Wednesday, October 12, 2016

How Deutsche Bank Is Lehman Brothers And How It Isn’t

By Ivan Martchev
October 12, 2016

As the accelerating negative news from Germany's largest lender, Deutsche Bank DB, -2.01% began to pile up last Friday, someone asked me: "How big and how important is DB to the U.S. and global financial system?

"Twice as big as Lehman Brothers," was my blunt answer.

That was my initial guess, but after I sat down to write this column, I realized I had underestimated the importance of Deutsche Bank. Lehman Brothers on May 31, 2008, (the last 10-Q it had filed before it went bust) showed assets on its balance sheet of $639.4 billion and stockholders' equity of $26.3 billion. By comparison, Deutsche Bank, as of June 30, 2016, has assets of €1.8 trillion and stockholders' equity of €66.5 billion. Given the size of Deutsche's balance sheet, it is three times as large as Lehman Brothers was.

Three Times As Bad?

The next question on everyone's mind should be: Does this mean that the global financial crisis will get three times as bad if DB fails? While no one actually knows, here is my answer. The Great Financial Crisis of 2008 was not caused by Lehman Brothers. It was caused by failure of regulatory oversight, irresponsible lending practices, and financial engineering that took over a decade to accumulate before it became the crisis of 2008. If we go back even further, the 2008 crisis started with the practice of shoving debt down the throat of the financial system every time the economy stumbled via negative real (adjusted-for inflation) policy rates, and later on by global QE campaigns and negative nominal interest rates.

Lehman Brothers was simply a spectacular catalyst for the unravelling of a mortgage-debt bubble that was going to take probably a couple of years of accelerating losses and failures of smaller banks to unwind — that is, if the U.S. government had bailed Lehman out in September of 2008. The Lehman catalyst basically compressed two years' worth of declines in the debt and equity markets into a six-month period that is only comparable to the 1929 stock market crash when it comes to historical U.S. financial crises.

Is The Stock A Deal Here?

Needless to say, nobody will let Deutsche Bank fail, given its size, even if it means nationalization and wiping out the shareholders. If Lehman were too big to fail, Deutsche is much bigger. That, of course, raises an interesting question: Could Deutsche's depressed stock be a good value? After all, it registered all-time lows last week and the shares trade somewhere in the vicinity of 20 cents per-book-value dollar.

My short answer is "no." (This is my opinion, of course.)

German regulators — and U.S. regulators, for that matter — have the tendency to dilute shareholders on massive bailouts. This can be seen in the share price history of 1-for-10 reverse splits in Commerzbank CRZBY, -0.63% and Citigroup C, -1.13% represented by the black and green lines, respectively, in the chart here.

While a history of diluting shareholders is not a guarantee that the same would happen to Deutsche Bank, it is not a reassuring historical pattern, either. Plus, given that Commerzbank kept on sliding after the bailout, given the more precarious deflationary situation in Germany, even though it is more domestically oriented than Deutsche Bank, this historical record is definitely a warning sign to stay away.

Other than a possible dilution and governmental bailout, I think the global deflationary situation will get worse. If that happens, DB is likely to be dead money for a long time, the same way Japanese financials have been dead money for 25 years.

The Bank As A Symbol For The Economy

In previous postings, I flagged the close correlation between Deutsche Bank's stock and 10-year U.S. Treasury yields (see June 24 Marketwatch article, "A look at the global economic malaise through Deutsche Bank"). If we take a look at a longer-term chart, we can see the correlation has been there for a long time . I wondered how I had not noticed this previously. My conclusion is that it is a little odd to think about government bond rates in the U.S. in the same paragraph as stock in the largest bank in Germany. It would have been more appropriate to look at the German bund market to make a connection between the two, but U.S. Treasury bonds?

The conclusion I reached last June is that the Treasury yield/DB-stock correlation is basically a reflection of how global deflation is a negative for Deutsche Bank, since lower 10-year Treasury yields signify deteriorating deflationary conditions that affect Deutsche bank negatively and vice versa. If you compare the 10-year Treasury yield and DB shares over a year, the correlation becomes surreally close.

I don't know if there will be a rate hike in December 2016, but if there is one, I expect it to be reversed as soon as early 2017, given the accelerating global deflation we are experiencing at present. That will only get worse in the case of a Chinese recession and devaluation that I expect to come as soon as 2017.

There weren't too many people looking for all-time lows in Treasury yields in 2016 at the time of the December 2015 rate hike by the Fed (see December 29, 2015 Marketwatch article, "Will 2016 bring new Treasury-yield lows?"). I am not sure if there are that many people who are now looking for the 10-year Treasury yield to fall to 1%, possibly in 2017, given the same accelerating deflationary trends.

A 1% 10-year Treasury yield certainly suggests a DB share price in the single digits, making the present dead-cat bounce into the low teens a bad deal for value investors. Furthermore, there are numerous reports of clients pulling money from DB. Such a run happened on Bear Sterns before it was devoured by J.P. Morgan, as well as to Lehman before it failed. These asset runs can be very rapid and tend to feed on themselves. Those assets are not coming back soon, if ever, so a dilutive bailout may not be avoidable.

Finally, there is a political problem. The Germans have been so outspoken about bailouts of irresponsible financial institutions under ECB supervision that now, when they have their largest bank in a precarious situation, they seem to have boxed themselves into a corner. I still think that a bailout will come, if need be, but probably at the 11th hour and at a cost that shareholders won't like, similar to Commerzbank.

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