You may have noticed in the news lately that there are a lot of concerns about Deutsche Bank (DB), Germany’s largest bank, so I thought it would be helpful to explain what all the fuss is about. Last week, Angela Merkel said that there will not be a bail out and this morning there are reports that the state is preparing to bail them out. I’m sure Merkel was hoping that her comments would instill confidence but anytime a government official openly says there’s no problem, it typically means “there’s a big problem here…” Deutsche Bank’s stock has fallen pretty hard over the past couple of weeks and is at all-time lows – below the 2008 low, which is a pretty ominous sign.
Deutsche Bank – 1999 to Today
On top of this, the US DoJ imposed a fine of up to $14 billion to settle mortgage related accusations from the 2008 GFC. I’m sure things will be settled for much less, but with a market cap of only $16 billion… that’s a big problem. And it’s not just Deutsche Bank. Virtually all of the European bank stocks, especially the Italian and Spanish, are trading like death, and this includes the Swiss giants Credit Suisse and UBS.
We can see these stresses by looking at the TED Spread, which measures the difference between the 3-month LIBOR rate and 3-month T-bill rate. LIBOR is the rate paid on US dollar-denominated deposits outside of the US. It’s basically the interbank rate that banks pay each other to borrow money. A rising spread shows that banks are not willing to lend to each other, despite the higher rate, and would rather store excess reserves in the safety of US T-bills. The only reason you don’t lend at a higher rate is because you’re afraid you won’t get the money back (i.e. bank defaults). For over a year now, DB and other European bank stocks continue to fall and the TED spread continues to rise – now at levels last seen during the 2011 European banking crisis (which never ended…it’s just been kicked down the road to today by the European Central Bank).
TED Spread – 6 years
Why we care about this as investors is because the global monetary system is highly interconnected and issues with European banks become issues in the entire banking system, which affects funding and eventually the unwinding of positions. You can see how the TED spread and the CBOE Volatility Index (the VIX) are highly correlated (until lately that is…)
TED Spread vs VIX – 6 years
The important thing to understand is that the European Banking system is as much of a mess as the Eurozone experiment itself. All of the banks hold the debt of other European countries as reserves and “high quality collateral” which also backs their highly leveraged derivative books. This means that if one country were to default, the “reserves” are wiped out and a bank can become insolvent. Remove one bank from the system and you now have counter-party risk against the derivatives in the whole system because there’s no longer a party (the bank that became insolvent) on the other side of the trade…which would essentially wipe out the rest like a chain of dominoes. The notional value of Deutsche Bank’s global derivatives book is estimated to be somewhere around $75 trillion (give or take a few trillion…) which is roughly 20x the size of the entire German economy!
This all matters because the Eurodollar system is the global monetary system: that being a fiat, credit-based system with the US dollar acting as the world’s reserve currency. It’s how everything functions. If DB or any other large bank goes bust, it would make the Lehman Brothers failure look like a walk in the park. My clients own put options on Deutsche Bank as a small hedge against this tail-risk because I personally think it’s only a matter of time before they are nationalized, making the equity pretty much worthless. That’s certainly what DB’s bond and stock prices are saying at least. They would have to do it to prevent contagion from spreading; they have no other choice.
-Nick