Deutsche Bank AG (NYSE:DB) In Big Trouble: Bloomberg Markets Most Influential Summit
“It’s like déjà vu all over again.”
— Yogi Berra
Something just doesn’t feel right to me. In March 2008, Bear Stearns executives made a shocking discovery: They were nearly out of cash. They faced a barrage of withdrawals from worried clients. In a blink, confidence was lost. In what seemed like a blink, Bear was gone. They were the first casualty of the great financial crisis.
Now, as was the case back then, we are walking on thin ice. What do I mean? How do I explain this in an understandable way to my team, my wife Susan and our children? We are near a Bear Stearns moment but this time in Europe. What is happening there right now matters to you, me and to all investors everywhere.
In the next few paragraphs I’ll do my best to share what I’m seeing in a way that I hope makes sense. I’ll try my best to keep it simple.
Deutsche Bank is in trouble. Really big trouble. What is needed is a bailout by the German government, but that may or may not happen. The political environment both pre- and post-Brexit adds to the drama. The point is that if Deutsche Bank goes down, it affects banks here, there and everywhere. Why? Read on.
But first, get in the mindset of how humans tend to respond. Recall how the CEOs from Bear and Lehman went to exceptional lengths to profess the strength in their balance sheets. How much did they really know? Think about the recent problems at Wells Fargo. How could Chairman and CEO John Stumpf not know about the practice of setting up phony accounts to meet sales goals? He seems like an honest and straightforward guy.
I think he is being honest and I believe that perhaps he did not know. Regardless, his employees had, over the course of several years, opened as many as 1.5 million bank accounts and 565,000 credit card accounts that may not have been approved by customers.
I’ll bet my pay that there were some pretty good bonuses tied to reaching certain metrics. Doing right isn’t front of mind for some people. Bad behavior happens. Certain policies, conceived with good intentions, may actually stimulate bad behavior. It happened with no-doc mortgages, subprime lending and the seemingly small (at the time) mortgage risk exposure that sat on the books of some of our biggest banks (again, Bear and Lehman come to mind).
The point is that these are really big institutions with many moving parts. When you mix leverage into the equation and losses mount, there is little room for error. Keep that in the back of your mind.
Deutsche Bank is one of today’s great systemic risk. Yesterday, Bloomberg reported that 10 large hedge funds are withdrawing their capital from the bank. Predictably, Deutsche Bank Chief Executive Officer John Cryan rushed to shore up confidence as the stock price dropped to record lows.
“The bank’s balance sheet is safer than at any point in the past two decades,” Cryan told staff in a memo Friday. “Trust is the foundation of banking. Some forces in the markets are currently trying to damage this trust,” he said. (Source)
The bank’s balance sheet the best in two decades? Some forces trying to damage trust. Personally, that doesn’t sound so good. Recall the same kind of rhetoric prior to Bear Stearns and Lehman Brothers hitting the mat.
Let’s look at some simple math.
JP Morgan’s equity capital is about $250 million. Their balance sheet is about $2.5 trillion. Think of the balance sheet as all of the loans they have made and capital set aside to support trading, derivative exposures and other bank functions. Here is the skinny: U.S. banks are currently leveraged approximately 10 to 1. Under the Third Basel Accord (“Basel III”) and the controls the Fed wants, banks can lever up 10 times. U.S. banks are in that range today.
Think of it this way. If you were a bank and you had $1 million in capital, you can loan out as much as $10 million. If a few of the businesses you loaned money to get into trouble, you might not get paid back. If 10% of the loans you made default, then you lose $1 million. Subtract that from your original $1 million in capital and your bank is bust. You have to be really good with the loans you make.
Deutsche Bank ’s equity capital is $15 billion. Their balance sheet is about $2.5 trillion. That puts them at over 100 times leveraged. If you are down ¼% (0.25%) and you are leveraged 100 times, you lose $25 billion in equity capital. Subtract that from $15 billion and you are more than knocked out. That means the bank has to do perfect banking, everyday all the time.
Did Jimmy Cayne, the CEO of Bear Stearns, have a handle on the mortgage risk exposure before or after it was signaled when one of their mortgage hedge funds sparked warning of what was to come? Did John Stumpf know about the fake accounts? Did the president of that particular unit know about the fake accounts?
Do we trust the Deutsche Bank CEO when he says “the bank’s balance sheet is safer than at any point in the last two decades.” Not sure.
It is impossible to be safe when you are leveraged 100-1. Oh, by the way, they are loaded up on exposures to Italian, Portuguese, Spanish and Greek sovereign bonds. There is no room for error. This could call “checkmate” on the entire European sovereign debt mess. Will Draghi do “whatever it takes?”
My Susan might look at me and say, “So what? They are way over there. What does this have to do with us?” Well, one of the big problems is that major banks across the world all trade with each other. This is where it gets messy for our banks. We are interconnected by a highly complex web of what is called counterparty risk.
What that means is that if I bought a structured note to hedge my currency exposure, or to hedge my exposure to a bond I bought, or to place a bet against the decline or gain in a particular credit facility or to buy a structured mortgage instrument; I have to post my collateral at the bank and if the bank goes bust, I won’t get my money back. If the bet or hedge I put in place is tied to a bank-created structured note moves in my favor, I will not only lose the collateral I had to post, but I won’t get paid off on my win. So I have risk to the bet I made and risk to the bank who is the counterparty to my trade.
If Deutsche Bank goes bust, you can see in the next graph all of the exposures other banks have to Deutsche Bank being on the other side of the trade. This is when leverage and highly leveraged structured products can become what Warren Buffett described as “financial weapons of mass destruction.”
In a picture Deutsche Bank looks like this: