The U.S. Department of Justice announced it's seeking a record $14 billion penalty against Deutsche Bank AG (DE:DBKGn) USA in relation to mortgage-securities fraud in the run up to the global financial crisis that's roiled markets since 2007.
Another naughty bank, another big fine. Regulators quietly charge banks and financial institutions with rules and policy violations all the time. Most of them are settled just as quietly after a bunch of legal wrangling, without causing so much as a blip in the headlines.
So what's the big deal?
Well, Deutsche Bank is facing a $14 billion fine at a time when the bank has "litigation reserves" of just €5.5 billion ($6.17 billion). It simply doesn't have the cash on hand to pay just the penalties sought by U.S. regulators as it stands today.
What's more, that $14 billion fine stems from just one of the more than 7,000 ongoing legal cases, according to The Guardian.
These problems are bad, but they pale in comparison to the problem no one's talking about…
The $42 Trillion Anvil Hanging Over the Markets
Even by Deutsche Bank's standards, this has been a bad week.
The company has lost one-fifth of its market capitalization in less than two weeks, and if my calculations are correct, roughly half its value since the beginning of 2016.
Again, you may ask, "So, what's the big deal? Stocks tank all the time – even banks."
Well, this isn't just a big deal, it's the big deal. I'll show you why.
It doesn't advertise it, but Deutsche Bank has more than $42 trillion-with-a-T in derivatives on its books. That's nearly 14 times the size of Germany's $3.3 trillion economy, and much more than twice the size of the European Union's $16.3 trillion GDP.
To put this in perspective, that's 20 times the derivatives exposure that Lehman Brothers had… and we all know how that ended up.
And as we've seen, Deutsche Bank doesn't have the cash to settle its own legal troubles, let alone any "surprises" that might come its way.
Make no mistake, as things stand today, Deutsche Bank is at the brink of failure.
You can see the desperate straits this bank is in right now.
To make matters worse, this weekend, speaking in response to the Justice Department's $14 billion fine and questions over the bank's ability to pay, German Chancellor Angela Merkel told Focus magazine that there will be no bailouts.
If Merkel sticks to her guns and lets Deutsche Bank fail, her actions will make it virtually impossible for the world's central bankers and their political masters not to do the same with other big banks.
If Deutsche Bank goes, then Italian, Spanish, and French banks go next. Then EU and U.S. banks will go.
It's going to burn the global financial sector and the euro at once.
But as Chief Investment Strategist, it's my job to make sure you and your money make it across to the other side, safe and sound.
Here's how that's going to happen.
This Move Will Put Us Ahead of the Game
Since the crisis began, I've argued forcefully that the markets have rallied because of central bank support, and not their own merits.
We've seen the evidence of this in the markets' obsessive parsing of every word Janet Yellen says.
That's why, with some small exceptions, I've recommended against investing in the financial sector; since the crisis, it's always been "one comment" away from disaster.
And with her "Nein," I think Angela Merkel's just made that comment.
So here's what I recommend we do (and don't do) right now.
For starters, I don't recommend shorting Deutsche Bank at the moment.
We did that in April, when Deutsche Bank was back-page news and few others saw the same potential we did in shorting those shares. The stock is down a hefty 55% since then, and we've been laughing all the way to the bank (just not Deutsche Bank, I trust).
Now this story is all over the headlines, so the short side will be crowded. There's simply no advantage for us even if the stock tanks from here.
Besides, survival is the most powerful instinct – a lot of late shorts could get burned if Merkel and her cronies change course to "work something out." Even Yellen could step in and say she'll back everyone "just in case," which could cause banking stocks to take off like a rocket, causing a short burn… and a good deal of financial pain for folks with short positions who haven't properly prepared.
Instead, the smartest move here is to establish a speculative short against the U.S. banking industry which, unbelievably, most investors believe is immune to any crisis "over there." People perceive this as a German or European problem, but they're missing the fact that there's nothing whatsoever to stop this from crossing the Atlantic.
The easiest way to do that is to consider buying the ProShares Short Financials ETF (NYSE:SEF), which provides unleveraged exposure to the Dow index. It'll appreciate as stocks decline.
I'd recommend staying away from the leveraged alternatives that also short the financial sector, because tracking error could really eat into any potential returns as you wait for the stuff to hit the fan.
As always, sweat the details on a trade like this. Never, ever invest money you can't afford to lose, and don't bet the ranch on this or any other trade – ever.