Deutsche is walking dead, but may not fall

When the markets question the viability of a financial institution, then that firm is toast.

The capital markets were the ultimate forum for picking winners and losers, that was until 2008, when the term “Too Big To Fail” came into vogue.

Once a firm is tagged with the TBTF label, markets no long can become efficient and take the financial institution out through bankruptcy or merger.

This is where you see Deutsche Bank today. In the past before TBTF, Deutsche would be in a liquidity squeeze as markets question the viability of the firm ( see Lehman).

However, there has to be an explicit backing by the German government in order for Deutsche to still have its doors open.

Yes we get headlines that Deutsche’s borrowing costs are going up, that other firms are poaching Deutsche’s bankers and that its derivative book has been reduced to 43 trillion euros from 75 trillion euros.

But let’s work the notional value of a 50 trillion euro book, which conservatively could be 5 trillion euro in exposure. Deutsche’s current book value would have trouble covering the $14 billion Justice Department fine for mortgage security fraud charges. So how can the bank cover a 1% move on 5 trillion euro?

If the market could clean out a troubled firm (see Citigroup), then we would not have had to go through the last eight years of economic malaise. But that’s not to be, as governments and central banks — not the markets — pick winners and losers.

So if the Merkel government has given the markets a thumbs up in backing up Deutsche, which is the only explanation, then we can welcome back the zombie banks in Europe.

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Almost Armaggeddon revisited 8 years later

Eight years ago today Lehman Bros. filed for bankruptcy.

Everything that happen to the US economy since then can be attributed to that filing and its ramifications.

After Lehman failed, that was the last financial firm allowed to fail under capitalism. All other weak financial firms were forced into shot-gun marriages with larger firms in order to keep the ATMs working.

Too big to fail came into vogue in a move away from capitalism towards socialism and propping up crippled Wall Street banks so as to avoid another Lehman.

Four days after Lehman Bros., I was one of the first journalist to write on Washington’s massive intervention into the markets, which began the socialistic banking sector.

The article carried the headline: Almost Armageddon, with the lead saying:

“The market was 500 trades away from Armageddon on Thursday, traders inside two large custodial banks tell The Post.”

What would follow was to bring all the Wall Street CEOs together over that weekend and the next weekend at the New York Fed’s office down on Liberty St. in lower Manhattan to merge stronger banks like JPMorgan and Bank of America with weaker firms like Wachovia and Merrill Lynch.

In order for these shot-gun marriages to be consummated the stronger CEOs like Jamie Dimon extracted a pound of flesh from Treasury and the Federal Reserve with guarantees that Uncle Sam would prop up the banking system with cash to help the Lehman wounds to heal.

Unfortunately those wounds have not healed sufficiently in the last eight years and we still have ailing institutions being propped up by Federal Reserve actions even after all of the QE programs.

Capitalism only works if you are allowed to fail, Unfortunately on Wall Street that does not apply, still.

What's going on in the derivative market?

I want to give up a primer on derivatives. These are esoteric contracts generally linking two or more securities in a “If … then” scenario.

Theses instruments have a notional value in the 100s of trillions of dollars — with no one knowing the true market cap of the entire market.

Some will say its a zero-sum game but that’s only the case if all contracts execute at the same time. That’s not how it works. A subset of derivatives craters as a Lehman Bros. implodes and then squeezes liquidity out of the market causing crashes in stocks and bonds.

So with that said, we have two very different news events tied directly to the derivative market.

The first deals with Deutsche Bank. The German bank has a huge exposure to the derivative market, with some putting its book at $60T alone.

Well Deutsche Bank is now offering in Europe a 90-day CD with an interest rate of 5%. In a zero-interest rate environment, 5% return to bring cash into the bank, has to send up a flare that something is wrong with DB.

This is not the first canary in the coalmine for DB. The stock is down 45% over the last year and 30% just this year.

The bank is struggling to get liquidity into its coffers through this offer, but the rate tells you how desperate the bank is and also what a credit risk it may be for its new savers.

The second news event is the Federal Reserve earlier this month issued a new decree for derivative contracts.

New contracts written will have a 48-hour cooling off period before a derivative contract can be called in and collected on. The measure is to take effect next year, but the language for the contract is already in place.

The idea is to give the central banks time to bail out a troubled bulge-bracket bank or important company before liquidity is yanked in a fire sale due to insolvency.

This again is a perversion of capitalism as it takes bankruptcy out of the equation and re-enforces the “Too Big To Fail” conspiracy.

I’m not sure what will be the first match that ignites the┬áderivative market, but from DB’s actions it appears it might be a failed stress test, due to lack of capital at the German bank.

So when you hear a problem in the derivative market, don’t say it doesn’t affect me. Because it most certainly will.