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Nomi Prins - Deutsche Bank

The Daily Reckoning Presents: “Too big to fail” could get even bigger...

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Deutsche Bank and the Derivatives Bomb

By Nomi Prins

In the wake of the 2008 financial crisis, the bank bailouts did not save the economy as their architects advertised. Rather, they bolstered the biggest U.S. banks from an insolvency crisis of their own creation. Those banks were, and remain, too big to fail. Their CEOs are too connected to jail.

But as in Fight Club, the first rule of big bank survival is not to talk about it publicly. All federal and central bank support are downplayed. The byproduct of more than 10 years of zero to still historically low interest rates has benefitted banks, but it’s not meant to be talked about. Meanwhile banks get to overvalue any securities on their books (because when rates are low, prices on bonds are higher).

This is an implicit aid to these government-subsidized financial institutions. Bank chiefs like Deutsche Bank’s might publicly disparage the European Central Bank (ECB) for its QE policy, but the bank has been a beneficiary of it.

In 2008, banks like Bear Stearns and Lehman Brothers were allowed to die. (I can tell you from working at these two, they had nowhere near the political and power connections that the surviving banks did). Meanwhile, politicians and central bankers enabled the Big Six banks to thrive (J.P. Morgan, Citi, Bank of America, Goldman Sachs, Morgan Stanley, Wells Fargo).

In 2008, Deutsche Bank was entangled in the same mess as the big U.S. banks who had bought insurance for their toxic assets from insurance giant AIG.

As it faced collapse, DB received $12 billion from the bailout given to AIG. It was a recipient of the same kind of help that Goldman Sachs, Merrill Lynch, and Morgan Stanley received.

The simple reason is that all of their positions were co-dependent financial dominos. If one went down, they’d all go down. Between 2007–10, DB ranked 9th in total emergency loans received from the Fed.

Today, DB’s total derivatives figure is around $49 trillion. This is down from $55 trillion in 2013, but something like 12 times the size of the German economy. Rather than chopping derivative positions — which are entangled with other global mega banks — DB could cut thousands of jobs to compensate for the shortfall.

The argument big banks make about their mega derivatives positions is that they are “hedged.” In other words, though the total (or “notional”) figure is large, most of the long and short positions net out against each other.

The problem with that assessment is that the big banks take long and short positions against each other. They have set themselves up again in domino fashion. If there’s too much stress on one side, as we saw in the financial crisis of 2008, then liquidity dries up and crisis occurs.

That’s when central banks and governments step in to contain — rather than fix — the core of the mess.

Today, the big six banks control about 93% of all derivatives.

Incidentally, I happen to know a little about derivatives. When I was at Goldman, I was actually responsible for the analytics underlying credit derivatives.

Getting back to Deutsche Bank specifically, it has failed “stress tests” from the Federal Reserve. It has not done much between them to improve its capital shortfall. ECB President Mario Draghi allowed DB to cheat on its own stress tests.

As he said in the past, “If a bank represents a systemic threat for the euro zone, this cannot be because of low interest rates — it has to do with other reasons.” But that’s simply not true. Low or negative rates provide banks access to cheap capital if they need it, which encourages greater recklessness than if they had to “pay” more for it.

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The bottom line is that leaders of the major banks oversaw multi-trillion dollar enterprises that committed fraud, lost other people’s money, harassed public service members, and fired thousands of low-level employees. Worst of all, they have put the entire financial system and markets at the edge of ruin again.

Today, the mentality remains the same. Big banks know they will have political and Federal Reserve support. They have taken this as a license to gamble large.

By rescuing and supporting the big banks’ dangerous behavior, such recklessness has been not only condoned but encouraged. Every instance that a central bank (or government using taxpayer money) has to bail out, bail in, or act in an emergency capacity has put us at greater risk.

The Fed and ECB policies of lavishing cheap money on the banking system through bond purchases have floated the biggest financial players. Deutsche Bank is an example in point. It is a Global Systemically Important Bank (G-SIB). Deutsche Bank is Germany’s largest bank and one of the largest banks in Europe.

It’s also been in trouble in recent years. Hedge and investment funds have been dumping Deutsche Bank precipitously due to many ailments, including lack of transparency, onerous derivatives positions and its entanglement with the U.S. Department of Justice over mortgage-related frauds.

The latest trouble arose when the U.S. Congressional subpoenaed the bank’s records of President Trump. On Wednesday DB admitted it used faulty software to screen for money laundering.

And its stock plummeted this Monday when UBS downgraded its stock to a “sell.”

Today it’s trading at around $7.20, which is pretty remarkable when you consider that it traded for $145 back in May 2007. That’s how far it’s fallen.

While there’s no way that DB would be allowed to fail, the stock could still get battered further from where it is now. In my view, the only way DB will be able to raise enough capital to regain solvency will be if the ECB and German government oversee a “bail in” that dilutes the claims of today’s DB shareholders into oblivion.

A bail-in is different than a bailout. A bailout is when the government uses taxpayer money to save a financial institution.

A bail-in uses money from the bank’s depositors, bondholders, or equity holders to repair the balance sheet.

We are heading for another financial crisis at some point. No one can say when for certain, but probably sooner than later.

The major central banks of the world are subsidizing the private banking system and financial markets with cheap credit. 11 years after the financial crisis, there’s a lot more money supporting the system artificially that the central banks have conjured than we had going into the last crisis.

If that subsidy was to go away or be reduced, the money would come draining out of the same financial system that it’s been inflating. That’s the definition of a crisis. We’re in a dangerous time because we’ve never had this much money provided by the central banks lifting up the financial system. We’re in unknown territory.

Meanwhile, the derivatives market is much larger than it was in 2008. And Deutsche Bank in some ways sits at the center of that deeply interconnected network.

If it ever blows up, it could make 2008 look like child’s play.

Regards,

Nomi Prins for The Daily Reckoning

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