Is Deutsche Bank a Serious Threat to the Financial and Monetary System?

by the Curmudgeon with Victor Sperandeo

Disclaimer: Unless otherwise noted or attributed, the opinions expressed herein are those of Victor Sperandeo.

The Problem:

Deutsche Bank (DB) has been struggling to build up capital during the stricter financial system regulatory environment of recent years. The largest bank in Germany has a huge derivative exposure (estimated to be $46T at year end 2015), has been accused of silver market manipulation, and falsifying the accounts of Italy’s third-biggest bank (which itself is in deep trouble). One week ago, DB was threatened with a $14B DoJ fine for its involvement in selling tainted mortgages during the financial crisis of 2008-2009. Many investors wondered if a fine that size would be a fatal blow to DB. Yet others are more sanguine.

Not to Worry: DB Not a Real Threat?

In fact, many financial market professionals don’t think Deutsche Bank (DB) failure is a real threat to the monetary system.

They either believe central banks and/or government agencies would save the biggest bank in Germany (too big to fail) OR that the derivatives and hedge fund business counter-party risk is not as great as many (e.g. NY Times, UK Telegraph, and many other well respected newspapers) believe it is.

When asked to compare the possible bankruptcy of DB with the cascading financial fall-out of the Lehman Brothers failure and non-rescue in September 2008, Don Luskin, chief investment officer at investment firm Trend Macro said:

"Whatever happens with Deutsche Bank, this is not — I repeat, not — a Lehman moment. We are not looking at globally interconnected fragility like we were in 2008. And if anything goes wrong at all, after the 2008 experience, the central banks of the world know precisely what to do to put the fire out."

Several analysts and money managers believe global regulators are better equipped to deal with a crisis than they were eight years ago when Lehman filed for bankruptcy and financial market liquidity dried up.

"Banking systemic risk is much lower now than in 2007-08," says David Kotok, chief investment officer at Cumberland Advisors. "German bank supervision is also tighter," he added.

That view is based on a somewhat shaky belief that the ECB, EU or the German government itself, would take the necessary steps to keep DB operating and avoid a failure. [That’s after Germany’s Merkel denied there were any talks of her government rescuing DB.]

"When push comes to shove, Merkel will bail out Deutsche Bank," says Luskin of TrendMacro.

DB Presents Systematic Risk to the Financial System:

“What makes Deutsche Bank systemic is their sheer size combined with the leverage that is required to stay in the flow and be an intermediary,” said Anthony J. Perrotta Jr., an expert in the structure of financial markets at TABB Group, a consulting firm. “But as capital becomes more scarce, this becomes a fragile equation.”

A simple calculation from a NY Times article shows DB’s fragility. Deutsche Bank has €67 billion ($75 billion) in equity that supports assets of €1.6 trillion ($1.8 trillion), which mean it is levered at a ratio of 25 to 1.

Making Deutsche Bank’s ratio more troubling is that many of these assets are of the most illiquid variety, called Level 3 securities, for which establishing a price is guesswork and finding a buyer near impossible. According to the last annual report, DB’s Level 3 assets stood at €32 billion, which was about half of the bank’s equity buffer.

DB is also highly interconnected with other financial institutions which increases systematic risk if it fails.

Graphic courtesy of Fortune.com

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Stuart Graham, a banking analyst with Autonomous Research in London, says that Deutsche Bank has more high-paid risk takers than any other bank — including JPMorgan, Goldman Sachs, Barclays and Credit Suisse.

Robert Engle, an economist at New York University who was awarded the Nobel Prize for his work on volatility and capital markets, has designed a model that ranks financial institutions in terms of their systemic risk. It takes into consideration leverage, the bank’s stock price and its equity base, and as such it represents a real-time measure of the dangers a bank poses to the financial system at a given moment in time.

Currently, DB is ranked at the top among European banks in terms of risk, requiring close to €100 billion in fresh cash to ensure that it could survive a sustained sell-off in the markets.

"If you fear a bank has solvency problems, financial managers withdraw from the bank because there is no reward and all risk," says Bruce Bittles, chief investment strategist at Baird. "It doesn't mean that Deutsche Bank is in immediate danger, but you certainly do not want to be the last one out."

Victor: DB’s Problems Stem from ECBs Flawed Monetary Policies

The most interesting and stimulating headline I read on this topic was titled: ECB Says Deutsche Bank “Systemic Threat” Is “Not ECB Fault.”

The European Central Bankers, who are unelected politicians, are blaming elected politicians for the problems of the largest bank in Germany. Of course, the problem stems from the central banks themselves with zero or negative interest rates and control of the bond markets.

Yet the typical elected and appointed political leaders are very much to blame, as they expect CENTRAL BANKS to save their decaying collectivist agenda with monetary policy alone since their fiscal policies have failed badly. Here’s an excerpt from an article posted at ZeroHedge:

ECB president Draghi brazenly "refused to answer questions" regarding Deutsche Bank during a closed-door meeting in the German parliament. Afterwards in conversation with journalists, he denied that the negative interest rates being imposed by the ECB are partly responsible for Deutsche Bank and the German financial system’s troubles.

“If a bank represents a systemic threat it cannot be because of low interest rates. It has to be for other reasons,” Mr Draghi asserted to reporters somewhat dogmatically and simplistically.

However, he was contradicted by the head of Germany’s Banking Association, Michael Kemmer, who told Deutschland funk radio that the ECB’s low interest rate policy was partly responsible for the current problems that Deutsche Bank and Commerzbank are facing."

Yet Mario Draghi’s QE policies have caused bond prices to rise such that bond price appreciation became the objective and yields didn't matter anymore. Bonds have become trading objects, not income investments. Else why would ANYONE buy a bond with negative interest rates if not for the expectation that ECB buying will make them more negative?

Low (or negative) rates on the short end of the yield curve have virtually become one with the long end via QE. Without a spread between short and long yields banks can’t make profits as middle men to borrowers. So big banks like DB greatly suffer when short rates are zero or negative!

DB’s stock price has declined over 53% this year. However, one has to hold back a gasp of awe to look back to 2007 when DB was $140.13 in dollars. It closed Tuesday, October 4^th at $13.33, which is a loss of over 90%!

Again this is the LARGEST BANK in Germany, which is the strongest nation in Europe! Being compared with Lehman Bros is a joke. DB is 1000 x's Lehman! If DB fails, the world is over as you know it. Adding to the DB’s stress (and investors’ fears) was German Chancellor Angela Merkel's promise NOT to bail the banks out, but rather bail the banks in.

Commerzbank Also In Trouble:

Few noticed that Commerzbank¹, the second largest bank in Germany, has suspended its dividend and cut a net 7,300 full time jobs as it tries to shore up its business in the face of ultra-low interest rates and sagging client activity. The bank said its decision to cut almost one in five of its employees worldwide and merge two of its largest businesses will result in a €700m write-off and a loss for this quarter.

Note 1. Commerzbank, has assets that are about a third of those of Deutsche Bank.

Victor’s Conclusions and End Quote:

DB will be saved- forget Merkel's absurd claim, which is political. The question for investors is what about the OTHER big banks that are in big trouble? For example, Italy's oldest (large) bank "Banca Monte dei Paschi di Seiena” is on life support as is Uni-credit. And there are many more Italian banks like it. How will they ALL be saved?

This in turn means it is time to be very concerned! Having government(s) save big banks that were brought down by counterproductive (if not egregious) central bank monetary policies could be the beginning of the end of our modern financial system.

It is best described by Screwface (which means to make an angry face), a Jamaican drug lord character in the 1990 movie Marked for Death:

"Everybody want go heaven. Nobody want dead. Afraid.”

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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