A Take on Deutsche Bank

Doug Nolan

 
 
September 30 – Wall Street Journal (James Mackintosh): “Lehman failed the way all banks fail: It ran out of cash and liquid assets it could quickly sell to pay clients and counterparties as they ran for the exit. In principle, the same could happen to any bank, as they never have enough easy-to-sell assets to pay back every depositor immediately. Deutsche is now in focus in part because clients have been spooked by its plummeting shares… But Lehman was particularly vulnerable, due to its reliance on the overnight repurchase, or repo, market and on hedge funds to finance itself. Billions of dollars of cash and other assets from its so-called prime brokerage business drained away in its final few days, while repos couldn’t be renewed and banks and other counterparties demanded extra collateral to back derivatives trades. Deutsche is different. It has a far more diversified client base, sourced from German retail banking and multiple institutional business lines. It has a lot more liquidity, amounting to $246.8 billion at the end of June, equal to 12% of assets, against the $45 billion Lehman had a month before its downfall, 7.5% of assets.”

Deutsche Bank comparisons to Lehman Brothers resonate with bulls and bears alike. The bulls are comforted that policymakers readily admit their mistake allowing Lehman to fail back in 2008. As revisionist thinking goes, no Lehman failure would have meant no “worst financial crisis since the Great Depression.”

Learning from the crisis, Deutsche Bank’s balance sheet is these days heavy on liquid assets. There are as well various emergency liquidity facilities available from the ECB and Bundesbank. Deutsche Bank is better prepared, policymakers are better prepared and the world is better prepared. From the bullish perspective, it’s almost unthinkable that global policymakers would sit back and watch the collapse of the “world’s most systemically risky bank.”

The sanguine bullish view is supported by Deutsche Bank (senior debt) Credit default swaps. Despite Friday’s morning’s 20 bps surge, CDS closed at 240 bps, still below trading highs from February. While elevated, these are not levels indicative of a looming Lehman-style collapse. Moreover, there’s the U.S. equities VIX index. Closing the week at 13.29, a level suggesting nothing but blue skies ahead. Moreover, the S&P ended Q3 only about 1% below record highs.

The bears, well, they’re convinced the bulls are nuts. More important than whimsical CDS pricing, the naysayers point to an incipient exodus of Deutsche Bank clients. Global markets were shaken Thursday by a Bloomberg article discussing how some key hedge funds were abandoning ship. Not yet faded from memory, Lehman Brothers proved a prime brokerage and counter-party exposure nightmare. Those who panicked first panicked best.

It’s perfectly rational for hedge funds in particular to shift assets, collateral and derivative business away from the slow-motion train wreck, Deutsche Bank. The bears see an approaching point of no return: a crisis of confidence and “run” on Deutsche that will necessitate a bailout and restructuring.

September 30 – Financial Times (James Shotter, Martin Arnold and Laura Noonan): “Hedge funds have started to pull some of their business from Deutsche Bank, setting up a potential showdown with German authorities over the future of the country’s largest lender. As its shares fell sharply in New York trading, Deutsche recirculated a statement emphasising its strong financial position. European regulators and government officials have kept a low profile in public over Deutsche’s deepening woes. However, in private they have struck a sanguine tone, stressing that in extremis there is scope under European regulation to inject state funds to support the bank, provided it is done in line with market conditions.”
I’ll take a somewhat different tack. Deutsche Bank is to the global government finance Bubble what Lehman was to the U.S. mortgage finance Bubble. Lehman may have been the catalyst, but the root of the problem was Trillions of mispriced securities, unsustainable home prices and deep structural impairment (financial and economic). Deutsche Bank is much larger today than Lehman was in 2008, and its tentacles are everywhere. The scope of the global government finance Bubble is multiples of the mortgage finance Bubble. Mispriced securities are in the tens of Trillions. Global structural impairment is unprecedented. There were lessons learned from 2008 – though most now work to bolster and prolong history’s greatest Bubble.

Deutsche Bank is rather clearly in trouble. But it is unclear if a crisis of confidence is imminent. This institution desperately needs to raise capital. Transparency is lacking with regard to Deutsche Bank’s massive derivatives portfolio. Their investment banking, prime brokerage and derivatives businesses, already thin on profits, will suffer. But as Germany’s largest bank, it is not clear that as an institution it’s today as vulnerable to a run as Lehman was in 2008.

Rumor of a Department of Justice settlement saw Deutsche Bank shares rally 10% intraday to close Friday’s session up 14%. Italian stocks rallied 6% intraday. European stocks recovered 4.5%. Even with Friday’s gains, it was another rough week for global financial stocks. Notably, Japan’s TOPIX Bank index sank 7.5%, increasing 2016 losses to 30%. Hong Kong’s Hang Seng Financials dropped 2.7%. Italian stocks declined another 1.7% this week, taking its y-t-d decline to 50%. Europe’s STOXX 600 Bank index declined 1.0%, increasing 2016 losses to 23%. The wild volatility in financial shares is reminiscent of 2008.

Deutsche Bank is a potential catalyst for the bursting of the global Bubble. It has company. Though it is almost unique as a poster child of the mess global policymaking has made of things. After the 2008 crisis, Deutsche Bank had the opportunity to take market share in global prime brokerage, derivatives and investment banking – and couldn’t resist. As a German institution, it benefitted from European economic and banking system fragility. Not surprisingly, all the abundant cheap finance ensured the bank found myriad avenues to get itself into trouble. And then the Draghi ECB, along with global central bankers, lost their minds, with massive QE and negative rates inciting dislocation throughout the massive global bond and derivatives markets.

Deutsche Bank exemplifies the fragility of the global financial system. And this vulnerability is associated directly with egregious monetary stimulus – past and present. Trouble at Deutsche Bank comes at an inopportune for the unsound European banking system. It comes at a tough time for Merkel, the Bundesbank and the German government more generally. The political backdrop makes it difficult for the German government to support its largest bank. A faltering Deutsche Bank will only toughen German public enmity toward ECB policymaking.

To be sure, Deutsche Bank is illuminating the serious predicament associated these days with being a highly leveraged financial institution in a world of acute monetary disorder and price instability. They are certainly not alone. Sinking global bank stocks provide another important crack in global confidence – confidence in finance and confidence in policymaking.  Importantly, the Deutsche Bank imbroglio comes as faith in central banking is waning.  It comes with geopolitical tensions running high.

The VIX is about 13. Meanwhile, the costs of all types of market derivative insurance are rising – especially in currency swaps markets. Deutsche Bank will have little option than to back away from derivatives market-making activities. This comes at the expense of already susceptible marketplace liquidity, ensuring heightened caution from other major derivatives players. The cost of market insurance is on the rise, with negative ramifications for risk-taking and market liquidity more generally. While convenient, don’t blame it all on Deutsche Bank. It’s becoming increasingly systemic.

September 30 – Bloomberg (Liz McCormick): “Quarter-end is often a tumultuous period. Banks typically rein in collateral lending as they shore up balance sheets, driving up rates on repurchase agreements. When banks curb repo activity, money funds -- the key cash providers in the transactions -- need alternative places to invest. In the past few years, one option they’ve turned to is directing more money into the Federal Reserve’s reverse repos, the tool the central bank uses to put a floor under its target for overnight rates. But this quarter, the movements are out of the ordinary, partly because of the looming Oct. 14 deadline for the overhaul of rules governing money funds. Treasury repo rates have reached the highest since 2008. Meanwhile, the amount of money piling into the Fed’s overnight reverse repos surpassed $270 billion, one of the highest levels since officials began testing the program in 2013.”
September 30 – Bloomberg (Lukanyo Mnyanda and Liz McCormick): “Banks borrowing dollars are paying the most since the height of the euro region’s sovereign-debt crisis as concerns mount about the health of Germany’s largest lender, just as new money-market rules are disrupting U.S. short-term financing markets. The three-month cross-currency basis swap, the rate for banks to convert euro payments into dollars, fell to 58 bps, or 0.58 percentage point, below the euro interbank-offered rate. That’s the most negative reading on a closing basis since July 2012, when the debt crisis was seen threatening the very existence of the euro. It widened to 210 bps below Euribor as banks refused to lend to one another in 2008 after the collapse of Lehman Brothers…”

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