Global Financial Crisis Act II – Deutsche Bank

Series: Global Financial Crisis Act II

With Brexit serving as the catalyst, Season 2 of the European banking crisis may be about to unfold.

The commercial break at the close of the opening act of the global financial crisis in 2008 is finished. Here comes Act 2 with the globe’s most risky bank as featured guest.

Part 2 of the series describes the sequence of a typical bank failure and explores the list of options available to Deutsche Bank and the likely outcomes.


Clichés like “no respect” or “when it rains, it pours” do not begin to describe the predicament of the latest of a series of fallen bank giants.

The recent US Department of Justice’s $14 billion claim against Deutsche Bank, German’s largest and one of the world’s top investment banks, for its criminally deceptive behavior in pushing toxic mortgage back securities leading up to the 2008 financial crisis is already wreaking havoc on the share prices of the banking sector in general and causing DB’s stock price to swan dive.

Just-in news: several current and former managers of Deutsche Bank have been charged in Milan for colluding to falsify the accounts of Italy’s third largest bank Monte Paschi, another major bank currently being resuscitated in the ICU, in an attempt to hide losses and manipulate the market. (link)

If you are part of the “So what? I don’t bank with Deutsche.” crowd or one of those who was broadsided by the 2008 financial crisis and are eager not to have same repeated to your financial well-being, you should pay close attention to this latest episode of the slow motion train wreck otherwise known as the global banking crisis.

One reason sufficient alone is that Act 2 of the banking crisis, when it washes ashore, will be much bigger than the first one.

Another sign that Act 2 is well past its opening scenes and is on its way to its climax is that the tempo of unfolding events has noticeably been picking up in the past few months. Things are coming to a head and painful and drastic decisions are getting increasingly difficult to be avoided or delayed.

How We Got Here

For those who just tuned in or want a better historical backdrop, here’s a quick refresher of Act 1 of the global financial crisis.

Subprime mortgage crisis, circa 2008. The subprime housing mortgage which went sour in the US in 2007 resulted in a large number of financial actors, most notably banks and hedge funds, to fail due to the bad loans. The loan failures morphed into a much larger problem due to the use of derivatives by these players (see primer on derivatives). The prolific use and daisy chaining of opaque derivatives ensured that a single failure resulted in cascading failures for actors which are inextricably interconnected. The cascading failure crystallized into a major banking crisis when Lehman Brothers defaulted. Blackmailed by the major banks, the US government bailed out the major depository banks – as well as non-banks such as Goldman Sachs whose alumni member was none other than Hank Paulson who happened to be the serving Treasury Secretary. After the initial public outrage at the $800 billion bail-out price tag subsided, trillions more were secretly funneled to the bailed-out banks by the Fed in subsequent years. The dirt was swept under the carpet.

European sovereign debt crisis, circa 2010. Further bloated by the additional public debt created to bail out their banks, the erosion of investor confidence in the public debts of some lesser EU member nations, notably Portugal, Ireland, Italy, Greece and Spain (the PIIGS nations) culminated in a sovereign debt crisis which saw their bond interest rates go through the roof. The fix? The ECB printed hundreds of billions of Euros out of thin air to paper over the problem. Again, sweep it under the rug and hope it will go away.

Greek sovereign debt crisis, circa 2011. The European debt crisis re-emerged again as Greece was unable to roll over its debt. Fearing a Greek default would inflict fatal wounds to their own national banks which own a significant amount of Greek sovereign debts (a common practice among EU banks), creditor countries such as Germany and France arranged a bailout of the Greek government. The vast majority (upwards of 90%, link) of the bailout money ended up leaving Greece to pay off the foreign banks – a stealth way for other EU countries to bailout their own banks using (public) EU money and pile that debt onto the Greek citizens.

In the course of the subsequent years, the Greek debt crisis flared up giving rise to the Syriza Party taking over the government, promising to demand debt relief from the creditors. Refusing to discuss debt haircuts, the ECB threatened to cut off liquidity to Greek banks and succeeded in ‘setting an example’ on how debtor countries need to behave.

Cypriot bank bail-in, circa 2012. Overburdened by overextended bank loans going bad, the Greek government debt crisis and the downgrading of the country’s sovereign debt rating, a banking crisis erupted in Cyprus resulting in a bailout from the ECB and IMF. Accompanying the closure of the country’s second largest bank, a portion of the unsecured deposits there plus a portion of Cyprus’ largest bank were confiscated, or bailed-in, as part of the rescue conditions. (See Bail-in At Your Local Bank series)

The EU hailed the bail-in mechanism as a new beginning which should serve as a template to deal with future banking crises in the EU (link) . In other words, no more you the taxpayer bail out failing banks; instead, you the bank depositor will be bailed in to save failing banks.

Underground smothering fires, circa 2013 – 2015. In between acts of major banking crises, there have been numerous minor acts of sub-terrain mini crises, the majority of which escaped by accident – or not – the attention of the mainstream media. Among them were the problems with banks in Portugal, Spain, and Austria. (links here and here)

Disastrous policy, unintended consequences, circa 2008 – 2015. One fundamental underlying problem with the EU banking system is the amount of questionable sovereign debts and non-performing commercial loans (NPLs) in their books. Not only are they not turning healthy again, the years of economic stagnation resulted in the NPLs continuing to balloon.

Throughout the major crises which broke out and all subsequent smaller fires which flared up on regular occasions, the standard practice of the ECB was to paper over them with money printed out of thin air. The ECB forced interest rates to zero and even negative in its misguided hope to encourage borrowing. Ironically, not only did this perverse monetary policy not encourage people to borrow more or the banks to lend more, the collapsing yields take away one of the key revenue sources of the commercial banks, pushing them further into financial dire straits. Talk about unintended consequences.

Italian banking crisis, circa 2012 – 2015. The Italian banking crisis is as predictable as night following day and its underlying causes and failure trajectory are not different from the other lesser banking crisis mentioned above. The key difference, though, is that Italy is the third largest economy in the EU and the failing banking sector is too big for the EU to sweep under the carpet or squash with its thumbs like it did on Greece and Cyprus. (See European Banking Crisis Season 2 Is At Hand)

EU bail-in regime, circa 2016. A new bail-in regime went into effect on Jan 1, 2016 throughout the EU. The purpose of the new rule is to prevent EU member countries from using taxpayers’ money to bail out failing banks. Instead, creditors of the failing banks will first share the burden of rescuing the banks – in order words, creditors are being bailed-in. Creditors would be bailed in according to their seniority. Among such creditors, notably, include retail depositors who happen to be the least senior unsecure creditors of the banks.

Monte Paschi, circa 2016. The latest in a series of bank failures falls on Monte Paschi, the country’s oldest and third largest bank. After several failed attempts to ring-fence the bad debt and re-capitalize the ailing going concern and the latest attempt (circa Aug 2016) to arrange a private bail-out from its banking peers which is looking increasingly shaky (link), there is rising expectation that Italy will be calling for a public bailout of Monte Paschi.

Determined to enforce the newly enacted bail-in regime, Germany, the biggest creditor in the EU, is adamant that a bail-in should be applied over any bail-out. She insists that creditors such as bondholders (and depositors) should be bailed in and then, and only then, taxpayers’ funds get used. However, for Italy, many bondholders also happen to be retail investors and savers. Facing an October referendum on constitutional reform, over the defeat of which the Renzi government offers to resign, in the process potentially ushering in a first anti-EU party which openly calls for an exit from the Eurozone, the least the Renzi government can afford to do is to bail-in its citizens (bondholders or depositors), not to mention the mere hint of a bail-in could trigger a bank-run on Monte and possibly the entire Italian banking sector.

The disagreements between Italy on one side and the ECB and particularly Germany on the other have gradually devolved from behind-closed-doors diplomatic private debates to public shouting matches, and the sugar coating from both sides is wearing thin.

To wit, responding to the Bundesbank’s lecture on the importance of sticking to the bail-in regime, the pissed Renzi fired back, saying that the Bundesbank needed to solve the problem of German banks which had “hundreds and hundreds and hundreds of billions of Euros of derivatives” on their books. (link)

The bank which Renzi was referring to, of course, is Deutsche Bank.

Which brings us to the present topic at hand. Sorry for the long winding road to get here.

Deutsche Bank – Why It’s a Big Deal?

On the surface, the common problems faced by Germany’s largest bank are no different from those faced by other European and international banks.

In terms of bad loans, the bank has its share of NPLs just like other banks, thanks to the 2008 financial crisis and ensuing economic depression in Europe and elsewhere. A large pile of the bad debt is known and some of that gets transferred to the ECB via various quantitative easing programs and other money printing mechanisms. Others are buried and hidden under creative accounting.

In terms of criminal behavior, the bank is no worse than other mega banks which have been repeatedly caught money laundering, peddling toxic mortgage debts to unsuspecting retail investors, manipulating the LIBOR market, fixing the currency market and manipulating the bullion market. Just like other banks, no executives have been prosecuted, let alone jailed to date for said crimes. Again, it is just another too-big-to-jail criminal enterprise.

What makes Deutsche Bank stand out from other too-big-to-fail peers is, of course, its derivatives books.

With a notional amount between $75 and $42 trillion (yes, trillion with a T; that’s a thousand billion), depending on who you ask, the size of its derivatives book is 20 times Germany’s GDP and 5 times bigger than the entire output of the Euro zone. Its sheer size edges out other behemoth too-big-to-fail banks such as JP Morgan and Citibank and earns the bank the dubious distinction of what the IMF calls ‘the most important net contributor to systemic risks’.

DB interconnectCounterparties of Deutsche Bank (source IMF)

What makes these derivatives singularly scariest is the interconnectedness among the counterparties. As the above chart courtesy of the IMF shows, the linkages among these banks through derivatives and other non-exchange-based, over-the-counter arrangements reach wide and deep. Nobody, including Deutsche itself, knows for sure how long the daisy chain is linked and who is counterparty to whom along each link. Should this time bomb go off, the cascading failures will certainly take down the financial market in a flash.

As mentioned above, when Renzi snarled at the Bundesbank, telling it “to solve the problem of German banks which had hundreds and hundreds and hundreds of billions of Euros of derivatives on their books”, Renzi ‘went there’ and uttered the dreaded word Voldemort, so to speak, without name-dropping the bank, and merely pointed to the biggest elephant in the room – one big elephant which is so giant and discussion of which presence has been carefully avoided by extend-and-pretenders, the mainstream media, the banking industry and its regulators, as any mention of such dreaded word would simply destroy the narrative that the root cause of the financial crisis has been solved.

Unfolding Events

The slow motion collapse of Deutsche since the last financial crisis has seen 90 percent of its share prices erased since its height before 2008. Here’s an abbreviated timeline.

  • January 2015 – Amid regulatory and criminal investigations, the board sent two of its CEO’s packing. (link)
  • October 2015 – The bank announced major assets write-down resulting in a Q3 loss of 5 billion Euros. (link)
  • October 2015 – in full-blown survival mode, Deutsche eliminated stock dividend and fired 25 percent of its workforce, some 23,000 workers. (link)
  • July 2016 – the shock wave from the Brexit vote sent the European banking sectors reeling. Having lost close to 50 percent of its share value in the past 12 months alone, Deutsche share price now hovered around €11. A single-digit share price for a bank historically signals a precursor to a bank-run of said bank. (see European Banking Crisis Season 2 Is At Hand)

Which brings us to just about this past week.

Unfortunately for the bank, the events are now coming fast and furious and there are now clear indications that both the bank and the regulators are losing control of the situation. Denials start to fly and the blame game goes public.

Here are some of the rapidly unfolding events as we speak:

  • The US DoJ demanded $14 billion for its toxic mortgages criminal transgression. Merkel said Germany government will not interfere. (link)
  • Merkel said no bailout for Deutsche. (link)
  • Deutsche share price dropped below single digit first time ever. (link)
  • Deutsche CEO said share price collapse a result of ‘perception issue’. LOL (link)
  • Hedge funds and other investment funds started pulling cash and moved part of their derivatives holdings to other banks. (link)

In Part 2 of the series, we will describe the causes and sequence of a bank collapse. We will also explore the set of action choices laid in front of the authorities and the likely scenarios soon to unfold in this Deutsche saga.

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