The problems of Deutsche Bank (DE:DBKGn), and other European banks, are not new. At this stage, these problems are not about to precipitate a “Lehman moment” -- a panic like the one which ultimately gave us the central bank QE programs and bailouts of 2009. For now, these are problems only for Europe – problems which will put downward pressure on economic growth in the EU. Even more significant than this brake on growth, though, is the damage that a weak European banking system will cause to the bloc’s political integrity.
European banks, as mentioned in these pages before, are not financially prepared for contraction of leverage and economic growth.
In Europe, the problem lies neither with real estate speculation, nor with a stock market or commodity bubble. The European problem is that European banks have been encouraged by their governments to buy the bonds of Europe’s weak peripheral economies in order to support them – for example, Greece and Portugal. Many banks have some very dodgy paper on their balance sheets, and much of this paper is opaque – part of it may not pay off. Investors are taking a very conservative approach; Deutsche Bank’s stock was pummeled in large part because very little was known about the third-tier loans on the balance sheet. Cautious investors assumed they were all bad. The trigger was the U.S. $14 billion fine levied by U.S. officials.
In short, lack of capital or some other serious structural issue was not the problem during the recent decline. This was a transient and minor panic, not one of the big panics that have occasionally engulfed banking systems as long as they have existed. Nevertheless, we may have a bona fide panic of the larger kind in the European banking system in the next year or two. Why?
Reasons for the looming panic:
1. Modern financial structures are complex. Counter-party risks are hard to analyze clearly (and in some cases, almost impossible). Nervous investors who do not have adequate information, and in many cases lack even the willingness to dive deeply into the information they do have, go into panic mode. Part of the backdrop to this panic mode is an irresponsible press and a 24/7 news cycle which causes people to jump to conclusions – and often to print misleading, sensationalistic, and biased news in order to collect viewers or readers.
2. Some national governments which have levered up too much (using monetary policy to create QE and buy bonds) will now have to employ fiscal policy (tax cuts, government infrastructure spending, etc.) if they want to get out of their slow-growth trap.
3. European banks have weak balance sheets and hold the debt of many sickly European economies. The Greek crisis has been papered over against the opposition of critics like the International Monetary Fund. Italy, Portugal, and Spain are facing looming problems with their debt burdens as well. European banks have not responded to these potential problems by strengthening their balance sheets with capital raises or by selling assets.
4. The election of populists has challenged the fiscal condition of many governments. They have printed money; their central banks have bought bonds and now may begin to buy stocks in order to stimulate economic activity, which slowed dramatically over the last decade.
5. U.S. institutional investors no longer feel secure using Deutsche Bank as a clearing bank; institutions are removing money from Deutsche Bank to avoid a potential bail-in of depositors under European banking rules in the event that it needs funds from the German government.
6. In coming months and for the next several years, European banks who are counter-parties will see outflows from non-European clearing customers. (Many European banks act as counter-parties on large transactions in currencies, commodities, bonds and stocks.) Even though their mainstream politicians loudly protest that they are unwilling to do it, Germany, Spain, Italy, and other European countries will eventually be forced to bail out many European banks.
Investment implications: Deutsche Bank’s troubles are not a “Lehman moment” which will precipitate a real crisis. Nevertheless, investors are behaving as if a crisis were in the air. In part they’re driven by the paranoia of the 24/7 news cycle, which is always looking for a catastrophe in its quest for viewers. But in part they’re responding to the risk that European banks, laden with bad paper from weak peripheral European economies, may need to be bailed out by the governments -- and under European laws, creditors of those banks would need to be bailed in before the government funds flow in. As long as European banks continue in this weak, un-recapitalized state, foreign customers will avoid them where possible, adding to the pressure on them. In short, the day of reckoning is becoming visible -- but it is not yet imminent. We are also particularly watching the political stresses that will worsen in the EU as the problems get worse. Keep your eye on Italy as Italian voters cast their ballots in December’s constitutional referendum. Contrarian speculators could consider some European banks that have been heavily hit for a short-duration trade.