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To Big to Fail, v2.0 - Deutsche Bank

Wednesday, October 5, 2016

Yup, here we go again...

Recently the Department of Justice levied a $14B fine against Germany's Deutsche Bank (DB) for its role in the last financial crisis - which was mainly a matter of selling securities based on mortgages they knew were bad.

DB, however, is on the brink of becoming the next "Lehman Brothers" (LB).  If that name isn't familiar, LB was the "systemically important" bank which went bankrupt, triggering the last financial crisis.  The way LB triggered the crisis was actually best explained in "The Big Short" - by Selena Gomez of all people! (Seriously, folks, please watch the video - you may well be about to see a re-run in DB.)

After you've watch this clip, read here.  This is the Reuters story on the quiet talks going on between German and U.S. officials about the fine.  There are so many angles to this, it is hard to know which ones to pursue and in which order.  I'll pick a few, to wit:

1) This is going to blow up the 'myth' that is the European Union and the fraud that is its money (the Euro) in a way that the Brexiteers couldn't have dreamed of;

2) This is going to prove that Central Bank intervention not only did nothing to end 'too big to fail', but actually made it exponentially worse; and;

3) This is going to demonstrate, once and for all, that we were lied to the first time around (the last financial crisis).

Taking these three up in reverse order: We are about to hear the term "under-capitzalized" again.  This was the reason we were given for the bailouts in the last financial crisis.  If we pay attention this time, we will discover there is actually another way of describing the same situation: Too much bad debt.

The difference is between looking at bank through the 'lens' of the asset side of the accounts instead of through the 'liabilities' side.  All we have to do - and no, you do not need a degree in anything to understand this - is ask ourselves how banks are supposed to be doing business.  Its actually pretty simple: they lend out money against collateral.  If you own a home, you understand this.  The bank lent you money to buy the home, and home itself is the collateral.  If you stop making payments, they take it from you and sell it to offset the loss.  A debt that is backed by good collateral - like your house - is considered a 'good' debt even if the borrower stops paying, because there is recourse.  Debts, however, that are not being paid back and have no such recourse are given all kinds of wonderful names like "non-performing loans" (NPLs), or "impaired" loans.  Its all euphemisms for 'bad debts.'

Banks are supposed to maintain a certain percentage of 'good' collateral against their outstanding loans to make sure they have recourse to survive when a certain percentages of those loans go bad.  The problem with DB is no one knows how to value their outstanding debts which were used for 'derivatives'. (Replay the Selena Gomez clip.  A 'derivative' is a bet on a bet on a bet on a bet on a player's Blackjack hand.)  Having good collateral is useless if you do not know what your liabilities exposure is.

We have seen this movie before.  When mortgages started going into default, no one could value the liabilities of banks like LB who had played at this Blackjack table (sub-prime mortgage backed securities).  If you cannot calculate your liabilities, you have no way of balancing the books, and therefore no way of knowing what each share of stock is worth.  When the market concludes they cannot know what a share should be priced at, everyone sells.  When everyone is selling something, and no one is buying it, that something is - by definition - worthless.  This is where DB is right now - even without the DoJ fine.  The only thing the DoJ fine may do is accelerate the day of reckoning.

We are learning that "government officials in Berlin, speaking on condition of anonymity,... hoped to facilitate a quick deal that would buy Deutsche Bank time to regain its footing."

What we are not told is how they propose DB "regain its footing."  Their "feet" are supposed to be planted on good collateral.  Either you have enough of it or you don't - and DB doesn't.  There are only two options: 1) Discharge the 'bad debt' in a bankruptcy; or 2) Raise more capital.  The raising of capital would require DB to offer more shares of stock.  There are two problems with this: First, it dilutes the value of the shares currently outstanding, making them unattractive to investors.  Second, it means investors are asked to buy shares in a company which cannot reliably state its liabilities.  You have to be smoking some choice herbs to make such an investment.

So then what?  A Central Bank - or a consortium of Central Banks - buy up the bad debt on DB's balance sheet to make it possible for DB to have a reliable print on the liabilities side of the books, so it can then raise more capital.  And in some cases, the CBs themselves buy that new stock.  When you address this problem from the 'assests' side of the sheet like this, you leave completely unaddressed the underlying cause - the excess of bad debt.

Sound vaguely familiar?  It should... again, we have seen this movie before.

On to my second point.  We have to go back to the 'dot com' bubble of 2000 to understand how we got here.  Easy money created massive speculation in 'dot com' companies because the Internet was so new and its promise so great.  When that bubble popped, 'geniuses' like Paul Krugman (single handedly responsible for the destruction of Japan's economy) called for a housing bubble to replace the dot com bubble.  We all know how that ended.

Central Bank intervention on the 'asset' side the sheet has done nothing to curb the appetite for bad debt.  In fact, by pushing interest rates ever lower, they have forced banks to 'reach for yield' in ever riskier ways.  Money and the economy is like nature and a vacuum.  The money has to go somewhere, so when all of the otherwise sound, productive uses have been funded, if money is left sloshing about the system, it will ALWAYS end up as chips on a Blackjack table.

So where are we now?  On the top of an 'everything bubble' led by junk bonds.  And a junk bond is nothing but the corporate version of a sub-prime mortgage!  DB, in particular, is the king of junk-bond-backed derivatives.  Again, replay Serena Gomez above to see what DB has been doing - only now it is in corporate bonds across the entire economy rather than mortgages.

Lastly, I have to honest about being a good German ('Horst' is actually a common German first name); I like my Schadenfreud paired with a stein of San Diego craft beer!

The entire European project has been built on a house of cards of debt denominated in Euros.  The idea is that Europe's people act in the interests of all Europeans - until they don't.  Listen to what is being said about DB:
The resolution of the crisis through a reduced settlement is crucial for Chancellor Angela Merkel, who faces a federal election next year. It could be political poison for her government to rescue a bank that got into trouble through speculating. At the same time, officials recognise that Germany's biggest bank, which employs around 100,000 people, cannot be allowed to fail.

'We are not Austria. We are the biggest economy in the European Union, one of the world's leading exporters. We need a big bank with a European and international presence but which is anchored here in Germany.' The official added that merging Deutsche with a European rival was fine in principle but only if Germans controlled the combined entity.
But wait! What happened to Europe?

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