What is going on at Deutsche Bank?

Deutsche Bank Financial Security

We asked our tame analyst, Steve Williams, for his thoughts about Deutche Bank, liquidity and patterns on 3rd October:

In the good old days, when large financial institutions were on the brink of collapse they were bailed out. Cast your mind back to 1998.

By then, Long Term Capital Management (LTCM) – a large ‘fixed income arbitrage’ hedge fund with not one, but two Nobel prize winners on its board – had been hugely successful in delivering returns for investors since its inception four years earlier. But LTCM didn’t count on a ‘black swan’ event, or two. On top of the Asian Financial Crisis, the Russian government opted to default on domestic debt and impose a moratorium on repayments of foreign-held debt too. LTCM’s subsequent impressive losses precipitated a dearth of liquidity for the fund. And because LTCM had dealings with, more or less, the full range of Wall Street firms its demise was scary enough to prompt the US treasury Department to force a costly bail out.

LTCM was not a precedent, by 1998 such bailouts were the norm*.

But then came Lehman Brothers. There was no bailout for Lehman. It filed for ‘chapter 11’ bankruptcy protection on 15 September 2008. Shortly after, the Dow Jones Industrial Average experienced its largest one-day points loss.

So, to some extent I can understand last week’s volatile movements in the price of Deutsche Bank’s (DB) shares. Market participants were likely reacting to news that some of DB’s institutional clients were withdrawing funds. After all, what happened to Northern Rock very visibly on the UK’s high streets might be happening to DB much less visibly on keyboards across the world.

If that isn’t dramatic enough, the International Monetary Fund describes DB as ‘the most important net contributor to systemic risks in the global banking system’.

Shares in Germany’s behemoth bank, with €1.8 trillion in assets, were trading at €27 a year ago and just €13 on Friday; a few weeks after The Wall Street Journal broke the news that the US Justice Department had proposed the bank pay $14 billion in an opening bid in talks wrapped around mortgage-securities litigation. A fine that large would certainly take a sizable chunk out of its capital cushion. Indeed, the Wall St Journal reports that the bank’s US unit has failed the last two yearly Federal Reserve ‘stress tests’.

And, while history suggests that the final settlement will be much lower than the $14 billion mark, DB still looks vulnerable. The Financial Times reported in June that DB was €10 billion short of the minimum capital requirement written into recent regulatory changes. And while those changes don’t come into force for a few years yet, DB’s low profitability and depressed share price makes raising the requisite capital more difficult.

But are we faced with another Lehman moment? Are we about to see the collapse of another banking giant with the potential to spark a global recession?
Well, my guess is as good as yours but I would be among the more surprised if Deutsche Bank gets close to collapsing in the first instance and is then allowed to collapse in the second.

Of course, what done for Lehman was a dramatic withdrawal of credit; hitherto liquid markets dried up. As Autonomous Research’s Stuart Graham puts it… ‘Deutsche has many problems, but liquidity is not one of them. There can be no doubt that Deutsche could access significant additional liquidity from the European Central Bank (ECB), should it ever need it.’

That is the difference. The bail out, in part at least, is already here.

*Though I suppose it could be argued that the collapse of Drexel Burnham Lambert in 1990 was the canary in the coal mine.

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