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Central Banks at Full Throttle, DB Starting to Wobble

Central Banks at Full Throttle, DB Starting to Wobble

Talking Points:

- The vulnerable state of banks continues to raise concerns, as years of QE and low rates have compressed profit margins of the very same institutions that global governments are using to ‘stimulate’ their economies.

- Deutsche Bank continues to garner attention, as this is one of the larger, more exposed and highly-levered banks in the world; and a recent fine from the Department of Justice for roughly the entire market capitalization of the company’s stock ($14 Billion) raises fresh questions about state-sponsored bailouts in European banks.

- If you’re looking for trading ideas, check out our Trading Guides. If you’re looking for an even shorter-term indicator, check out our recently-unveiled GSI indicator.

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The biggest problem from the Financial Crisis wasn’t really just the mortgages that went bad when people stopped or couldn’t pay them; it was the contagion effect amongst the banks that were levered up on mortgage debt. With banks not knowing which Collateralized Mortgage Obligations were toxic and which were still investable, this meant that a key market locked up from a lack of liquidity. And further, even if you did have an issue that you were fairly confident in trading, the grave state of the financial industry at the time meant a huge increase in counter-party risk; or to put it otherwise, banks didn’t know which other banks would still be solvent for the delivery of the trade, so your incentive to do business was just hit by the risk that the party you agreed with can’t hold up their end of the bargain. Prices on CMOs plummeted and the U.S. Government had to step in to stage a bailout; and after a lot of work and negotiation, that was enough to stem the bleeding at the time. But the monetary tools that were deployed to stop the bleeding were never designed to grow an entirely new limb, and in the eight years since the financial collapse, that’s basically been what the world has come to expect.

While stock prices have shot higher across-the-world on the back of fast and loose monetary policy, many economic variables have continued to lag, like interest rates. Growth remains fleeting, and inflation is curiously ‘non-existent’ although if you look at prices from other angles the argument can be made that prices are increasing rapidly in areas that simply aren’t included in the CPI-basket. The other mandate of the Federal Reserve, employment, has shown some signs of promise. But with factors such as underemployment, declining labor force participation and weak wage growth (inflation’s precursor), even that is a debatable point.

The one thing that everyone can seem to agree on at this juncture is the vital importance of banks to the continued global economic recovery. The same banks that were ‘levered to the hills’ to bring on the Financial Collapse are the same entities, the same arms that governments around the world are using to try to ‘stimulate’ their economies. In the United States, passing a spending bill requires Congressional approval (no small feat). Doing more QE or electing to hold rates at ‘emergency-like’ levels simply requires six votes from the Federal Reserve to get a majority. In Europe, many countries are already near their debt limits, meaning they simply can’t spend anymore without taking in more revenue. Taking in more revenue is difficult to do when inflation doesn’t exist and unemployment stays egregiously high.

To compound matters – the business of being a bank took a major hit after the Financial Collapse. Normally banks’ business is fairly simple: Take in money from savers and pay a small interest rate; then take that money and loan it out at a higher interest rate (this can be done through markets by buying a bond, or internally by creating a loan), pocketing the difference between the two rates as their revenue. Banks can speed up the revenue generation part of this process by taking on higher levels of leverage, or to put it simply, by loaning out that dollar of deposits two times as opposed to just once (2x leverage versus 1x or ‘no leverage). But as rates go lower, the margin that banks can earn on loan activities dwindles; this is a direct hit to their revenue stream and the primary business of being a bank.

US Financials (IYF) lagged the S&P during post-GFC ‘recovery’ as low rates constrained banks’ margins

Chart prepared by James Stanley

After six-plus years of low rates, many banks were in a beleaguered state. Loan demand remained weak, rates remained low and banks had to look for any avenue of investment in order to produce earnings. This is where a market like Oil comes into play, because the steady and consistent price gains seen in Oil from 2008-2014 made investments into this space seem really attractive. As US Oil production was growing every year, banks around the world rushed in to loan money to these explorers and drillers on the prospect of having some type of investable medium. But as Oil prices crumbled last year, cracks began to become exposed as an already fragile banking industry looked extremely vulnerable to the continued fall in Oil prices.

And to be sure, it wasn’t ‘just’ the lower Oil prices that were a risk, and we covered this in the article The Looming Boom of Energy Debt. Oil prices were simply the pressure point, the bigger issue was the prospect of contagion: Should one of these major banks get hit so hard from being levered-up on Oil investments that other banks took notice, got more risk averse and began to duck for cover; we could have ‘collapse like’ conditions coming back really fast. The first six weeks of this year made this prospect all the more real as Oil prices fell to decade-lows; but disaster was averted on the morning of February 11th when Chair Janet Yellen assuaged markets by assuring that the Federal Reserve would likely not be tightening in the face of a global slowdown.

As Oil prices moved back up, this concern seemed to wane for many banks; but for the more vulnerable, the cracks were already exposed and it became obvious that one or two ‘adverse events’ could set off a domino-effect throughout the European banking industry. The ECB saw/sees this coming, or at least they could see the ill-effects of their policy eventually eroding banks’ capital requirements, and in March the bank started a ‘rebate’ program in which they would refund the negative rates for money that commercial banks loaned out. But again, this did nothing to solve the problem of lagging loan demand. So, while this move from the ECB ‘could’ be helpful, it’s likely the worst possible environment for such a scheme to possibly see success. But more to the point, this policy hasn’t solved any problems for European banks: This has simply kept them going in a beleaguered state.

Growing divergence between US Banks (in blue) and European Banks as ECB policy enhanced

Chart prepared by James Stanley

Of the vulnerable banks, Deutsche Bank is and has stood out for a while now. This was the ‘big’ worry in our Looming Boom of Energy Debt article because, to this day, DB appears to be one of the more highly levered and vulnerable, one of the more complex and one carrying considerable cross-border counter-party risk. To put it bluntly, the world may not be able to afford a meltdown at DB unless German taxpayers are willing to foot the bill to bail out the bank. And this matter appears to be caught in a political fingertrap as Angela Merkel’s Christian Democrat Party is giving up ground with German elections less than a year away; and most signs show a German electorate unsupportive of a state-sponsored bailout of DB.

European banks lagging the S&P, and DB lagging European banks

Chart prepared by James Stanley

More recently the United States Department of Justice has fined Deutsche Bank $14 Billion for improprieties in CMO trading during the Financial Collapse. This fine of $14 Billion was roughly equal to the entire market capitalization of Deutsche Bank at the time of the announcement. This is troubling for the entire industry, because this fine can potentially put DB over the capitalization brink, and this could spread as counter-party risk makes every trade with DB on the ticket questionable. Since this fine was announced on September 15th, prices in DB securities have been falling like a rock. DB management has made multiple assurances that ‘everything is fine’ but it doesn’t appear as though markets believe that.

Making matters more dramatic is the fact that it would appear that DB is going to need help from the German government. The European Central Bank is essentially running at full throttle right now on the QE-front, and it doesn’t appear as though there are many options there for the ECB to help. As we’ve seen with Greece and Italy in the past, the ECB can’t bail out banks directly; so the onus for solving this problem rests with a German government heading for a crucial election cycle already dealing with internal headwinds on topics like open borders and national security. But if the problem isn’t solved, then we may be watching DB erode away until, eventually, they’re forced to sell securities on their books simply to raise capital to avoid the dreaded ‘big’ margin call.

So is the United States Department of Justice going to set off a cascade effect across Financial markets by forcing DB to pay a fine that’s roughly the value of their entire market capitalization: Probably not. But, this does serve as yet another example that a banking sector that has become a crucial fulcrum point for Central Banks to execute their strategies is a) seeing their power wane and b) becoming more vulnerable to the impact of near-term adverse price movements. And this may be something that Central Banks can no longer offset as the next year brings an angry French electorate to the polls just ahead of critical German elections in August of 2017. And directly relevant is that an already fragile Deutsche Bank is likely going to face even more headwinds as another bill is tacked on the bottom line to further compress already weakened margins.

--- Written by James Stanley, Analyst for

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