Deutsche Bank 2016 is far from Lehman Brothers 2008

Problems at Deutsche Bank (DB) came to a head this week.

The German bank has been in a downward spiral for the last two years, losing 75% of its equity value amid lackluster global economic growth, record-low interest rates and plummeting investment banking revenues. Making matters significantly more urgent, earlier this month the U.S. Department of Justice (DoJ) announced plans to seek a $14 billion fine from the firm related to mortgage securities sold leading up to the financial crisis. DoJ fines stemming from 2008 are nothing new, but unlike many similar settlements, the proposed amount for Deutsche Bank in this case is no drop in the bucket – the company’s market capitalization at the time of the announcement was only around $19 billion. Given it was already facing capital concerns – its Tier 1 Capital ratio of 10.80 and leverage ratio 3.40 are the lowest among global systemically important banks (GSIBs) and the cost of insuring its debt has skyrocketed – DB got caught this week in an echo chamber of doom reminiscent, at least on the surface, of 2008.

Deutsche Bank is likely to settle with the DoJ for far less than the initially quoted $14 billion figure, but given the bank’s fragile condition the report was enough to trigger alarm bells. DB shares were sent tumbling Friday morning by a Wall Street Journal report, citing anonymous sources, that 10 of its hedge fund clients had withdrawn “billions of dollars” worth of securities or cash and dialed back their trading activities with the firm. CEO John Cryan moved quickly to reassure staffers the bank’s ill health was being greatly exaggerated, but by then the damage had been done. 

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The fundamental differences between Deutsche Bank in 2016 and Lehman Brothers in 2008, however, are immense. Not only do 10 investors and “billions of dollars” represent a small fraction of Deutsche Bank’s 800 client, $600 billion prime-brokerage unit, but because of their volatility, prime brokerage assets aren’t considered to be a funding source for banks in the first place. The WSJ report was, in essence, much ado about nothing.

Deutsche Bank has access to as much liquidity as it needs via the European Central Bank (ECB), and has a stronger buffer than U.S. banks did in 2008 because of post-crisis regulation. It could also raise capital if needed by converting CoCo bonds, cutting costs more rapidly and unloading assets, as it did Wednesday with the long-awaited sale of its U.K. insurance business for $1.2 billion.

But in banking often there is nothing to fear but fear itself, and with DB in free-fall Friday morning “anonymous sources” popped up once again to turn the tide of sentiment. At around 11 AM ET French news service AFP tweeted “confirmation” of rumors Deutsche Bank was near a $5.4 billion settlement with the DoJ over the mortgage bond issue. The tweet triggered a remarkable turnaround in DB stock, which closed the day up 14% after having previously been down more than 8%. However, neither AFP nor any other source provided follow-up on the report, leading to accusations the news was planted from an official looking to restore confidence. The plot took another twist Saturday when Deutsche Bank and five former executives were charged in an Italian court for colluding with Monte dei Paschi di Siena to falsify the Italian lender’s accounts in 2008.

While Deutsche Bank may have the tools to cope with short-term liquidity demands, the bigger question is whether the firm can find more stable long-term footing in the current economic environment. The company has been aggressively cutting costs, freezing capital return programs and dumping risky assets, but many believe it will not be able to pivot its business fast enough to avoid eventually receiving state aid. Given in July the International Monetary Fund (IMF) warned Deutsche Bank appears to be "the most important net contributor to systemic risks” among GSIBs, it’s unfathomable that if conditions worsened the German government would not step in. The problem for Angela Merkel is her administration has taken such a hard line against state aid in other European nations that not only would the hypocrisy of a Deutsche Bank bailout likely torpedo her own political career at home, but could lead to revolt among other EU governments who have long sought greater leeway in recapitalizing their depleted banking systems. 

Right now all parties in Germany are trying to avoid even uttering the words “state aid,” but there is case to be made they should just go ahead and get it over with. Not only would rewriting EU bailout rules give DB the necessary runway to complete its massive restructuring, it would provide a much needed boost to Italian banks, among others. Recapitalization plans at Monte dei Paschi di Siena have hit a snag, and if forced to bail-in the country’s ailing financial institutions (which would mean wiping out junior bondholders, many of which are middle-class Italian households) Prime Minister Matteo Renzi would be at high risk of losing December’s constitutional referendum. If the new measures fail, he has pledged to resign, paving the way for the Eurosceptic Five-Star Movement to further grab power within Italian politics. Inflexibility in regard to banking rules could be the fraying thread that leads to an eventual unraveling of the entire EU experiment.

ECB CHAIRMAN DRAGHI STANDS UP TO CRITICAL GERMAN LAWMAKERS

In further evidence of growing discord among European finance officials, ECB Chairman Mario Draghi was forced Wednesday to appear in front of the German parliament to explain his policies and answer questions from lawmakers critical of central bank overreach. German officials talked tough leading up to the confrontation, promising to “put a range of critical questions to him” about “what monetary policy has achieved, apart from an expansion of joint liability in the euro zone.” In particular, it was seen as a forum for complaints about the damage negative interest rates have done to German banks (see: Deutsche Bank).

While he may have walked into an ambush, Draghi didn’t back down. Long critical of the German government over its insistence on running a budget surplus rather than using fiscal policy to stimulate demand within the Eurozone, Draghi used the two-hour closed-door session to double down on that message. He said the financial industry writ large must stop blaming central banks for their problems and focus on fixing internal risk failings. 

OPEC AGREES TO CUT PRODUCTION AS SAUDIS SURRENDER TO U.S. SHALE

Oil was the other major factor driving global markets this week.

Crude prices surged in the days leading up to the OPEC Summit in Algiers despite few indications an output agreement was forthcoming. Both the Saudis and Iranians downplayed the likelihood of a compromise, while only two of 23 analysts surveyed by Bloomberg predicted a deal would be reached. However, oil prices extended prior gains when OPEC surprisingly agreed to curb production for the first time in eight years.

When the oil market ran into a supply glut in 2014, Saudi Arabia declined to push OPEC for a production cut, instead choosing to open the spigot in hopes of killing the American shale revolution. However, two years into that experiment U.S. shale firms have proven remarkably resilient. Despite more than 100 North American energy bankruptcies this year, companies have continued pumping and becoming more efficient through Chapter 11 proceedings. Oil production has fallen by only 535,000 a day from a year ago (when it averaged around 9.4 million), while Goldman Sachs predicts North American producers will ramp up production by as much as 700,000 barrels by the end of next year, more than making up for the prior downturn.

In addition, with output from older oil fields declining by an average of 5% a year and global demand continuing to rise 1.2% a year (The International Energy Agency (IEA) estimates demand will break through the 100 million barrel-a-day mark by 2020), the fundamentals support higher prices. Skeptics of the recent oil rally like to point to the sharp downturn in the late ‘80s as an example of how the market could eventually shake out, but it’s not a good comparison - in 1986 the world’s oil supply capacity was 20% higher than demand, while today the market is oversupplied by only about 1%.

Ironically, Saudi Arabia has been the greatest victim of low oil prices.

Amid massive budget shortfalls, the kingdom on Monday announced plans to cut state employee allowances, cancel bonus payments, reduce minister salaries by 20% and cut pay to members of the Shura Council, which advises the monarchy, by 15%. Saudi stocks fell nearly 4% Tuesday, their biggest drop since January, in response to the austerity measures. Saudi Arabia’s leading index has been one of the worst-performing equity markets so far this year, down 17%.

As well-known energy expert Robert Mabro, who died last month, used to say: OPEC should change its logo to a tea bag "because it only works when in hot water."

QUOTE OF THE WEEK

"If a bank represents a systemic threat to the euro zone, it can’t be because of low interest rates. It has to do with other reasons."

- ECB Chairman Mario Draghi, defending the central bank's current policies in the press conference following a contentious two-hour closed-door meeting with German lawmakers

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