Up and Down Wall Street
The Danger From Deutsche Bank
By roiling the markets, it and other European financial institutions could push up rates, hurting the global economy.
By Randall W. Forsyth
What’s German for “too big to fail?”
There probably is some “alphabetic procession,” as Mark Twain described the multisyllabic monstrosities of mashed-up German words in his musings on “The Awful German Language,” to describe the status of the world’s biggest financial institutions. Perhaps even worse are the linguistic proclivities of 21st century bureaucrats, who have dubbed them G-SIBs, for globally systemically important banks.
Either in German or government-speak, too big to fail is how to describe Deutsche Bank, and that would be true even if didn’t share its name with its fatherland. But worries on that score, which had been a low rumble for months, have erupted in recent weeks. And recalling another of Twain’s aphorisms, history seemed to rhyme, if not repeat.
Deutsche Bank’s equity (ticker: DB for its American depository receipts) and debt securities plunged last week, amid reports that hedge funds had withdrawn money held as collateral at the bank for their derivatives transactions and other positions. That recalled the exodus by hedge funds from Lehman Brothers shortly before its collapse almost exactly eight years ago.
The storm had been brewing since the U.S. Justice Department was reported in mid-September to be seeking a $14 billion penalty for Deutsche Bank’s alleged transgressions in the mortgage bubble and bust. That brought a denial from Angela Merkel’s government that a bailout of the bank was contemplated. Given the long record of pronouncements in previous crises that there was no chance of an action—followed often by a bailout—markets heard the rhyme of Lehman’s history.
Friday brought some relief, however, as Deutsche’s chief, John Cryan, sent a message to his troops that the bank had “strong fundamentals” and that reports of hedge funds’ collateral withdrawals had aroused “unjustified concerns.” Perhaps even more importantly, an Agence France Presse story on Friday said the bank is close to settling with the DOJ for $5.4 billion—more than 60% less than the $14 billion penalty leaked earlier in reports. (Where did the latter number come from? There seems a coincidental symmetry with the 13 billion euro [$14.6 billion] tax bill the European Union sent to Apple [AAPL] in late August, which CEO Tim Cook described in straightforward English as “total political crap.”)
Coincidences abound in the whole Deutsche episode, which sent the bank’s shares tumbling to lows not seen in decades and yields on its bonds and the cost of insuring its debt soaring. It is an ill wind that blows no good, however. The Wall Street Journal reported on Friday that some hedge funds had handsomely profited by shorting Deutsche stock—including some of the very ones that were said to have yanked their collateral, news of which helped propel the stock lower. Another coincidence, no doubt.
Failure of Deutsche was never an option. As for the $14 billion supposedly sought by the DOJ, that number isn’t realistic. “U.S. regulators want to squeeze as much out of DB as they can, but it would make no sense for them to push DB into a capital crisis in the process of doing so, and no sense for DB to agree to such terms,” writes Kathleen Shanley of the razor-sharp and fiercely independent Gimme Credit.
That doesn’t mean investors in Deutsche Bank’s securities are off the hook. Its stock market capitalization totaled about $18.1 billion, even after a sharp 14% rebound on Friday, which no doubt was assisted by short-covering. Whatever the impetus, the pop in DB managed to push its market value above “troubled Twitter,” to about $16.3 billion, according to the ever-ebullient, if not bullish, Doug Kass, head of Seabreeze Partners.
Before the end-of-week rally, Deutsche’s common stock traded for around a quarter of its book value, weighed down by the market’s massive haircut from the stated value of its assets, as well as the uncertainty about how many pounds of flesh could be extracted by regulators.
That isn’t all. “The elephant in the room is DB’s $60 trillion derivatives book,” writes Michael Lewitt, editor of the Credit Strategist letter. This sum represents the gross exposure of the bank’s contracts, many of which are long positions that would be offset by short exposures, resulting in a much smaller net position. That’s in a perfect world, he contends. If, in a financial crisis, counterparties can’t meet their obligations, this netting of positions won’t occur. In any case, “DB’s net exposures are sufficiently large to blow up the financial system,” Lewitt warns.
The deep discount to book also reflects the potential for a highly dilutive capital issuance. In catch-22 fashion, that in turn makes it harder to raise needed equity to bolster the balance sheet. And politics also preclude a bailout. Germany, which has mandated austerity for other euro-zone countries, would find it difficult to bail out its biggest banks, Gimme Credit’s Shanley observes. All of these complications come back to the simple fact that, eight years after the financial crisis, some institutions remain too big to fail. Which also suggests that they’re too big to bail out.
ALL OF THIS STUFF ABOUT big European banks and their derivatives exposure would seem rather foreign back in the U.S.A., outside the leafy enclaves of Connecticut, where many hedge funds reside (and some of the biggest suckle on the public teat of taxpayer subsidies). But some U.S. homeowners stand to pay for the market roilings caused by Deutsche and other big, financially stressed European banks.
“Dollar funding stress is back,” according to Citigroup’s money-market research team. The negative headlines last week sharply pushed up European banks’ funding costs, resulting in the highest spike in dollar borrowings from the European Central Bank since the European crisis of 2012-13, they write.
To be sure, U.S. money-fund reforms set to take effect in mid-October have helped to push up short-term rates, notably the benchmark London interbank offered rate, as I’ve written previously (“Is the Market Doing Yellen’s Dirty Work?” Aug. 10). Libor is the base rate for many U.S. loans, including some home mortgages. Three-month Libor has risen by more than 50 basis points (one-half of a percentage point) over the past year, to 0.8456%, while the Fed has boosted its federal-funds target range just 25 basis points, to 0.25-0.5%.
That’s real dollars and cents for U.S. homeowners. In a commentary, David Kotok of Cumberland Advisors quotes Madeline Schnapp, whom he describes as a “superb economist and researcher of the housing market in the West”:
Taking a $700,000 adjustable-rate mortgage tied to Libor, a 25-basis-point rise in the loan rate to 3.5% from 3.25% would increase the monthly payment about $100, to $3,150, which would be “tolerable.” But if Libor jumps to 1.5%, the resulting rise in the adjustable rate mortgage to 4.25% would boost the monthly payment to around $3,500. “Yikes!” she writes. As for loans that were as much as 97% of the original purchase price, what happens to high-priced San Francisco Bay Area properties bought on that kind of shoestring?
She notes that sales there have been trending lower, on a year-over-year basis. And prices have rolled over in two Bay Area counties, with a third county flat, “suggesting that we may be at or near a top,” she adds. One month doesn’t make a trend, but back East, there also are well-advertised toppy signs at the high end.
If the rise in Libor impinges on the housing market, the Federal Reserve would have another reason to go slow on further rate hikes. A rate increase in December has a 59% probability, based on Bloomberg’s data on fed-funds futures. But odds are against a further boost in 2017.
Indeed, the probability of the Fed’s target range remaining at the current 0.25%-0.5% are roughly equal to the chance of it hitting 0.75%-1%.
OCTOBER MEANS POSTSEASON BASEBALL and stock market volatility. To show that anything could happen on either score, this year could see a once-improbable matchup of the Boston Red Sox and the Chicago Cubs.
October has a fearsome reputation for stock investors from the crashes of 1929 and 1987, but, according to the Stock Trader’s Almanac by Jeffrey and Yale Hirsch, the month actually is a “bear killer.” October “turned the tide in 12 post–World War II bear markets: 1946, 1957, 1960, 1962, 1974, 1987, 1990, 1998, 2001, 2002, and 2011.” But the best Octobers followed horrid Septembers. The month just concluded managed to end basically flat on the S&P 500, with the boost from a nice 0.8% gain on Friday.
There is one important exception the Hirsches note: October is the worst month in election years, according to their records, which date back to 1950. The S&P 500 averages a 0.7% decline and the Dow industrials average a 0.8% decline. But the more-volatile Nasdaq and Russell 2000 small-cap index do appreciably worse, with average setbacks of 2.1% and 2.6%, respectively.
Of course, nothing is average about this election year. Despite the risk of negative market reactions to political surprises leading up to the Nov. 8 election, Barclays ’ strategists don’t profess worry. If the financial and economic backdrop “is supportive of greed, rather than fear, the markets are unlikely to adopt worst-case interpretations of political events—the reaction to Brexit being a case in point,” they comment.
The S&P 500 gained some 3.3% for the third quarter in the wake of the United Kingdom’s vote to leave the European Union. That was bolstered by the Fed remaining on hold and the Bank of England easing. Central banks, rather than politics, seem the more reliable backstop for the markets.