June 20, 2016

Deutsche Bank comparison to Lehman should be taken seriously

"It is important to note that the European banking system is much more leveraged than that of the United States. Oversight and regulation are weaker and EU banks play a greater role in their economies, as they are far larger relative to European GDP than in the United States."
- Doug's Daily Diary (July, 2014)

I believe that Deutsche Bank (DB) is a "canary in the coal mine" for Wall Street.

DB is Germany's largest bank, with more than 100,000 employees and $1.8 trillion of assets. But that includes one the world's largest (and most opaque) derivative books, and Deutsche Bank's market capitalization has shriveled to just $20.1 billion.

That's similar to the market cap of U.S. bank SunTrust (STI) , which has one-fifth of Deutsche Bank's workforce and one-tenth of its asset base. DB's market cap is also:

-    Roughly half the market cap of foundering Yahoo (YHOO) .

-    Twice as large as the market cap at struggling Twitter (TWTR) , which has just 3% of the workers that Deutsche Bank does.

-    Some $3 billion to $4 billion above the estimated market cap of privately held Snapchat (based on a latest funding round). But remember, Snapchat an unprofitable tech company so far, and produces just some $100 million in annual revenues.

Some say that Wall Street should ignore the massive drop in DB's share price -- but many said the same thing about Lehman Brothers, Fannie Mae, Countrywide and other U.S. financial institutions that crashed during the 2008-2009 market meltdown.

Personally, I say that ignoring Deutsche Bank's implosion and the associated risks (counterparty, etc.) is beyond the pale. It's also a poor analysis of the situation that European banks currently face, as well as how much the European economy depends on its banks (much more than the U.S. economy depends on American banks).

Also note that Deutsche Bank's price is tumbling at a time when banking's problems are multiple and unlikely to get resolved over the near or intermediate term. Issues include:

-Contracting Spreads

-Interest rates have seen an unprecedented decline into negative territory in many countries.

For example, the 10-year German bund's yield went negative yesterday for the first time in history:

Such moves are causing a steady erosion in banks' profits and net-interest margins.

Other concerns:

-    Brexit Fears. If U.K. voters decide next week to pull Britain out of the European Union, that will create a number of uncertainties.

-    Continuing Credit Losses. Credit-quality issues (read: "bad loans") are weighing on an already leveraged and undercapitalized banking industry's balance sheets. Asset-to-equity ratios are nearly 40x.

-    Slow economies. Global economic growth is weak.

-    Regulatory issues. Banks generally face increased and expensive regulatory pressures.

-    Money Laundering, Market Rigging and Fraudulent Trading. European banks are notoriously bad actors. Click here, here, here and here for examples.

The Bottom Line

Deutsche Bank's plummeted by some 2.5% to new recent lows. At the same time, credit-default spreads climbed.

To me, it's growing ever clear that Deutsche Bank's problems are almost insurmountable.

Last month, a Berenberg analyst downgraded DB to "Sell," writing:

"Too many problems still -- the biggest problem is that DBK has too much leverage. On our measures, we believe DBK is still over 40x levered. DBK can either reduce assets or increase capital to rectify this.

On the first path, the markets do not exist in the size nor pricing to enable it to follow this route. Going down the second path also seems impossible at the moment, as the profitability of the core business is under pressure. Seeking outside capital is also likely to be difficult as management would likely find it hard to offer any type of return on new capital invested."

The analyst then moved on to address the structural problems facing European banks in general, writing:

"The difficulty in analyzing investment banks from the outside is that it is hard to establish core profitability. In an industry in structural decline, investment-bank management teams are also likely to face similar challenges. Each weak quarter is seemingly greeted with an excuse that it could have been better if not for the wrong type of volatility, client uncertainty or central bank intervention.

First-quarter 2016 saw the absence of one-off profitable events that have protected revenues in the past. We have perhaps had the first glimpse of what core profitability in the investment banking industry really is (ROEs in the mid-single digits at best) and it could be even worse if the traditional seasonality occurs."

The Coal Mine Doesn't Look So Hot

My advice: Don't dismiss the problems facing Deutsche Bank and the rest of the European banks. Some suggest that drawing parallels between Deutsche Bank and Lehman is "laughable," but it's not. It's a serious, realistic comparison to make.

Many of the same people who failed to see the problems associated with U.S. banks prior to the 2008-2009 meltdown are now understating the economic and market risks that could result from European banks' woes. But the next shoe is likely about to drop for DB and its European brethren, and investors should fear an adverse outcome (and possible grim reaper).

Given this context, I'm short on the Financial Select Sector XLF etf, and I'd recommend that you continue to avoid U.S. banking stocks.

Position: Long TWTR, Short XLF.

via thestreet.com