http://themacrotourist.com/images/DBSep2716.png

Badly in need of a lift, Merriwether called an old friend, Vinny Mattone, who had been the fund’s first contact at Bear Stearns. Mattone, who had retired, was everything that J.M.’s elegant professors were not. He wore a gold chain and a pinkie ring, and he showed up at Long-Term in a black silk shirt, open at the chest. He looked as if he weighed three hundred pounds. Unlike J.M.’s strangely wooden partners, Mattone saw markets as exquisitely human institutions - inherently volatile, ever-fallible.
“Where are you?” Mattone asked bluntly.
“We’re down by half,” Merriwether said.
“You’re finished,” Mattone replied, as if this conclusion needed no explanation.
For the first time, Merriwether sounded worried. “What are you talking about? We still have two billion. We have half - we have Soros.”
Mattone smiled sadly. “When you’re down by half, people figure you can go down all the way. They’re going to push the market against you. They’re not going to roll your trades. You’re finished.

  • from When Genius Failed - Roger Lowestein 2000

The Deutsche Bank bleed continues this morning. Worries about Europe’s largest bank are filling financial news headlines. Deutsche Bank CDS swaps are grinding higher, while its stock price hits a new fresh 25 year low.

Merkel and her band of hard money zealots’ convictions are about to be tested. It will be interesting to see how long they can hold out as their country’s largest bank faces a crisis of confidence.

But what’s going on? Why now?

Although Deutsche Bank’s rejection of the settlement with the US Department of Justice is cited as the catalyst, that’s not really the underlying cause of the angst. If Deutsche Bank was in good shape, the market would look through this recent development as merely a negotiating tactic. Heck, in the right environment, they might even lift DB’s stock price in the hope they would be able to settle for less.

Instead the market is taking a shoot first ask questions later approach.

The question I am pondering is whether Deutsche Bank is the cause of the problems, or merely a symptom.

There is no doubt some of Deutsche Bank’s pain is self inflicted. A few years ago they chose to aggressively expand their balance sheet, and that decision is coming back to bite them in the ass. Check out this terrific article from Alhambra Investment Partners’ Jeffrey Snider from last year:

The bank has been under considerable pressure for years, as suddenly after the taper summer of 2013 the bank, like its eurodollar peers, lost its prior profitability boost. That was a huge problem because the bank had been inordinately dependent upon internal profitability to restore some semblance of leverage discipline. Instead, everything turned upside down whereby leverage remained high only without anything close to sufficient returns to justify it. Again, this was a similar situation to other eurodollar banks but to an added degree (think Deutsche’s enormous derivatives book, dark leverage, in its CB&S division).
What Deutsche did to restore balance in the wake of 2013’s changed QE profit circumstances was almost unique (Credit Suisse would try something similar). The bank loaded additional capital early last year, under circumstances that remain somewhat unclear, and then plowed ahead into as much risk as it could possibly source. In its press publications displaying those forward intentions in May 2014, the bank (this is somewhat unbelievable in hindsight, far more so than it was then) openly discussed how it expected to drive returns while maintaining leverage from new ventures into US junk and leveraged loans as well as emerging market debt. Given that the price inflection seems to have occurred as the “dollar” turned only a month or so later, Deutsche seems to have placed all its chips right at the top.

Only those banks TBTF can play here. As DB makes plain, there are only “5-6 FIC players left” and there exist exceptional barriers to entry ensuring smaller banks stay smaller. This oligarchical structure is perfect for DB in “attractive products”, such as high yield and leveraged lending (both can fairly be termed the modern incarnation of junk). To sum up the weekend [May 19, 2014]: DB acknowledges last year’s taper selloff permanently altered its business and capital plans. The bank will shift its focus for primary profits to US junk because that is where the bubble is currently taking place, a frenzy fit for only those TBTF.

Now, in later 2015, you can appreciate the scale of the problem Deutsche’s new CEO finds the bank firmly entrenched within. The leverage still remains (last year’s “capital” issues were supposed to help alleviate that, as well as kickstart the returns in the junk bubble) and now profitability is again hammered by ill-mannered (desperate and, frankly, ridiculous) past decisions.

Although the Germans were quick to blame the US banks for the credit crisis of 2008, it appears the shoe is on the other foot as Deutsche Bank’s recent reckless behaviour is a contributing factor to the current crisis of confidence.

Yet merely dropping all the blame in Deutsche Bank’s lap is probably too easy.

The tide has headed out, and we have just realized the Germans were skinny dipping. But what if the real problem has more to do with the tide than Deutsche Bank’s positions? I know this is not a popular view, as it is much easier to blame the Germans for getting themselves in this mess, but there are loads of signs the plumbing in the financial system is all plugged up. Maybe Deutsche Bank merely holds the weakest hand and if wasn’t them, it would be the next bank.

Over the past year the TED spread has headed steadily higher. Many market pundits have blamed this widening between Treasury Bill rates and Eurodollar rates (the rate at which banks lend US dollars to each other overseas) as a side effect of recent money market legislation reform. They argue that banks are not increasingly worried about lending to one another (as was the case during the 2008 crisis), but that investors are being forced to swap into true riskless treasury bills.

http://themacrotourist.com/images/TEDSep2716.png

All I can respond is who cares about the reason? The net result is that banks (and all the other fixed income securities issuers tied to that rate) have to pay more to borrow. In high school when a pretty girl said no to me when I asked her to dance, it didn’t help that she had a good reason to explain her refusal. The end result was the same.

What we should be asking ourselves is why aren’t there more US dollars available to borrow? And this is where it gets complicated. I can barely keep all the different causes and effects straight in my head, but the important thing to realize is that, as strange as it sounds, the global financial system is starved for US dollars.

During the years that followed the 2008 credit crisis the Federal Reserve expanded its balance sheet at a fierce rate.

http://themacrotourist.com/images/FarbastSep2716.png

The global financial system needed that US dollar liquidity. The Federal Reserve is not the only way US dollars are created, but given the state of the banking system, and the fact the private sector was in the process of destroying credit, the Fed was the only game in town.

Over the past two years the Federal Reserve has tapered their balance sheet expansion, and has attempted to start the process of normalizing rates. Yet this withdrawal of liquidity is having disturbing side effects.

First is the price of the US dollar. As the liquidity creation was stopped, the US dollar supply shrank, and the price of US dollars sky rocketed.

http://themacrotourist.com/images/DXYSep2716.png

This had the knock on side effect of making all the US dollar borrowing by other countries and corporations more expensive. This created a self reinforcing deflationary loop whereas debt destruction caused asset prices to sink, which encouraged more deleveraging, which meant more selling, which only caused the US dollar to appreciate further.

But you are probably asking yourself why hasn’t this happened in previous economic cycles? Surely the US has raised rates before, why can’t they do it this time?

The problem is the US dollar is the world’s reserve currency, and there needs to be a certain constant growth to facilitate a nominal increase in GDP. During the period from 2000-2007 global banks created credit at a blockbuster pace.

Yet in the fallout from that bust, regulators have clamped down on banks’ activities. Whether it is increasing capital requirements (new Basel changes), lengthy new regulations (Dodd Frank), or just plain moral pressure, banks have greatly curtailed their old role in creating US dollars.

This lack of private bank balance sheet expansion can be seen in the bizarre anomaly of negative swap spreads. Once viewed as impossible, negative swap spreads have become common place.

This next chart is a slight modification I made to an Alhambra Investment Partners’ graph.

http://themacrotourist.com/images/SwapSep2716.png

Deutsche Bank seems uncomfortably correlated to US swap spreads. Maybe this is a spurious relationship. I might be cherry picking data that has no real correlation.

Or maybe all the anomalies we are seeing in the fixed income markets are either causing, or are caused by the problems at Deutsche Bank. As most things in life, the answer probably lies somewhere in the middle. No doubt DB’s problems are having an effect on markets, but I wonder if the lack of US dollar credit creation is root cause of all their problems.

Unfortunately there are no real signs of anything changing for the foreseeable future. And although there are lots of shorts in Deutsche Bank that will create some vicious short covering rallies, the most likely path is down. Just ask Merriwether.

Thanks for reading,
Kevin Muir
the MacroTourist