DEUTSCHE BANK: WILL IT BE THE NEXT \’LEHMAN BROTHERS\’?

™s biggest investment bank, Deutschebank, is in big trouble. This Sunday it will announce a major restructuring. It’s also a harbinger of a bigger problem with European banks in general, which are loaded with trillions of euros in non-performing bank loans they haven’t been able to shed since the crisis of 2008-10 (and subsequent Eurozone double dip recession of 2011-13).

Deutsche, the biggest, is among the worst shape, much like the largest Italian banks. Deutsche soon will announce this Sunday, according to reports, a 20,000 cut in jobs, as well as asset sales of entire divisions, as it pulls out of the US and other economies and consolidates back to Germany. (It formerly tried to challenge US investment bank giants, Goldman Sachs and Morgan Stanley, by acquiring the large US bank, Bankers Trust, several years ago but has now clearly lost out in that competition and is trying merely to survive.)

But even before the next financial crisis hits Europe, which is coming soon, Deutsche is already in the process of being ‘bailed out’. One means of bail out is forcing a merger with another large bank. That was recently attempted by the German government, with German Commerz bank, but the effort failed. Another bailout measure is to get the bank in trouble to raise capital by selling off its best assets. Now firesales of its better assets are underway. Another approach is to set up what’s called a ‘bad bank’ in which to dump its non-performing assets. That’s going on with Italian banks. But those solutions may not be enough should the bank’s stock price collapse further even more rapidly. At only $7 a share now, speculators could soon jump in and drive it to near zero, as what happened in the month preceding Lehman’s collapse.

Like Lehman in 2008, another major problem with Deutsche is the composition of its risky asset portfolio of derivatives contracts undertaken in recent years and the potential for it to precipitate a global ‘contagion effect’ should its financial condition worsen rapidly.

Deutsche currently holds $45 trillion in derivative trades with other institutions. And some sources and analysts are beginning to compare it with the Lehman Brothers investment bank collapse in 2008 in the US. Like Lehman, the derivatives connection is the historic channel through which contagion and asset value collapse is transmitted across other financial institutions, leading in turn to a general credit freeze across multiple financial markets in Europe. The giant US insurance company/shadow bank, AIG, over-issued and held trillions of Lehman derivatives which it could not pay when Lehman collapsed. Deutsche may thus represent a kind of Lehman-AIG in a single institution.

Whether the European Central Bank, ECB, could successfully bail out Deutsche in the event of a crash is another related question. Unlike in 2008, the ECB is no longer in as strong a position to do so. Its policies since 2015, of QE and driving down government interest rates to negative levels, may mean a Deutsche bailout could intensify a European crisis. An ECB bailout might inject even more liquidity into the European banking system, driving interest rates significantly further into negative territory. Negative interest rates already range from 64% to 69% of all government bonds in Europe.

A recent reader of this blog raised a series of questions about Deutsche as a repeat of Lehman and asked my response. The following are his questions, and my replies:

Reader’s Question:

The largest bank in Germany is Deutsche Bank,and it is also the largest bank in the EU. Its stock has been plummeting. It laid off 20,000 employees, and I noticed that its PE ratio is 600 to 1, which means it is earning about 10 cents per share. It seems like it is getting close to being a zombie bank. The bank, however, has 45 trillion dollars in derivatives, and these appear to be heavily interconnected to U.S. banks. Can a bank be too big to fail and too big to save? If it goes under, is there a chance of contagion? Can a bank collapse and yet leave its $45 trillion in derivatives unaffected? On a scale of 1 to 10, what are the chances of a Lehman collapse and global contagion with Deutsche Bank in your view

My Reply:

The percentage potential for collapse is probably around 7 out of 10 should the next recession hit Europe. It also depends of course on which institutions are counter parties to the $45 trillion. That’s unfortunately not knowable because of the opacity of derivatives contracts (except for rate swaps). And it also depends on how financially fragile other institutions are, apart from the Deutsche-derivatives connection. My view is that European banks and financial institutions are quite fragile–given the trillions in non performing loans, negative rates, etc. Along with certain emerging market economies’ sovereign debt (and dollarized corporate debt) loads (Argentina, Turkey, etc.), India’s shadow banks leverage and NPLs, and China’s debt, Europe banks may prove the next locus of the global financial crisis on the agenda. That more general financial fragility (and thus instability) would certainly raise the probability of Deutschebank repeating the role of Lehman in the next crisis. In short, you can’t evaluate Deutschebank just in relation to its (and its counterparties) derivatives exposure. Contagion will not occur just within a certain subset of the banking system; it will soon spread via expectations to other sectors of the credit system (as it did in 2008), and that will quickly feedback negatively on the Deutschebank-partners derivatives exposure condition.

ON CHINA DEBT COMPARED TO EUROPE\’S

A reader of my blog, jackrasmus.com, recently noted the magnitude of the debt problem in China and argued it will be the locus of the next debt-financial crisis–not Europe. Making good points in support of his view, my reply follows arguing it is not the magnitude of the debt load that is, by itself, key. True, the quantity of debt–and the quality of that debt–are important. But the ability to ‘service’ that debt (paying interest and principal when due) is just as critical. And that ability to ‘service’ in turn depends on the assured cash/near cash assets available, which depends on maintaining price levels and sales levels (i.e. revenue) and returns on near cash assets in order to make the payments. The various terms and conditions associated with the servicing may also be critical (i.e. can the borrower roll over the debt, what’s the interest rate and term structure of rates, can it legally suspend payments, are the covenants that relieve payments generous or not, etc. Here’s the reader’s notable comments and my reply:

The Reader’s Comments on China debt:

I came across some of your writings and been reading for a few hours… I am curious to know why you seem to be thinking the financial crisis isn’t coming from collateral shortage in Eurodollar Markets ? Since baoshang 30 % haircuts, AA bonds no longer accepted, AAA 2 to 1 value only sovereign bonds accepted at face value in china repo. Eurodollar markets seem to want Sovereign Bonds and stopped accepting HY Bonds, Gold furious bid indicates Collateral problems, Gold collateral of last resort in money markets.

European banks are the starting crisis point, due to Trillions in USD loans to EM’s and china china has 3.5-4 Trillion US bond issuance, on paper borrowing 100 Bil USD + a Quarter… Then add 250 Trillion + of derivatives between Big 9 of New York and EU, the biggest financial collapse the world will ever see. China is the catalyst by far right now, they make Wall St look noble. Their 10 year isn’t being bid much which indicates serious cash flow problems in their banks, while every other sovereign bond in the world is being full blown bought, money dealers and banks running towards liquid and accepted collateral, credit cycle is done… Baoshang sealed it, no way European banks are making it out, Chinese collateral is bunk, not worth much and big haircuts, PBOC isn’t gonna cover much on foreign debt… Hengfeng bank failing now, 16 more to go.

I think you are hell bent on America and the ” Establishment ” but give credit where it’s due… China was the biggest cause to Inflation in this cycle, they will be the biggest cause to deflation, gravity Jack… What goes up, always comes down

Please let me know your thought process behind China not being the catalyst given they accumulated close to 80 % of world’s debt in this cycle ( Corporate, Local Gov, Household and Central Gov )… Price Per Income is 45-50 in Tier 1’s, their income to mortgage average in the country is 330 %, it doesn’t make sense the amount of leverage, everybody is indebted to their eyeballs with over 100 Trillion Yuan in shadow banking loans to consumer, their Consumption GDP is the lowest in the world in net terms, highest investment GDP in the world… I don’t get how you think they are even growing at 4 %, with debt servicing they are negative growth, M1 growth is horrendous in China

My Reply:

Indeed, China debt is extremely high, in all sectors, government, household, etc. But debt magnitudes are not the entire picture when it comes to an asset crash. Servicing of the debt is key, and in turn price levels and revenue from sales of output which generate the income with which to service the debt. When debt servicing reaches a point where income is insufficient and then defaults occur, that’s the threshold to watch. China has shown its willingness, and has the resources, to absorb defaults. Also, it can respond quickly before the expectations of creditors deteriorate too far, and they precipitate a general asset price collapse that begins to snowball. The US, EU, Japan-S.Korea can’t respond as quickly as China might. Also, China is still growing, although far more slowly than reported. That growth generates income for debt servicing. In contrast, Europe is not growing at all, hasn’t really since 2009, and has never really recovered from the 2008-09 and 2011-13 crises. Its bank lending is still mostly flat. Money capital keeps flowing offshore. Central banks’ QE has not gone into real investment in Europe but has been diverted elsewhere. Negative rates have not proven effective in stimulating bank lending in Europe. Non-performing loans totals are very large. QE has failed miserably and it will again when they try it again soon. In contrast, China can turn to boosting government investment quickly in lieu of revenue from exports now slowing because of the global trade slowdown and US trade war. Europe cannot or will not seek to offset its exports slowdown with government direct investment as an alternative. Its bankers driving policy and the Euro system have structured austerity systemically. It’s therefore far more dependent on export revenue but the global slowing of manufacturing and exports means less ‘income’ from revenue with which to service debt.

In short, my point is that magnitude of debt is not the only determining variable of financial fragility and instability and eventual financial crashes. Excessive debt levels and leverage are necessary conditions for a crisis, but the quality of that debt, the ability to service it, the means and willingness of government to avoid or cut short defaults preventing contagion, etc., are all important.

Read my equation in the appendix of the Systemic Fragility in the Global Economy book written in 2016. It considers the role of debt in relation to ability to service the debt and the numerous terms and conditions and covenants that may be associated with debt servicing.

I’m currently developing these equations further, using neural network data analysis to determine the actual multiple causal relations between government, household, corporate, bank debt as well as, within each of these sectors of the economy (government, household, business), the degree of causality between debt levels, quality of debt, income available to service the debt, and terms and conditions of debt financing.

But you’re right, the situation in China is worse than it appears. But so is Europe even worse. China debt may be higher in absolute terms, but Europe’s debt servicing ability, after eight years of double dip recession and near stagnant growth (what I call an ‘epic’ recession that still continues), is weaker than China’s ability to ensure debt servicing and thus avoid defaults contagion that sets off a general financial asset price crash. And let’s not forget EMEs like Argentina, Turkey, Pakistan, as well as India which has a very serious problem with its shadow banks. Their debt servicing ability may be even weaker than Europe’s.

I think the crisis will involve feedback effects between Asia (China, India, Japan) and Europe and EMEs. Where it first erupts is important. I’m leaning toward Europe as the initial focal point, although I could be wrong.