Streetwise Professor

October 4, 2016

Going Deutsche: Beware Politicians Adjudicating Political Bargains Gone Bad

A few years ago, when doing research on the systemic risk (or not) of commodity trading firms, I thought it would be illuminating to compare these firms to major banks, to demonstrate that (a) commodity traders were really not that big, when compared to systemically important financial institutions, and (b) their balance sheets, though leveraged, were not as geared as banks and unlike banks did not involve the maturity and liquidity transformations that make banks subject to destabilizing runs. One thing that jumped out at me was just what a monstrosity Deutsche Bank was, in terms of size and leverage and Byzantine complexity. Its

My review (conducted in 2012 and again in 2013) looked back several years.  For instance, in 2013, the bank’s leverage ratio was around 37 to 1, and its total assets were over $2 trillion.

Since then, Deutsche has reduced its leverage somewhat, but it is still huge, highly leveraged (especially in comparison to its American peers), and deeply interconnected with all other major financial institutions, and a plethora of industrial and service firms.

This makes its current travails a source of concern. The stock price has fallen to record low levels, and its CDS spreads have spiked to post-crisis highs. The CDS curve is also flattening, which is particularly ominous. Last week, Bloomberg reported signs of a mini-run, not by depositors, but by hedge funds and others who were moving collateral and cleared derivatives positions to other FCMs. (I’ve seen no indication that people are looking to novate OTC deals in order to replace Deutsche as a counterparty, which would be a real harbinger of problems.)

Ironically, the current crisis was sparked by chronic indigestion from the last crisis, namely the legal and regulatory issues related to US subprime. The US Department of Justice presented a settlement demand of $14 billion dollars, which if paid, would put the bank at risk of breaching its regulatory capital requirements: the bank has only reserved $5 billion. Deutsche’s stock price and CDS have lurched up and down over the past few days, driven mainly by news regarding how these legal issues would be resolved.

The $14 billion US demand is only one of Deutsche’s sources of legal agita, most of which are also the result of pre-crisis and crisis issues, such as the IBOR cases and charges that it facilitated accounting chicanery at Italian banks.

Deutsche’s problems are political poison in Germany, for Merkel in particular. She is in a difficult situation. Bailouts are no more popular in Europe than in the US, but if anyone is too big to fail, it is Deutsche. Serious problems there could portend another financial crisis, and one in which the epicenter would be Germany. Merkel and virtually all other politicians in Germany have adamantly stated there would be no bailouts: politically, they have to. But such unconditional statements are not credible–that’s the essence of the TBTF problem. If Deutsche teeters, Germany–no doubt aided by the ECB and the Fed–will be forced to act. This would have seismic political effects, particularly in Europe, and especially particularly in southern Europe, which believes that it has been condemned to economic penury to protect German economic interests, not least of which is Deutsche Bank.

No doubt the German government, the Bundesbank, and the ECB are crafting bailouts that don’t look like bailouts–at least if you don’t look too closely. One idea I saw floated was to sell off Deutsche assets to other entities, with the asset values guaranteed. Since direct government guarantees would be too transparent (and perhaps contrary to EU law), no doubt the guarantees will be costumed in some way as well.

The whole mess points out the inherently political nature of banking, and how the political bargain (in the phrase of Calomaris and Haber in Fragile by Design) has changed. As they show quite persuasively (as have others, such as Ragu Rajan), the pre-crisis political bargain was that banks would facilitate income redistribution policy by provide credit to low income individuals. This seeded the crisis (though like any complex event, there were myriad other contributing causal factors), the political aftershocks of which are being felt to this day. Banking became a pariah industry, as the very large legal settlements extracted by governments indicate.

The difficulty, of course, is that banks are still big and systemically important, and as the Deutsche Bank situation demonstrates, punishing for past misdeeds that contributed to the last crisis could, if taken too far, create a new one. This is particularly true in the Brave New World of post-crisis monetary policy, with its zero or negative interest rates, which makes it very difficult for banks to earn a profit by doing business the old fashioned way (borrow at 3, lend at 6, hit the links by 3) as politicians claim that they desire.

It is definitely desirable to have mechanisms to hold financial malfeasors accountable, but the Deutsche episode illustrates several difficulties. The first is that even the biggest entities can be judgment proof, and imposing judgments on them can have disastrous economic externalities. Another is that there is a considerable degree of arbitrariness in the process, and the results of the process. There is little due process here, and the risks and costs of litigation mean that the outcome of attempts to hold bankers accountable is the result of a negotiation between the state and large financial institutions that is carried out in a highly politicized environment in which emotions and narratives are likely to trump facts. There is room for serious doubt about the quality of justice that results from this process. Waving multi-billion dollar scalps may be emotionally and politically satisfying, but arbitrariness in the process and the result means that the law and regulation will not have an appropriate deterrence effect. If it is understood that fines are the result of a political lottery, the link between conduct and penalty is tenuous, at best, meaning that the penalties will be a very poor way of deterring bad conduct.

Further, it must always be remembered that what happened in the 2000s (and what happened prior to every prior banking crisis) was the result of a political bargain. Holding bankers to account for abusing the terms of the bargain is fine, but unless politicians and regulators are held to account, there will be future political bargains that will result in future crises. To have a co-conspirator in the deals that culminated in the financial crisis–the US government–hold itself out as the judge and jury in these matters will not make things better. It is likely to make things worse, because it only increases the politicization of finance. Since that politicization is is at the root of financial crises, that is a disturbing development indeed.

So yes, bankers should be at the bar. But they should not be alone. And they should be joined there by the very institutions who presume to bring them to justice.

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  1. I don’t know why I chose this one to comment on, since I don’t know squat about this topic, but I will anyway. Germany, like Japan, South Korea, and probably others, have created a web of companies that basically keeps their countries functioning. It is funny to me that they could violate regulations and get fined for it when it’s them doing it to themselves. I work for Daimler now and their relationships with other German companies are extremely incestuous. More than American companies? I have no idea. Still, Germans scratch each others’ backs as much as anyone and can very easily weave traps for themselves. One even more naive question though. The numbers I see for reserves, 5 billion, seems tiny. Am I missing something?

    Comment by Howard Roark — October 4, 2016 @ 10:27 am

  2. It’s not just Deutsche and the DoJ. The US justice system, viewed from outside, seems less and less like an impartial system of justice and more like a protectionist racket and a way of bilking large foreign corporations. Go ask BP, Barclay’s, etc., etc..

    Comment by Recusant — October 4, 2016 @ 12:20 pm

  3. That’s not to say that the EU hasn’t latched on to the same trick, as Apple might confirm.

    Comment by Recusant — October 4, 2016 @ 1:34 pm

  4. @Howard Roark
    I share your expertise on the topic, but also your thoughts. I’m also wondering about the knock-on effects in, inter alia, Italy and Greece.

    Comment by Craig Landon — October 4, 2016 @ 7:35 pm

  5. Hi, Howard. Dunno why you chose to comment on this either, but I’m glad you did. Welcome back.

    The $5 billion refers to the amount that Deutsche reserved to pay for potential liability in the US mortgage cases, not their total capital.

    German hypocrisy on these issues is pretty amazing. It’s not just an incestuous relationship among companies, but between companies, unions, and the government. A very corporatist model.

    The most extreme example I can think of is when Porsche cornered VW stock during a complex attempt to take over the company, driving up its price to 1000 Euros/share, making the company the highest market cap company in the world for a few days. It was a flagrant corner, but the Porsche management escaped any legal accountability. There was some justice, I guess. VW ended up taking over Porsche.

    The ProfessorComment by The Professor — October 4, 2016 @ 7:56 pm

  6. @Recusant. It is a racket. Yes, foreign companies are targeted, but US banks don’t escape. But justice has little to do with it.

    The ProfessorComment by The Professor — October 4, 2016 @ 7:57 pm

  7. Unfortunately, politicians and regulators will not be held “to account.”
    2008-9 was just phase 1 of a long wave down. Phase 2 is well under way
    although its recognition (always manifested by lagging indicators)is not
    widespread–yet. The outcomes of phase changes in complex adaptive systems
    are not predictable, so expect lots of surprises (and chaos).

    Comment by eric — October 4, 2016 @ 10:51 pm

  8. […] Professor has a post up about the difficulties facing Deutsche Bank and the arbitrary nature of the $14bn fine the US has […]

    Pingback by Ze problem with ze Germans | White Sun of the Desert — October 5, 2016 @ 1:16 am

  9. The most extreme example I can think of is when Porsche cornered VW stock during a complex attempt to take over the company

    This was being praised as an act of genius at the time by corporatist publications like the FT and The Economist.

    Comment by Tim Newman — October 5, 2016 @ 1:21 am

  10. “expect lots of surprises”: how can I?

    Comment by dearieme — October 5, 2016 @ 2:50 am

  11. The looting of foreign firms by the US is disgraceful, but would at most be a trigger for a Deutsche collapse, wouldn’t it?

    Comment by dearieme — October 5, 2016 @ 2:51 am

  12. @dearieme–Yes. It would be the straw that broke the camel’s back. $15 billion could be a big deal primarily because their balance sheet is already a mess.

    The ProfessorComment by The Professor — October 5, 2016 @ 9:03 am

  13. DB ain’t going anywhere. The Bloomberg story about clients moving PB balances was mainly fabricated. I understand their PB balances have actually gone up! Which trading counterparties actually lost money on the Lehmans close out? (I take your well made point from about the redistributive effects of derivs Prof). There have been some big improvements in the industry since Lehmans too (trade reporting, more clearing and less outstanding trade confirms – remember those!?) The credit folks I know have all run their exposures against DB and no-one is overly concerned. This is no Lehman moment.

    That’s not to say that DB aren’t screwed in their current form. They will shrink and shed businesses and staff but talk of DB going to the wall is, in my opinion, fanciful.

    Comment by Greenwichmeantiger — October 5, 2016 @ 9:12 am

  14. @Tim-I remember. I was gobsmacked.

    And the German “regulators”! At the time, I remember likening them to Sergeant Schultz from Hogan’s Heroes. “I zee nothink! NOTHINK!” And the court in which the Porsche executives were tried was similarly blind, and likely deliberately so.

    FFS, the stock price went from 100 Euro to 1000 Euro (I am writing from memory) in a day! If you look at the implied price from options–a measure of what the price should have been–it barely budged above 100.

    But the main people who were hosed were US hedge funds, and the Germans rallied around their companies. Porsche successfully avoided litigation in the US, on jurisdictional grounds. German courts also gave the back of their hand to lawsuits, on more substantive grounds. But those grounds were extremely flimsy, strongly suggesting it was a homer call.

    The whole episode is very revealing, not least in pointing out German double standards on issues of corporate malfeasance.

    The ProfessorComment by The Professor — October 5, 2016 @ 9:33 am

  15. Professor, what does “corner” mean in the above context?

    Comment by Dr. Toboggan — October 5, 2016 @ 10:16 am

  16. @Tim–thanks for the nice shout out on your blog re this post. Thomas Sowell calls the phenomenon that you mention “the physical fallacy,” i.e., the belief that only production of physical goods matters. It’s only a slight intellectual advance on mercantilism or the labor theory of value.

    The ProfessorComment by The Professor — October 5, 2016 @ 10:32 am

  17. @Dr. Toboggan-a corner means the exercise of market power in a derivatives market, with the purpose of causing an artificial inflation of the price of the cornered commodity or security. The basic idea behind a corner is that someone obtains a position allowing him to demand delivery of more stuff than is available at the competitive price. The inability to deliver at the competitive price forces the shorts to cover their position at supercompetitive prices. In the case of Porsche-VW, Porsche had obtained a large options position, and also had lent shares to hedge funds. When the hedge funds were obligated to make deliveries on their stock borrowings and options positions, they found out that there weren’t enough shares available to do it.

    I wrote about that here and here. Damn, that was a long time ago. I wrote about the regulators here.

    The ProfessorComment by The Professor — October 5, 2016 @ 10:38 am

  18. Speaking of a long time ago, I think I stumbled upon you while living in Ukraine back in 2009. Wow, time flies. Thanks for everything you write here.

    Comment by Howard Roark — October 5, 2016 @ 8:21 pm

  19. Germany’s most famous protectionist racket is its “Reinheitsgebot” or “purity law” that places in front of non-German brewers constructively insuperable barriers to entry into the German beer market. You don’t see foreign beer in Germany, and in fact you hardly even see Cologne beer in Dusseldorf 30-odd miles away, so tightly stitched up is it.

    For the same reason you don’t see German beer outside Germany. Why would a German brewer bother setting up an exporting operation when they can just sit at home collecting rents?

    Comment by Green As Grass — October 6, 2016 @ 2:41 am

  20. Cool, thanks. Now, what do all those other words mean? And how do finances work?

    Comment by Dr. Toboggan — October 6, 2016 @ 6:50 am

  21. Green As Grass,

    Germany has a few of these rackets, one being the archaic law that everyone needs their chimney swept regularly and this service can only be provided by a small band of authorised chimney-sweeps. Free market my ass.

    Comment by Tim Newman — October 6, 2016 @ 10:14 am

  22. @Tim & @Green. It’s pervasive. The laws on store hours are another example. It’s a great way of reducing competition between retailers by making it costlier for consumers to search/shop around.

    The ProfessorComment by The Professor — October 6, 2016 @ 12:03 pm

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