. Lamont, his CDO

Group was “agnostic” towards the quality of the assets that HBK purchased for Gemstone 7, and

told the Subcommittee that investors had relied on HBK, the collateral manager, to analyze their

quality.1388 Mr. Lamont said that the role of the CDO Group was, not to select the CDO’s assets,

but to structure the deal and then use models to conduct stress tests on it.1389

1383 10/12/2010 letter from HBK’s counsel to the Subcommittee.

1384 Subcommittee interview of Kevin Jenks (10/13/2010).

1385 Id.

1386 See, e.g., 12/8/2006 email from Greg Lippmann to Kevin Jenks, DBSI_PSI_EMAIL01883072 (discussing trade

they agreed to). See also 2/23/2007 email from Jordan Milman to Greg Lippmann, DBSI_PSI_EMAIL02022054

(“I’d rather just have Ilinca show hbk, he loves bonds like this.”).

1387 Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33.

1388 Subcommittee interview of Michael Lamont (9/29/2010). Kamat also agreed that Deutsche Bank was agnostic

with regard to the quality of the assets. Subcommittee interview of Abhayad Kamat (10/8/2010).

1389 Subcommittee interview of Michael Lamont (9/29/2010).

357

(c) Gemstone Risks and Poor Quality Assets

Gemstone 7’s assets were assembled in late 2006 and early 2007, when the mortgage

market was deteriorating and subprime mortgages were experiencing record delinquency rates.

The CDO posed a host of risks due to both the state of the market and the poor quality of many

of its underlying assets.

Credit Report. In December 2006, Mr. Lamont’s CDO Group prepared a Credit Report

for Deutsche Bank’s credit risk management group to obtain internal approval for the

securitization of Gemstone 7.1390 The Credit Report noted the following business risks for

Deutsche Bank regarding Gemstone 7, including the possibility that the bank would be unable to

sell $400 million of the Gemstone securities, which carried “significant” risk:

• “The portfolio is concentrated on RMBS obligations, with 67.6%, 20.2% and 1.9% of

the RMBS exposure represented by 2005, 2006, and 2007 vintages, respectively,

which results in significant vintage risk.”

• “RMBS accounts for ~90.0% of the initial collateral portfolio.”

• “All unsold tranches have been taken back by HBK except for the Class A-1B

($400mm). Currently, we are working with [redacted] to see if they will be interested

in taking the tranche. The plan for distribution if [redacted] decides not to take the

tranche, will be a senior sequential repack. The Class A-1B will be broken into two

tranches. DB will take the senior part (Class A-1B(i) $200mm) and HBK will take

the bottom part (Class A-1B(i) $200mm). Once the repack is setup, then DB will try

to syndicate the Class A-1B(i).” 1391

The business risks described in the internal Deutsche Bank credit report relating to

“significant vintage risk” for the 2005, 2006, and 2007 vintage RMBS securities1392were not

disclosed in the Gemstone 7 offering materials given to investors. Although the March 15, 2007

Offering Circular contained a “Risk Factor” section describing multiple risks associated with an

investment in Gemstone 7, including those associated with residential asset backed securities, the

Offering Circular was silent with respect to the above risks identified in the Credit Report, which

were highlighted for Deutsche Bank management.

1390 Id. See undated Gemstone 7 Securitization Credit Report, MTSS000011-13 and 12/20/2006 Gemstone 7

Securitization Credit Report, DB_PSI_00237655-71. The 12/20/2006 Credit Report appears to be an earlier version

of the document.

1391 Gemstone 7 Securitization Credit Report, MTSS000011-13.

1392 Id.

358

The Offering Circular did, however, describe in detail a number of significant risks

associated with RMBS securities. For example, it stated:

• “The risk of losses on residential mortgage loans is particularly relevant now. While

there is always a risk of defaults or delinquencies in payment, recently losses on

residential mortgage loans have been increasing and may continue to increase in the

future. The losses have been most significant in respect of subprime mortgage loans

but all are affected.

• A number of factors are contributing to the increase in losses. Residential property

values that increased for many years are now declining. … Declining property values

also exacerbate the losses due to a failure to apply adequate standards to potential

borrowers. Failures to properly screen borrowers may include failures to do adequate

due diligence on a borrower (including employment and income history) or the

relevant property (including valuation) or failures to follow predatory lending and the

other borrower-protection statutes. Increases in interest rates may also contribute to

higher rates of loss. ...

• The increase in delinquencies and defaults has contributed to a declining market for

mortgage loans. The declining market has, in turn, seriously impacted mortgage

originators and servicers. … The financial difficulties of servicers in particular are

likely to result in losses in respect of securities backed by residential mortgage loans.

… At any one time, the portfolio of Residential ABS Securities may be backed by

residential loans with disproportionately large aggregate principal amounts secured

by properties in only a few states or regions.”1393

These disclosures demonstrate that both HBK and Deutsche Bank were well aware of the

deteriorating mortgage market and increased risks associated with RMBS and CDO securities,

even as they were marketing the Gemstone 7 securities and claiming HBK had applied careful

analysis in the asset selection process to ensure good quality CDO securities.

Long Beach-Fremont-New Century Bonds. A substantial portion of the cash and

synthetic assets included in Gemstone 7, 30% in all, involved subprime residential mortgages

issued by three subprime lenders, Long Beach, Fremont, and New Century, all known for issuing

poor quality loans and securities.1394

1393 3/15/2007 Offering Circular for Gemstone CDO VII, Ltd., GEM7-00000427-816 at 483-84. While an earlier

offering circular for Gemstone 7, dated February 14, 2007, identifies some risks associated with the CDO, the March

offering circular contains additional language, quoted above, on the risks associated with the deteriorating mortgage

market. 2/14/2007 Offering Circular for Gemstone CDO VII, Ltd., PSI-M&T_Bank-02-0001-370.

Loans by these lenders were among the first to collapse.

According to Moody’s, these three originators, plus WMC Corporation, accounted for 31% of

1394 For more information on these three lenders, see sections D(3)(d) and E(2)(c)-(d) of Chapter IV. Mr. Jenks of

HBK told the Subcommittee that he saw data showing that Long Beach and Fremont were poor performers, but he

thought the performance varied depending upon the tranche, and he believed he could pick the better tranches. He

thought he could buy low, structure the deal well, and make money. Subcommittee interview of Kevin Jenks

(10/13/2010).

359

the subprime RMBS securities issued in 2006, but 63% of the rating downgrades issued in the

second week of July 2007, when the mass rating downgrades began.1395

During the period when securities were being assembled for the Gemstone 7 warehouse

in late 2006 and early 2007, Mr. Lippmann frequently disparaged many of the same assets he and

his traders allowed to be included in Gemstone 7. About $27 million of these assets came from

Deutsche Bank’s own inventory. In emails to colleagues and his clients, Mr. Lippmann used

words like “crap” and “pig” to describe the assets. Mr. Lippmann brought some of the assets of

Gemstone 7 to the attention of some of his clients that shorted these assets.1396

On October 20, 2006, for example, one of Mr. Lippmann’s clients sent him an email

seeking advice about certain subprime bonds issued by Long Beach Mortgage Loan and Trust

(LBMLT) and other originators. Mr. Lippmann responded:

“LBMLT-06-5 M9-375. Long Beach is one of the weakest names in the market. We

shorted this bond to a CDO in the mid-300s on October 13[.] Deal was done before S&P

changed their criteria on July 1. Lots of 40 year mortgages …. Less than half the loans

have full documentation and 10% are investor properties. This is a real pig.

LBMLT -06-2 M9 350. See above on Long Beach. This one is already performing

poorly with substantial delinquencies .… Further the FICO is less than the 06-05 and

there are fewer full doc loans. This seems a better short than the 06-5. Only reason I can

think for my guys showing you a tighter level is that we are short this one and that the

June 06 deals have a taint that earlier months don[’]t due to the theory that late June deals

were crammed with bad stuff in order to beat the S & P revisions.”1397

Despite these negative views of Long Beach, Mr. Lippmann’s group raised no concerns

when $25 million in LBMLT 2006-5 M9 securities was purchased by HBK for Gemstone 7’s

warehouse account, $20 million of which was purchased on October 24, 2006, four days after

Mr. Lippmann’s email. Altogether, a total of $79.5 million in Long Beach bonds went into

Gemstone 7.1398

Mr. Lippmann had similar negative views of RMBS securities containing subprime loans

originated by Fremont, yet his group did not object to including Fremont securities in Gemstone

7. For instance, on December 6, 2006, Mr. Lippmann’s traders did not object to including $20

million of an RMBS known as SABR 2005-FR4 B3 for Gemstone 7, which contained Fremont

loans.1399

1395 7/12/2007 Moody’s Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions, at

Moody’s SI 2010-0046902, Hearing Exhibit 4/23-106.

One week earlier, on November 29, 2006, when asked by a bank colleague about the

1396 Subcommittee interview of counsel for Deutsche Bank (2/1/2011).

1397 10/20/2006 email from Greg Lippmann to Craig Carlozzi at Mast Capital, DBSI_PSI_EMAIL01774820-21.

1398 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.

1399 Id.

360

same RMBS security, Mr. Lippmann labeled it a “pig.”1400 Two days later, on December 1,

2006, Mr. Lippmann declared in an email to a client that the security was “blowing up.”1401

In addition, on November 29, 2006, Mr. Lippmann called still another RMBS security

with Fremont loans, FHLT 2005-A M9, a “pig.”1402 Yet a month earlier, on October 30, 2006,

approximately $1 million of FHLT 2005-A M9 had been purchased for Gemstone 7, with no

objection from Mr. Lippmann’s trading desk.1403

Mr. Lippmann made similar negative remarks about RMBS securities containing

subprime loans originated by New Century. On November 28, 2006, Mr. Lippmann wrote:

“MABS 2005-NC2 M9 … huge payment shock coming.”1404 Yet six weeks later, on January 17,

2007, $10 million of this exact asset, MABS 2005-NC2 M9, was purchased by Gemstone 7,

without objection from Mr. Lippmann’s traders.1405 On December 8, 2006, Mr. Lippmann wrote

about another New Century security underwritten by Goldman Sachs: “GSAMP 06-nc2 m8 this

is an absolute pig.”1406 Although Gemstone 7 did not purchase the M8 securities, it did purchase

a total of $30 million in GSAMP 2006-NC2 M9 securities – from a lower tranche in the same

securitization with less subordination. It purchased those securities over a month-long period,

with $10 million of the securities on November 13, 2006; another $10 million on December 8,

2006; and still another $10 million on December 21, 2006.1407 In addition, on December 18,

2006, Gemstone 7 purchased $8.8 million worth of a similar security, GSAMP 2006-NC2

B2.1408

Mr. Lippmann was equally critical of New Century loans securitized by ACE, an entity

created by and associated with Deutsche Bank. On September 21, 2006, for example, when

asked by a Deutsche Bank salesperson for his opinion of ACE 2006-NC1 M9, an RMBS issued

by ACE with New Century subprime loans, Mr. Lippmann responded that ACE was “generally

horrible.”1409

1400 With regard to the asset, Mr. Lippmann wrote: “pig probably a 400-525 market.” 11/29/2006 email from Greg

Lippmann to Francis Blair at Deutsche Bank, DBSI_PSI_EMAIL01853153.

On March 2, 2007, a client sent an email to Mr. Lippmann stating: “[T]hey are

1401 See 12/1/2006 email from Greg Lippmann to Tyler Duncan at Wayzata Investment Partners,

DBSI_PSI_EMAIL01864446 (Mr. Lippmann wrote: “sabr 05-fr4 b3 another Fremont blowing up we traded in

august at 260”). Later in January 2007, Greg Lippmann wrote: “SABR Fr [Fremont] blows.” 1/25/2007 email from

Greg Lippmann to Mark Lee at Contrarian Capital, DBSI_PSI_EMAIL01961580.

1402 11/29/2006 email from Greg Lippmann to Jashin Patel at Deutsche Bank, “Where is this pig marked?,”

DBSI_PSI_EMAIL01854608.

1403 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.

1404 11/28/2006 email from Greg Lippmann to Rocky Kurita, DBSI_PSI_EMAIL01846000.

1405 See 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.

1406 12/8/2006 email from Greg Lippmann to Peter Faulkner at PSAM, LLC, DBSI_PSI_EMAIL01882188.

1407 See 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.

1408 Id.

1409 9/21/2006 email from Greg Lippmann to Melissa Goldsmith at Deutsche Bank, DBSI_PSI_EMAIL01689001-

02. Mr. Lippmann confirmed to the Subcommittee that he believed ACE was “horrible.” Subcommittee interview

of Greg Lippmann (10/18/2010). On May 19, 2006, Mr. Lippmann wrote to a Deutsche Bank colleague, “We

traded that ACE piece of crap with Ike at 380.” 5/19/2006 email from Greg Lippmann to Rocky Kurita at Deutsche

Bank, DBSI_PSI_EMAIL0120552. On May 29, 2007, Mr. Lippmann wrote with regard to ACE 2006-ASP3 M7,

361

claiming that DB [Deutsche Bank] was one of the last ones to tighten standards on buying loans

to securitize. [Y]ou were right - ACE is crap.” Mr. Lippmann responded: “INDEED … IT

IS.”1410 Yet on December 19, 2006, Mr. Lippmann’s traders did not object to the purchase of $10

million of ACE 2006-NC1 M9 for Gemstone 7.1411

Mr. Lippmann also had negative opinions about other securities purchased for Gemstone

7. On March 1, 2007, for example, Mr. Lippmann wrote that ABSHE 2006-HE1 M7 was

“crap.”1412 But $5 million of this same security had been purchased three months earlier by

Gemstone 7, on November 16, 2006, without objection from Mr. Lippmann’s trading desk.1413

In still another instance, on March 19, 2007, Mr. Milman described FFML 2006-FF13 as “a

piece of crap.”1414 Yet over the prior five months, the Lippmann trading desk had approved the

purchase of a total of $38.5 million of this exact bond, FFML 2006-FF13, for inclusion in

Gemstone 7: $11.7 million of the class B1 securities on October 30, 2006; $16.2 million of the

class B2 securities on November 17, 2006 and January 9, 2007; and $10.6 million of the class

M9 securities on March 15, 2007.1415

Securities from Deutsche Bank’s Inventory. Gemstone 7 purchased five securities

totaling $27 million directly from Deutsche Bank’s inventory.1416 Mr. Lippmann, and his trader

Jordan Milman, shared negative views of one of the bonds, ACE 2006-HE1 M10, a security in

which over 75% of the loans had been originated by Fremont.1417 In an instant message

conversation in December 2006, Mr. Lippmann asked Mr. Milman his thoughts on ACE 2006-

HE1 M10. Mr. Lippmann asked: “DOESNT THIS DEAL BLOW,” to which Mr. Milman

replied: “yes it blows I am seeing 20-40% writedowns.”1418 Not only did HBK include $10

million of this asset in the Gemstone 7 warehouse account, HBK purchased it from Deutsche

Bank that same month through one of Mr. Lippmann’s traders.1419

“this stinks though I didn’t mention it.” 5/29/2007 email from Greg Lippmann to Danielle Pluthero at Deutsche

Bank, DBSI_PSI_EMAIL02532365.

Thus, Deutsche Bank

allowed Gemstone 7 to acquire a $10 million asset that its traders believed would perform

poorly, and effectively removed the financial risk of this asset from its own inventory, shifting it

to its customers.

1410 3/2/2007 email from Greg Lippmann to Clark Baker at Harbinger Capital, DBSI_PSI_EMAIL02038599.

1411 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.

1412 3/1/2007 email from Greg Lippmann to Joris Hoedemaekers at Oasis Capital, DBSI_PSI_EMAIL02033845.

1413 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.

1414 3/19/2007 email from Jordan Milman to Greg Lippmann, DBSI_PSI_EMAIL02412084.

1415 9/14/2010 Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03.

1416 These five securities were: (1) ACE 2006-HE1 M10, (2) Securitized Asset Backed Receivables (SABR) 2005-

OP1 B4, (3) Ameriquest Mortgage Securities Inc. (AMSI) 2005-R11 M10, (4) Deutsche Bank Alt-A Securities, Inc.

(DBALT) 2006-AR6 M10, and (5) First Franklin Mtg Loan Asset Backed Certificate (FFML) 2005-1 B4. See

Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33. See also 9/14/2010

Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03.

1417 9/14/2010 Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03.

1418 12/1/2006 instant message conversation between Greg Lippmann and Jordan Milman,

DBSI_PSI_EMAIL01863636.

1419 12/19/2006 email from Jason Lowry at HBK to Greg Lippmann and others at Deutsche Bank,

DBSI_PSI_EMAIL01910568; 12/19/2006 email from Greg Lippmann to Jordan Milman and others at Deutsche

Bank, DBSI_PSI_EMAIL01910580.

362

Mr. Lippmann expressed a negative outlook for other assets as well, including SABR

2005-OP1, that was taken from Deutsche Bank’s inventory and sold to Gemstone 7. On August

26, 2006, Mr. Lippmann wrote to a client about more securities “blowing up,” including SABR

2005-OP1:

“I am encouraged that in spite of the virility of the cdo bid, there are numerous examples

of bonds blowing up … the tripling of serious delinq [delinquencies] in sabr 05-opl to

over 6.5% since feb even though the avg [average] mortgage age is now only 21 months

i.e. hasn’t reset yet .… What I’m saying is there is plenty of fundamental evidence that

bonds are blowing up even as the new issue and index market are remaining

buoyant.”1420

On December 12, 2006, with no objection from Mr. Lippmann’s desk, Gemstone 7 purchased

$5.5 million of SABR 2005-OP1 B4 from Deutsche Bank, the same asset that he had described

months earlier as incurring “serious delinquencies.”1421

A third example involved securities issued by Ameriquest Mortgage Securities Inc.

(AMSI), which Gemstone purchased from Deutsche Bank’s inventory. On April 6, 2006, Mr.

Lippmann called AMSI 2005-R7 M8 a “crap name.”1422 In a June 16, 2006 email, Mr. Lippmann

called AMSI generally a “weakish name.”1423 On December 12, 2006, Gemstone 7 purchased $5

million of another RMBS, AMSI 2005-R11 M10, with no objection from the Lippmann trading

desk.1424

In still another instance, Deutsche Bank praised its sales force for placing a security it

was having difficulty selling as the underwriter, Deutsche Alt-A Securities Inc. (DBALT) 2006-

AR6, in Gemstone 7. On November 17, 2006, the Deutsche Bank Option Arms Desk sent the

following email, “The Arms Desk would like to express its sincere appreciation to the sales force

for an outstanding job in helping us place the bonds off DBALT 06-AR6. Thanks a lot!!”1425

1420 8/26/2006 email from Greg Lippmann to Richard Axilrod, DBSI_PSI_EMAIL01618236.

Less than two weeks later, on November 29, 2006, a member of the Deutsche Bank sales force

wrote: “Some success in CMO [collateralized mortgage obligation] land today: Sold 9 mm

[million] DBALT 06-AR6 M10 (Ba2/BBB-) to HBK. This class was never sold in the new issue

1421 Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33.

1422 4/6/2006 email from Greg Lippmann to himself, DBSI_PSI_EMAIL01075218.

1423 6/16/2006 email from Greg Lippmann to Rocky Kurita, DBSI_PSI_EMAIL01314036.

1424 Assets Purchased by Gemstone VII CDO during Warehouse Period. GEM7-00001831-33.

1425 11/17/2006 email from Deutsche Arms to Deutsche Bank employees, DBSI_PSI_EMAIL01831021; 11/14/2006

email from Deutsche Arms to Deutsche Bank employees, DBSI_PSI_EMAIL01822045. DBALT was “one of

Deutsche Bank’s own shelf offerings.” 3/21/2011 letter from Deutsche Bank’s counsel to the Subcommittee, PSIDeutsche_

Bank-32-0001-04.

363

marketing.” 1426 HBK records indicate that, the next day, it agreed to purchase $8.8 million of

DBALT 2006-AR6 M10.1427

Many investors would likely have found the negative views of Mr. Lippmann, Deutsche

Bank’s top CDO trader, important to their decision as to whether or not to buy Gemstone 7, but

his views, as described above, were not disclosed to them. At the time, the traders on his desk as

well as other Deutsche Bank CDO personnel knew that many clients valued and relied on Mr.

Lippmann’s opinion when making investment decisions, yet did not disclose his views of the

specific assets included in Gemstone 7.1428 M&T Bank told the Subcommittee that had it known

about Mr. Lippmann’s views, it might have “thought twice” before purchasing Gemstone 7

securities.1429

(d) Gemstone Sales Effort

Deutsche Bank began aggressively marketing Gemstone 7 to investors beginning in

January 2007.1430 The bank communicated with potential investors about Gemstone 7 in a

variety of ways, including through emails, telephone calls, face to face meetings, and at

conferences. Deutsche Bank personnel also went on what they called “road shows” to cities

around the world, to meet investors and pitch the CDO to them.1431 Sean Whelan, co-head of the

Deutsche Bank CDO sales force, and Ilinca Bogza, a vice president in the Deutsche Bank

syndicate group, worked to market Gemstone 7 to investors, including by scheduling road shows

and personal meetings with potential investors.

Investors were typically shown a “Debt Investor Presentation” that had been prepared by

HBK and Deutsche Bank.1432 That presentation provided an overview of the transaction, a

description of HBK’s organization, and its investment strategy. The presentation highlighted

investment considerations, including HBK’s expertise in the capital markets, how its structured

products exhibit relatively stable performance, and their low default history. The presentation

also contained a description of HBK’s analytical systems and surveillance capabilities, and

included an appendix describing the risk factors for the deal. HBK told the Subcommittee that

its employees attended investor meetings, and were at times called upon to answer questions, but

did not always participate in the Gemstone 7 sales efforts which were led by Deutsche Bank.1433

1426 11/29/2006 email from Larry Pike to Eleanny Pichardo and others, DB_PSI_01731794.

1427 11/30/2006 email from Jason Lowry at HBK to Abhayad Kamat and others, GEM7-00005480. See also Assets

Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33.

1428 See 7/6/2006 email from Axel Kunde to Greg Lippmann, DBSI_PSI_EMAIL01374694 (“If you tell the sales

guy the bond is really bad his investor will use that as an argument against us and demand we buy back his note,

because he trusted DB [Deutsche Bank] to pick a good portfolio etc, etc.”).

1429 Subcommittee Interview of M&T (9/20/2010).

1430 See, e.g., 1/25/2007 Deutsche Bank internal email chain, DB_PSI_00346491-99, at 99.

1431 Subcommittee interview of Sean Whelan (9/22/2010).

1432 See, e.g., 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 and 2/8/2007

Gemstone 7 Debt Investor Presentation, GEM7-00001687-1747.

1433 Subcommittee interview of Kevin Jenks (10/13/2010).

364

One Gemstone investor, M&T Bank, told the Subcommittee that, after observing a

presentation made by Mr. Jenks and receiving Deutsche Bank’s assurances in connection with its

solicitation efforts, it believed that Gemstone 7 securities posed minimal investment risk.1434

According to the transcript of a telephone call on February 5, 2007, Sean Whelan of Deutsche

Bank’s sales force pitched the Gemstone 7 deal to M&T Bank and stated in part: “If you

indicate early, like Gemstone deals go very well, and this deal will all go very well and it will get

oversubscribed.”1435 The following day, February 6, 2007, Mr. Whelan again pitched the deal to

M&T and stated that Gemstone 7 “was like a lay up.”1436 When asked about these comments,

Mr. Whelan told the Subcommittee that what he meant was that working with a quality hedge

fund like HBK was a “lay up,” not that the Gemstone 7 deal itself was a “lay up.”1437 With

regards to his comment about oversubscription, he said he was referring to the tranches that

M&T Bank was considering purchasing, which ultimately were fully subscribed.1438

In early 2007, as the closing date for Gemstone 7 neared, the Deutsche Bank sales force

was having difficulty getting commitments from investors to buy Gemstone securities. Many

investors who were solicited declined to invest because of concerns about the high concentration

in subprime RMBS with BBB or BB ratings.1439 In the beginning of 2007, there was a general

lack of buyer interest in mortgage related securities in the United States, other than from new

CDOs purchasing CDO securities from prior deals. It was not the first time, however, that a

Gemstone deal involving Deutsche Bank and HBK could not be fully sold. HBK had

conditioned Deutsche Bank’s participation in Gemstone 7 on its purchasing unsold securities

from Gemstone 4 and 5, BB rated securities that HBK still had on its books for $13.1 million. In

an email sent to a colleague, an HBK Managing Director Jamiel Akhtar wrote:

“As a condition for receiving the underwriting mandate, Kevin [Jenks] and I insisted that

DB [Deutsche Bank] buy from us the $13.1mm of BB rated CDO liabilities HBK

retained on its own books from Gemstone IV and V. This was a fairly sharp-elbowed

tactic on our part, as the BB bonds are the worst part of the capital structure, but I felt like

we should be sharp-elbowed with DB right now.”1440

The head of Deutsche Bank’s CDO Group, Michael Lamont, sent an email to the CDO

Group banker assigned lead responsibility for structuring Gemstone 7, acknowledging the risk

the bank took on by purchasing the earlier unsold securities, but also noting the “nice” fee being

paid to the bank: “[T]hat is part of the risk we took when we were awarded the mandate and we

are still making a nice all in fee.”1441

1434 Subcommittee interview of M&T (9/20/2010).

When Deutsche Bank told HBK that it intended to resell

the Gemstone 4 and 5 securities, the HBK official indicated it was “ok with that as long as it is

1435 2/5/2007 telephone transcript between Sean Whelan and Alex Craig of M&T, MTSS000920-25, at 22.

1436 2/6/2007 telephone transcript between Sean Whelan, and Alex Craig and David Borchard of M&T,

MTSS000929-31, at 31.

1437 Subcommittee interview of Sean Whelan (9/22/2010).

1438 Id.

1439 See spreadsheet containing potential investor feedback regarding Gemstone 7, DBSI_PSI00117568.

1440 10/5/2006 email from Jamiel Akhtar at HBK to Jon Mosle at HBK, GEM7-00006353.

1441 2/8/2007 email from Michael Lamont to Abhayad Kamat, DBSI_PSI_EMAIL04045219-24.

365

not blasted out to everyone so as not to affect his current deal [Gemstone 7] in the market.”1442

Deutsche Bank and HBK did not disclose in the Gemstone 7 offering materials both the bank’s

purchase of the Gemstone 4 and 5 securities as a precondition to the deal and the bank’s plan to

sell the Gemstone 4 and 5 securities contemporaneously with the Gemstone 7 securities.

Struggle to Sell Gemstone. Evidence obtained by the Subcommittee shows that both

HBK and Deutsche Bank were concerned about their exposure should Gemstone 7 not be fully

subscribed and worked hard to sell the deal in the face of U.S. investor disinterest.1443

According to the terms of the Gemstone deal, if the securities were not fully sold, the risk of the

first $80 million in losses would fall on HBK, while all remaining losses would fall on Deutsche

Bank.1444 On February 27, 2007, Mr. Kamat of Deutsche Bank wrote to Mr. Jenks of HBK

about selling the Gemstone 4 and 5 securities and brought up the CDO Group’s need to reduce

risk: “[W]e are trying to reduce our exposure right now given internal very senior mgmt review

of our business.” Mr. Jenks responded: “We are also trying to reduce exposure.”1445

In January 2007, Michael Lamont, head of Deutsche Bank’s CDO Group, and Mr. Jenks,

the HBK collateral manager, discussed the urgency of selling Gemstone 7 in the face of a

deteriorating market. On January 9, 2007, Mr. Jenks wrote to Mr. Lamont: “[W]ith this market

this way and probably going to get worse we would like to really move on the cdo. Please

allocate the resources to expedite this.” Four minutes later Mr. Lamont responded: “[W]e are

focused on this as well. We don’t have a deal in the market and you will be first.”1446

Several developments in early 2007 signaled problems in the mortgage industry. On

January 29, 2007, subprime lender Fremont Investment & Loan announced that it had “severed

ties” with 8,000 brokers whose loans had high delinquency rates.1447 The following week on

February 7, 2007, New Century, another major subprime lender, disclosed in a conference call

with investors that “the level of early-payment defaults and loan repurchases [had] led to tighter

underwriting guidelines,” that its nonprime loan production would be declining, and that it would

be restating its earnings.1448

1442 Id. at 24.

An additional warning to the market that occurred as Gemstone was

being marketed to investors was the plunge in the ABX Index that tracked the value of subprime

RMBS securities. In February 2007, the ABX Index fell from a high of $0.90 early in the month

1443 Subcommittee interview of Kevin Jenks (10/13/2010). Mr. Jenks recalled that there were more non U.S.

investors in CDOs in 2007, but he believed that was because there was not much of a CDO market in Europe.

Subcommittee interview of Kevin Jenks (10/13/2010). Mr. Whelan told the Subcommittee that in 2006 and 2007,

CDO subscription was “spotty.” Subcommittee interview of Sean Whelan (9/22/2010).

1444 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71.

1445 2/27/2007 email between Abhayad Kamat and Kevin Jenks, DB_PSI_00421609 (discussing potential exposure

due to purchase of earlier Gemstone 4 and 5 tranches in Gemstone 7).

1446 1/9/2007 email chain between Michael Lamont and Kevin Jenks, GEM7-00002156.

1447 2/1/2007 S&P internal email, “Defaults cause Fremont to end ties to 8,000 brokers,” Hearing Exhibit 4/23-93d.

1448 “New Century plunges on loan production,” MarketWatch (2/8/2007), http://www.marketwatch.com/story/newcenturys-

shares-punished-over-loan-production-warning. On the day before the New Century conference call,

Deutsche Bank received a request from HBK to approve a New Century asset purchase for the Gemstone 7 deal and

approved this request on February 9. See 2/9/2007 email from Jordan Milman to Ashley Bonilla at HBK,

DB_PSI_00845552.

366

to $0.69 by the end of the month, indicating a drop of more than 23% in the value of subprime

RMBS securities.1449

Emails reviewed by the Subcommittee show that CDO personnel at Deutsche Bank were

well aware of the worsening CDO market and were rushing to sell Gemstone 7 before the market

collapsed. On February 7, 2007, Mr. Lippmann, reacting to the New Century developments,

raised concerns with Mr. Lamont about the ability of Deutsche Bank to continue to sell CDO

securities: “I was calling about warehouse marks and distribution risk b/c [because] hearing

rumors about other dealers having big trouble placing this stuff.”

These and other events affected both the RMBS and CDO markets, since

so many CDOs included or referenced subprime RMBS securities.

1450 The next day, February 8,

2007, Mr. Lamont told Abhayad Kamat, the CDO Group employee structuring Gemstone 7:

“[R]egardless we need to sell it [Gemstone 7] now while we still can.”1451 The same day, Mr.

Lamont wrote to Mr. Jenks at HBK: “Keep your fingers crossed but I think we will price this

just before the market falls off a cliff.”1452 The next day, February 9, 2007, Ilinca Bogza, of the

Deutsche Bank syndicate group, wrote to Mr. Lamont: “Jenks just called me. … He is

frightened that accounts will pull their orders given the widening in abx today. … He

mentioned he was going to give you a call. He is very nervous.”1453

On February 13, 2007, the head of Deutsche Bank’s syndicate group, Anthony

Pawlowski, wrote to Mr. Lamont: “I am not sure how to push guys upstairs without having them

crack. Everyone wants to price this deal asap (Sean Whelan [co-head of Deutsche Bank’s CDO

sales force] is pushing for Friday to lock up his guys on the AAA and AA)[.] Let me know.”1454

A week later, on February 20, 2007, Mr. Lamont wrote to Deutsche Bank syndicate to ask:

“[O]n our managed mezz[anine] abs [asset backed security] CDOs last year what was the

split by risk tranche across deals between real money and cdo warehouses. The street

may be pulling back so this would be good info to have as we think about how we are

going to place risk.”1455

1449 On Feb. 23, 2007, MarketWatch announced: “The ABX.HE index that tracks CDS on the riskiest subprime

loans, rated BBB-, that were sold in the second half of 2006 fell to $0.69 on Friday, according to Markit.com, which

administers the indexes. That’s down from $0.72 on Thursday and $0.79 at the beginning of the week. In early

February, this index was above 90.” “Subprime mortgage derivatives index plunges; Bankruptcies, losses in

subprime home loan industry spark drop,” MarketWatch (2/23/2007), http://www.marketwatch.com/story/index-ofsubprime-

mortgage-derivatives-plunges-on-sector-woes.

1450 2/7/2007 email from Greg Lippmann to Michael Lamont, DBSI_PSI_EMAIL02366193-96, at 94. When Mr.

Lamont heard about the New Century developments he wrote: “yikes. I think we will stay short a while.” 2/7/2007

email from Michael Lamont to Greg Lippmann, DBSI_PSI_EMAIL02366194.

1451 2/8/2007 email from Michael Lamont to Abhayad Kamat, DBSI_PSI_EMAIL04045219-24.

1452 2/8/2007 email from Michael Lamont to Kevin Jenks, DBSI_PSI_EMAIL04045360.

1453 2/9/2007 email from Ilinca Bogza to Michael Lamont, DBSI_PSI_EMAIL04047421-23.

1454 2/13/2007 email from Anthony Pawlowski at Deutsche Bank to Michael Lamont, DBSI_PSI_EMAIL04049521.

1455 2/20/2007 email from Michael Lamont to Ilinca Bogza, DBSI_PSI_EMAIL04054492. On February 20, 2007, a

client of Mr. Lippmann’s who was looking to short more RMBS commented in an email to him about the negative

news concerning Novastar Financial Inc., which announced losses that day. His client described the situation in the

market “like the plague.” 2/20/2007 email from Steven Eisman at Frontpoint Partners to Greg Lippmann,

DBSI_PSI_EMAIL02008182.

367

In one odd instance, Ms. Bogza, from the CDO syndicate, sent an email to the Deutsche

Bank sales force suggesting that Gemstone 7 was experiencing greater investor interest than it

really was. The February 20, 2007 email by Ms. Bogza stated that the bank had received an

“indication of [investor] interest” in 75% of the BBB securities in Gemstone 7.1456 After

receiving this email, Mr. Lippmann wrote to Ms. Bogza: “[W]ow that much interest in the bbb?

Is that real?? We would take as much as you can oversell.”1457 Ms. Bogza responded: “no, that

is definitely not real …. it is at 50%; can’t oversell any tranche to be honest,” to which Mr.

Lippmann responded: “very sneaky.”1458

In late February, as the market continued to deteriorate, Deutsche Bank attempted to

motivate its employees to sell Gemstone 7 by providing special incentives to its sales force for

selling the deal. On February 21, 2007, Mr. Kamat wrote to Ms. Bogza: “[W]e need help on

selling the As and BBBs in the Gemstone CDO 7 transaction – we have nearly 50% unsold on

both tranches in the transaction.”1459 In another email the same day, he wrote: “[S]hould we

offer more PCs for Gemstone 7 CDO given the market?”1460 “PCs” refers to Production Credits,

which were used to boost a salesperson’s compensation including through an end-of-year bonus.

Later the same night, Mr. Kamat sent an email to the co-head of the CDO Group seeking to

increase the Production Credits that could be awarded for selling Gemstone 7: “[D]ouble digit

PCs? I guess my original offer of 300 on single-As and 600 on triple-Bs is too low … what can

we offer?”1461

Showing Investors Higher Marks. As the value of mortgage related assets grew more

volatile, some potential investors in Gemstone 7 inquired about the mark to market (MTM) value

of the CDO’s underlying assets. MTM is a valuation method by which the current value of an

asset is recorded on a firm’s books at the price it would sell in the marketplace on the day it is

marked. Investors at times inquire about MTM values to determine if the underlying assets of a

CDO have dropped in value since their inclusion in the warehouse account. Traders who closely

follow buy and sell activity for a particular class of assets are generally best able to provide the

most accurate current valuation. At Deutsche Bank, the CDO Trading Desk marked the value of

assets monthly as a service to its clients and at times provided this service to HBK for the assets

underlying Gemstone 7.1462 HBK also prepared its own internal marks valuing Gemstone’s

assets. According to both Deutsche Bank and HBK, assigning a mark is a very complicated

process that involves credit analysis of the securities at issue. Both explained it was not unusual

for different entities to mark an asset differently.1463

1456 2/20/2007 email from Ilinca Bogza to sales force, DBSI_PSI_EMAIL02007608.

1457 2/20/2007 email from Greg Lippmann to Ilinca Bogza, DBSI_PSI_EMAIL02007608.

1458 2/20/2007 email between Greg Lippmann and Ilinca Bogza, DBSI_PSI_EMAIL02007794.

1459 2/21/2007 email from Abhayad Kamat to Ilinca Bogza, DBSI_PSI_EMAIL04055827.

1460 Id.

1461 2/21/2007 email from Abhayad Kamat at Deutsche Bank to Michael Lamont and others at Deutsche Bank,

DBSI_PSI_EMAIL04056326-36.

1462 3/27/2007 email from Richard Leclezio at Deutsche Bank to Jordan Milman noting that HBK has requested

marks from Deutsche Bank, DB_PSI_00423053-61.

1463 Subcommittee interview of Jordan Milman (10/22/2010). Subcommittee interview of Kevin Jenks (10/13/2010).

368

During the marketing phase of Gemstone 7, documents indicate several potential

investors asked Deutsche Bank to provide MTM values for the underlying assets in the CDO. In

response, those potential investors were given HBK’s marks, rather than the generally lower

valuations assigned to the assets by Deutsche Bank’s CDO Trading Desk. On January 23, 2007,

Mr. Kamat sent an email to HBK explaining that some potential investors had requested marks

for the Gemstone 7 assets:

“Some investors are asking for current marks on the Gemstone 7 CDO portfolio. The

attached file has the purchase price and the current marks that we got from our desk.

There are many bonds where the price difference between purchase price and current

mark is more than 4% .… I have asked Jordan [Milman, a Deutsche Bank trader] to

review the marks but it would be great if you could have someone at HBK review also to

check if the current marks seem correct. It seems as if the entire portfolio price has

dropped since purchase by 1.74% which does not show well to investors.”1464

Before he heard back from HBK, Mr. Kamat sent a very similar request to Mr. Milman to

review the marks to verify them. He wrote:

“There are many [Gemstone 7] bonds where the price difference between purchase price

and the current mark is more than 4% .… Before we send these over to CDO investors,

pls could you review to check if the current marks are correct. It seems as if the entire

portfolio price has dropped since purchase by 1.74% which does not show well to

investors.”1465

The next day, a Deutsche Bank trader verified the marks: “I checked the names that Abhayad

[Kamat] highlighted [and] most are marked within the recent color[.] [T]here are 4 which should

be tightened.”1466

On January 23, 2007, Mr. Kamat learned that HBK’s marks showed a loss of 0.9% or

$9.4 million in the Gemstone 7 portfolio, while Deutsche Bank’s marks showed a greater loss of

1.7% or $19 million.1467 On January 24, 2007, Mr. Kamat directed Deutsche Bank’s syndicate

group to share HBK’s marks with investors instead of Deutsche Bank’s. He wrote: “[F]or

investors who have asked for current marks on the Gemstone CDO 7 portfolio, tell them: HBK

says that the overall current portfolio is down USD 9 million.”1468

A couple weeks later, a question arose about using Deutsche Bank marks for Gemstone 7.

On February 7, 2007, Ms. Bogza from the syndicate group wrote to Mr. Kamat: “Why can we

1464 1/23/2007 email from Abhayad Kamat to HBK, GEM7-00003101. This document has HBK showing a loss of

$9.4 million in the value of the Gemstone assets, whereas Deutsche Bank showed a loss of $19 million. In

interviews with the Subcommittee, both Mr. Milman and Mr. Lippmann said that a 1.74% drop would not have

concerned them because of the relative small dollars involved compared to the $1.1 billion deal.

1465 1/23/2007 email from Abhayad Kamat to Jordan Milman, DB_PSI_00465462.

1466 1/24/2007 email from Jashin Patel to Jordan Milman, DB_PSI_00843917.

1467 1/23/2007 email from Abhayad Kamat to HBK, GEM7-00003101.

1468 1/24/2007 email from Abhayad Kamat to Chehao Lu and others at Deutsche Bank, DB_PSI_00741750-52.

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not show a priced [marked] portfolio?? We need to show this [to investors].” Mr. Kamat

responded: “[T]he marks we got from Jordan are too low … and it will take quite some time if

we try to take on an exercise where we try to get kevin and jordan to agree on the correct

marks.”1469 Mr. Kamat wrote to another colleague later that day: “[U]se this for the current

prices to be sent to investors, but please note to investors that this is from HBK.”1470 HBK also

appeared to want to show higher marks to investors. When Mr. Kamat emailed Mr. Jenks

seeking marks for the Gemstone 7 portfolio on February 7, Mr. Jenks sent an internal email to an

HBK assistant trader. Mr. Jenks wrote: “Need line item marks for cdo portfolio[.] use dec or jan

depending on which is better[.]1471

When asked about these documents, Mr. Kamat stated that he advised using HBK’s

marks instead of Deutsche Bank’s marks, because HBK’s marks were better due to the collateral

manager’s familiarity with the assets.1472 However, Deutsche Bank’s trading desk was one of

the biggest traders in RMBS and CDOs on Wall Street, making it unlikely that the desk could not

adequately price the assets that it traded. Deutsche Bank also chose not to share both sets of

marks with investors; it shared only the HBK marks showing higher asset values.

When HBK was asked about this matter, Mr. Jenks told the Subcommittee that he did not

authorize Deutsche Bank to give out HBK’s marks to investors and would be “surprised” if

Deutsche Bank had given out HBK’s marks.1473 Mr. Jenks only recalled one time when an

investor asked Deutsche Bank for Gemstone 7 marks. When the Subcommittee asked several of

the investors who ultimately purchased Gemstone securities if they had asked for marks showing

the current value of the underlying assets, M&T Bank told the Subcommittee that it did not know

to ask for marks.1474 Standard Chartered, Wachovia, and Commerzbank told the Subcommittee

that they did not ask for the marks and it would have been unusual for them to do so. Eight days

before the Gemstone CDO closed and its securities issued, HBK estimated that its portfolio

marks were down approximately $30 million.1475

$400 Million of Unsold Securities. The mortgage market continued to worsen in March

as Deutsche Bank continued to market the Gemstone securities. On March 8, 2007, one week

before the Gemstone 7 deal closed, New Century – the subprime lender whose RMBS securities

made up part of Gemstone – filed an 8-K with the SEC which said: “The Company has only

been able to fund a portion of its loans this week. In addition, its capacity to fund new

originations is substantially limited due to its lenders’ restrictions or refusals to allow the

Company to access their financing arrangements.”1476

1469 2/7/2007 emails between Abhayad Kamat and Ilinca Bogza, DB_PSI_00434692-96.

New Century’s financial troubles were

1470 2/7/2007 email from Abhayad Kamat to Chehao Lu, DB_PSI_00711486.

1471 2/7/2007 email from Kevin Jenks to Jason Lowry, GEM7-00003084.

1472 Subcommittee interview of Abhayad Kamat (10/8/2010).

1473 Subcommittee interview of Kevin Jenks (10/13/2010).

1474 Subcommittee interview of M&T (9/20/2010).

1475 3/7/2007 email from Kevin Jenks to Abhayad Kamat, GEM7-00001958.

1476 3/8/2007 New Century Financial Corporation 8-K filing with the SEC. Even senior Deutsche Bank management

was aware of the problems involving New Century and Fremont during this time period. On March 2, 2007, Mr.

Lippmann sent an email to Mr. Misra, copying Mr. D’Albert, with a subject line: “Fremont Shut Down Sub-Prime

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prominently reported in the financial press on March 11, 2007.1477 On March 15, 2007, the day

Gemstone 7 closed, Bear Stearns said that “residential mortgage-related revenue decreased from

the prior year period, reflecting weakness in the U.S. residential mortgage-backed securities

market. … New Century Financial Corp., which had been a major provider of loans to people

with risky credit, said it has lost support from its financial backers and is being delisted from the

NYSE.”1478 New Century comprised 15% of Gemstone 7.

Ultimately $400 million of Gemstone 7 was unsold. Although not contractually

obligated to do so, Deutsche Bank agreed to split the unsold $400 million of Gemstone 7

securities between itself and HBK.1479 Meetings concerning taking back the $400 million were

held at the highest levels of both Deutsche Bank and HBK.1480 As Mr. Lippmann put it: “[W]e

don’t have much choice … either we repo for them or we take it down.”1481

Deutsche Bank and HBK were unable to sell 36% of the securities and instead kept those

securities on their books. Mr. Jenks of HBK told the Subcommittee that he always wanted to

know if unsold portions of a CDO he was interested in investing in would be bought back by the

business” that contained a number of negative news headlines concerning New Century including, “New Century

says U.S. attorney conducting criminal probe … New Century says NYSE reviewing transactions in its securities …

New Century says SEC requested meeting on restatement.” The next day Mr. Misra replied to Mr. Lippmann,

“Well, no regrets. Let’s hold tight on our shorts now. It will be a bumpy market to market ride but we will prevail.”

3/2/2007 and 3/3/2007 email chain between Mr. Lippmann and Mr. Misra, DBSI_PSI_EMAIL02392659-61.

1477 See, e.g., “Crisis Looms In Market for Mortgages,” The New York Times (3/11/2007),

http://www.nytimes.com/2007/03/11/business/11mortgage.html. (“On March 1, a Wall Street analyst at Bear

Stearns wrote an upbeat report on a company that specializes in making mortgages to cash-poor homebuyers. The

company, New Century Financial, had already disclosed that a growing number of borrowers were defaulting, and

its stock, at around $15, had lost half its value in three weeks. What happened next seems all too familiar to

investors who bought technology stocks in 2000 at the breathless urging of Wall Street analysts. Last week, New

Century said it would stop making loans and needed emergency financing to survive. The stock collapsed to

$3.21.”)

1478 “Bear Stearns 1Q profit rises 8 percent on strong results in bonds, credit,” Associated Press Financial Wire

(3/15/2007). Also see “New Century Understated Debt; Faces SEC Probe, Stock Delisting,” Associated Press

(3/13/2007),

http://www.cnbc.com/id/17590171/New_Century_Understated_Debt_Faces_SEC_Probe_Stock_Delisting; “New

Century Subpoenaed, Faces Delisting,” Washington Post (3/13/2007),

http://www.washingtonpost.com/wp-dyn/content/article/2007/03/13/AR2007031300603.html.

1479 On 3/14/2007, Fred Brettschneider, head of Deutsche Bank institutional sales, wrote: “We believe that we have

reached an acceptable compromise with HBK. We will be restructuring the unsold mezz AAA and we will

underwrite the senior portion leaving them [HBK] with the junior piece.” 3/14/2007 email from Fred Brettschneider

to Anshu Jain and others, DBSI_PSI_EMAIL02064810-12. On 3/27/2007, Larry Pike of Deutsche Bank wrote with

regard to Gemstone 7, “400mm of the unsold bonds were a middle (mezz) AAA class that were expected to be

purchased by an investor who backed out at a late stage due to a deteriorating market. HBK was upset about this

and wanted DB to take these bonds down, threatening to curtail business globally with HBK if we didn’t.”

3/27/2007 email from Larry Pike to Sean Whelan and others, DB_PSI_00859611.

1480 Subcommittee interview of Michael Lamont (9/29/2010).

1481 Apparently, Mr. Lippmann was explaining that either Deutsche Bank could “repo” or loan money to HBK in

order for HBK to purchase the unsold Gemstone 7 securities or Deutsche Bank would have to “take it down” –

either purchase the securities itself or liquidate the CDO. 2/20/2007 email from Greg Lippmann to Rich Rizzo at

Deutsche Bank, DBSI_PSI_EMAIL02377303.

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underwriter, but he did not know if everyone asked about this.1482 M&T Bank told the