September 2016 – Monthly Commentary

September 2016

To state the obvious, capital markets are complicated and susceptible to occasional problems related to supply and demand imbalances.  Typically, the problems become magnified at quarter-end, and the just-ended quarter was especially so.  With the October 14th money market reform deadline looming, money funds continued to flood the market with corporate and municipal note sales, while boosting their demand for Treasury Bills and Notes.   That demand added to the quarterly “window dressing” that banks engage in to give their balance sheets the appearance of being of higher quality than would otherwise be the case.  The confluence from banks and money funds drove the yield to maturity of T-bills down to 0.00% in the days prior to quarter end.  Simultaneously, the Federal Reserve’s reverse repurchase facility, designed to help financial institutions invest excess funds during times of stress swelled materially.  Typically, the average balance deposited at the facility is in the $50 billion area.  At quarter end, that number rose to $412 billion.  Since quarter end, demand has waned modestly with the size of the operation on October 10th still sizable at $226 billion.  The importance of the increase is that it is a direct expense to the U.S. government with the current interest paid of 0.25%.  While immaterial compared to the yawning annual deficit, it nonetheless is an unnecessary expense and distortive to the market.

Compounding the quarter-end madness was the U.S. Justice Department’s announcement of the intention to levy a $14 billion fine on Deutsche Bank for its role in the sub-prime mortgage crisis.  The equity capital at Deutsche is only $67 Billion, so a $14 billion dollar hit to equity would put the German bank’s capital well below regulatory requirements.  With the specter of issuing additional shares to meet some or the entire penalty, Deutsche’s stock price plunged to a 52 week low of $11.18, well below the $30 at which it was trading last fall.  German government officials said they had no intention of coming to the aid of the lender, which exacerbated the selling.

Several analysts have said that Deutsche Bank is very small compared to other money center banks and that regulators should allow the bank to go under.  Granted, at a market capitalization of about $15 billion, the value of the bank is less than 10% of J.P. Morgan.  However, we think to focus on market capital is to ignore the opacity and enormity of the risk on its balance sheet.  Total assets held, at $1.6 trillion, are equal to approximately one half of Germany’s annual GDP, and derivative exposure totals more than one half trillion dollars.  Arguably, the $67 billion of equity is not nearly enough to support such a balance sheet, which is why the bank’s stock price has been falling for years and the credit rating has fallen from Aa1 in 2007 to the current Baa2 – just two notches above junk.  The argument in favor of such a large derivative book is that it’s mostly paired off with hedges and in many instances over counted.  Our counter to that argument has been that if counterparties deem Deutsche too risky and it loses access to liquidity, there’s no telling how those securities would be valued.  Moreover, there’s no way of knowing the impact they would have on Deutsche Bank’s solvency or the risk it would pose to the global banking system.

Given that unknown, we wonder what the Federal Reserve and the European Central Bank were thinking.  The U.S. has the concept of a “living will” for the banking system, which details how a bank would dismantle itself in the event of a solvency crisis without collapsing the financial system.  Deutsche is one of five foreign banks that are subject to the living will concept, but the Fed and the ECB have been conspicuously silent on the matter.  Given the direness of the situation, it seems as though the Central Banks should have either been supportive of the bank or should have wound it down.  Is the concept of “living will” no more than a panacea to quiet the concerns of Senator Elizabeth Warren, Bernie Sanders, and others critical of Wall Street?

Deutsche bank has since stabilized amid talk of a much lower DOJ fine and the sale of $4.5 billion senior unsecured debt, but that doesn’t do anything to address years of seemingly poor management and their enormous derivatives business.