It wasn’t quite the Lehmann Brothers moment that sent the global economy into a tailspin some eight year ago. But, in many ways, it could end up even worse than that.
Deutsche Bank’s recent share market woes echo the first cracks that began appearing in the lead up to the 2008 financial crisis. Since the start of this year, Deutsche’s shares have plunged by a staggering 40%. Moreover, these past six months have seen shares fall by an eye watering 60%.
On Tuesday morning, DB’s stock was trading at €13.82. This, by the way, is the lowest the bank has traded at — ever.
So what’s all the fuss about?
There’s a good reason why investors are dumping Deustche stocks. People are nervous. They’re nervous about Deutsche’s ability to meet bond payments. They’re concerned about the bank’s liquidity. And they’re worried that, should worse come to worse, they won’t be able to recoup any of their losses.
Believe it or not, they have good reason to think all this.
Take credit default swaps (CDSs) for instance.
These are essentially contracts in which investors, who hold Deutsche debt (through bonds) try to limit any potential loss that could result from a default. So, in other words, CDSs are an insurance against the likelihood of Deutsche going to the wall.
Now, CDSs on Deutsche are at their highest levels in four years. You might remember that, back in 2012, the Eurozone was on the verge of blowing up. At the time, there was good reason for banking CDSs to be at those levels.
Since then, the immediate threat to the stability of the Eurozone has abated somewhat. But anyone foolish enough to believe the problem went away are now seeing the truth.
The fact that CDSs are at four year highs signals that a lot of people are anxious about Deustche defaulting. That’s not to say the bank will go bust tomorrow, far from it. But as an investor it’s not something you’d be happy about seeing.
Why does any of this matter? It matters a lot, not least because this is Deutsche Bank we’re talking about. It’s the biggest bank in the largest creditor nation in Europe. And it’s due to pay €350 million of Tier 1 coupons that are maturing in April. If Deutsche can’t meet its bonds payments to ease investor concerns, falling share prices will be the least of its worries.
To give you an example of why that might be, you need look no further than Portugal. Here’s an article dug up from Bloomberg, published 31 December, 2015. It starts:
‘Earlier this morning, Portugal’s central bank appeared to take aim at a key concept in the world of debt investing by inflicting losses on some — but not other — bank bonds.’
The article goes on to explain that bonds, worth roughly $4 billion, were transferred from one ‘bad bank’ to shore up another bank. It goes on (emphasis mine):
‘But the transfer has also left many debt investors scratching their heads and others raging from the rooftops since the move appears to fly in the face of the pari passu (literally “equal footing”) notion that demands creditors be treated equally and without preference.
‘CreditSights analysts led by Simon Adamson also see the potential for legal wrangling in the future, noting that “it is possible that there will be legal challenges from holders of the five bonds, on the basis they rank parri passu with other senior bondholders, but the legal position is unclear.”’
And here’s the really interesting bit:
‘To further complicate matters, it appears the technicalities of the transfer mean that credit default swaps (CDS) tied to the affected bonds might not be triggered, preventing investors from recouping some of their losses through the insurance-like payments.’
You can now see why investors are panicking.
They have every reason to believe the same thing could happen to Deutsche as well. And who can blame them? Not only does the bank look on shaky ground, but they have no idea of knowing what will happen to their holdings in the event the bank defaults.
Of course, Deutsche won’t take any of this lying down. Yes, there are doubts about the bank’s liquidity. And yes, investors need convincing it has enough cash to make bond repayments.
But will it end in a Lehmann style meltdown? Probably not.
What will likely happen next is the regulatory body will place a ban on short selling in Deutsche shares. That’d put an end to the kind of speculation we’ve seen particularly since the start of this year. It’s an act of desperation, but they won’t have much choice. As for Deutsche, it’ll do everything in its power to repay those bonds so it can reissue them in the future.
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Deutsche problem, or global problem?
Most troubling about all this is that none of it is really a ‘Deutsche’ problem. Instead, it’s a global problem affecting the financial system right across the world.
European banking stocks are down by 20% this year already. US bank have fallen some 8% over the past month alone. Morgan Stanley is down 6.4%. Goldman Sachs is slightly better off, losing 4.8%. The big four Aussie banks, CBA, NAB, Westpac and ANZ are all down. Everyone’s losing.
There are many different reasons for this, but they all converge on one ‘big picture’ problem. And that’s the rotten state of the global economy. Everything policymakers have brought out against this malaise is failing to work. Even stimulus measures are nothing but damp squibs that get the heart racing for a month at best.
Today, European investors look past the weak euro, central banking stimulus, cheap oil, and towards slowing global growth instead. Growth across the Eurozone will remain steady at 1.7% this year. But observers expect economic data to reflect the cyclical weaknesses in the global economy. If nothing else, that’ll raise concerns that events in the world, and specifically China, are weighing on the European economy.
Part of the problem on global markets at the moment is that China is selling bucket loads of US dollars in a bid to prop up the yuan. With China’s foreign exchange reserves declining fast, it’s only adding to global liquidity shortfalls. This, in an era of record low interest rates and QE, is really quite an achievement. But that’s the broken global economic system for you.
Another problem contributing to Euro banking woes is the carnage taking place across sovereign wealth funds. As the Australian Financial Review explains:
‘Markets are also assailed by a torrent of selling as sovereign wealth funds liquidate some of the large reserves they amassed during the days of buoyant oil prices.
‘In the past week, investors have focused on the damage that will likely be inflicted on markets as sovereign wealth funds and other government-linked investors in the Middle East, Africa and Norway start selling assets to drum up money.
‘And they’ve decided that European bank stocks are most at risk, because sovereign wealth funds have an overweight position in financial stocks, and particularly the European banks.’
Those banks include the likes of Deutsche, Societe Generale and even UBS. The fact that sovereign wealth funds are liquidating reserves will likely keep the pressure on European banks for the time being.
As for the European Central Bank’s response to this? Well, they could interest rates again, which are already in negative territory. And they could expand their bond buying QE program. Recent history will show that these measures have worked in fits and spurts in Europe over the past five years. It won’t be any different this time around either.
Unfortunately, they’re run out of ‘road’ to kick the can down any further.
Junior Analyst, Markets and Money
PS: The banking sector isn’t the only one under threat of a market correction in the near future.
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That’s why Vern’s written ‘Five Fatal Stocks You Must Sell Now’. In this free report, Vern wants to help you avoid the coming wealth destruction. He’ll show you which five blue chip Aussie companies could destroy your wealth. And you almost certainly own one of them. To find out how to download the report, click here.