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Deutsche Bank Nears Collapse

Friday, September 30, 2016 14:19
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This post Deutsche Bank Nears Collapse appeared first on Daily Reckoning.

One of the biggest banks in the world has come several steps closer to complete collapse.

I rely on signals from around the world for our information. These signals are what the intelligence community calls “indications and warnings,” and I use them to update my investment hypotheses.

Sometimes the signal is weak. But sometimes the signal is flashing bright red. This is one of those times.

The bank in question is Deutsche Bank. It’s the largest bank in Germany, by far, and one of the twelve largest in the world. It is difficult to overstate the importance of Deutsche Bank not only to the global economy, but also in terms of its vast web of off-balance-sheet derivatives, guarantees, trade finance, and other financial obligations on five continents.

Deutsche Bank’s gross notional derivatives exposure is €42 trillion — over 25 times what the bank reveals on the size of its balance sheet. This figure has dropped recently from over 70 trillion, which means counterparties are already terminating and replacing contracts. There’s a silent run on the bank already. As usual retail depositors are the last to know.

The financial distress at Deutsche Bank is like a “Lehman Moment” on steroids.

But Deutsche Bank is certainly in the “too big to fail” category. Therefore it won’t be allowed to fail. Germany will intervene as needed to prop up the bank.

First, let’s examine Deutsche Bank itself. Then we’ll look at the signal that tells us what’s happening. That signal, incidentally, is being ignored by most Wall Street analysts.

The problems at Deutsche Bank are well-known. They have suffered through bad debt write-offs and mark-to-market trading losses just like many of their big bank peers. But, the problems go deeper. Deutsche Bank’s capital is barely adequate under generous ECB “stress tests,” and is completely inadequate under real world scenarios involving a global liquidity crisis of the kind we saw in 2008.

Recently, the U.S. Department of Justice announced that it was seeking $14 billion to settle charges that Deutsche Bank engaged in misleading sales practices with regard to residential mortgage backed securities between 2005 and 2007. Of course, that’s just a claim. But, even if Deutsche Bank settles the case for a fraction of that amount, say $5 billion, it will significantly impair an already weak capital base.

Not surprisingly, Deutsche Bank’s stock has suffered enormously. From a pre-Lehman interim high of €104 per share, it fell to €34 per share by early 2015. That’s a 68% decline, mostly driven by the global financial crisis of 2007-08 and the European sovereign debt crisis of 2011-2015.

Just when investors thought things could not get worse, they did. From the €34 per share level in 2015, Deutsche Bank stock fell again to €10.25 per share in recent days. That’s a massive decline off the lower 2015 base.

This sequence makes an important point. When a stock falls 70% or more many investors assume the profit potential from a short position is gone. In effect, investors ask, “How much lower can it go?”

The answer is that no matter how low a stock goes, it can always go lower until it hits zero. This is the financial equivalent of Zeno’s Paradox. Zeno, a fifth century Stoic Greek philosopher, imagined an arrow shot across a room. He said that an arrow would first cross half the room.

Then it would cross the remaining half. Then the remaining half, and so on in an infinite series of remaining half-rooms. Zeno said the arrow could never cross the room because of the infinite time needed to cross an infinite number of half rooms. (Newton’s calculus resolved this paradox in the 17th century).

Likewise, a stock can fall 90%, and then fall 90% again, and 90% again and so on until it hits zero. Deutsche Bank is not going to zero. But it could go to €2 per share before Germany steps in to truncate the collapse and stop the bleeding. A €2 per share end-point is down over 80% from current levels.

The question is, what could take Deutsche Bank down from here despite the huge losses the stock has suffered already? This brings us to our market signal.

At Intelligence Triggers, we use a method called causal inference to make forecasts about events arising in complex systems such as capital markets. Causal inference methodology is based on Bayes’ Theorem, an early 19th century formula first discovered by Thomas Bayes.

This is the same method we used to correctly forecast the outcome of the Brexit vote. Now we’re using it to forecast the likelihood of a Deutsche Bank stock collapse in the next few months.

What signals are we getting that indicate a collapse?

The strongest signal is not coming from Germany — it’s coming from Italy. While the world is waiting for the denouement of the Deutsche Bank drama, another bank fiasco is playing out in Italy. This involves the Banca Monte dei Paschi di Siena (BMP), the world’s oldest bank still in operation, founded in 1472.

BMP was the only top bank to fail the ECB’s recent stress tests. It is required to raise capital and has announced plans to do so. The capital raise is being led by JP Morgan and a syndicate including Goldman Sachs and some of the largest banks in China.

The syndicate was formed in July and was supposed to announce results by the end of September. We’re almost there and the news is not good. Reuters recently reported that the capital raising effort is not going well, and the syndicate expects they will delay any announcement until after important Italian elections scheduled for November.

What do the travails of BMP have to do with Deutsche Bank? Both banks are too-big-to-fail and are failing, but BMP is closer to the brink. It’s the “canary in the coal mine” for Deutsche Bank.

Italy wants to bail-out BMP with taxpayer money. That’s the standard playbook that governments used in 2008. But the rules have changed.

At the G20 Leaders’ Summit in Brisbane in 2014, it was decided that bailouts would be replaced by “bail-ins.” In a bail-in taxpayer money is not used to recapitalize the sick bank. Instead bondholders and depositors take haircuts and are involuntarily converted into equity holders.

Imagine if you had $500,000 on deposit at the bank and you got a notice in the mail that said your deposit was now $250,000 (the insured amount) and the other $250,000 had been converted into stock in a “bad bank,” which might or might not produce returns in the future. That’s what happens in a bail-in.

The German government under Angela Merkel is telling Italy that they cannot bail-out BMP; they have to use the new bail-in rules instead. But what’s sauce for the goose is sauce for the gander. If Germany forces Italy to bail-in BMP, then Italy will insist that Germany also bail-in Deutsche Bank when the time comes.

Germany won’t like that, but if they don’t bail-in Deutsche Bank, the European Union will come apart because of acrimony between Italy and Germany. Compared to this dispute, UK Brexit is a sideshow. Greece is a sideshow of a sideshow. Italy is the real deal. If Germany and Italy can’t cooperate, then there is no European Union.

This is why the BMP capital raise syndicate pushed their announcement out past November. They know that if they announced their failure today, the bail-in option would be required immediately and the government would lose the elections. If the government can get past the elections intact, the bail-in of BMP (or bail-out as the case may be) can come in December.

Markets won’t wait while German and Italian politicians tiptoe around the bail-in question. They will draw their own conclusions and start a run on Deutsche Bank. It’s already happening. That will take the stock down another 90% on top of the multiple crashes that have already occurred.

The German government will let Deutsche Bank stock fall to €2 before they intervene. That’s how existing stockholders make their “contribution” to the bail-in.

Deutsche Bank won’t fail and the stock won’t go to zero. But there’s still plenty of room to fall, and this story is far from over. The eurozone is in trouble.

Regards,

Jim Rickards
for The Daily Reckoning

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The post Deutsche Bank Nears Collapse appeared first on Daily Reckoning.

This story originally appeared in the Daily Reckoning . The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today’s markets. Its been called “the most entertaining read of the day.

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