Sunday, October 2, 2016

A Look At Next Week's Market Drivers: Deutsche Bank and the Jobs Report

From Marc to Market:

The start of next week will likely be driven by Deutsche Bank's travails and dollar funding pressures, which may or may not be related.  The end of the week features the US monthly jobs report. Despite being a noisy, high frequency time series subject to significant revisions, this report like none other can drive expectations of Fed policy. 

Deutsche Bank is faced with two challenges: its business and several outstanding legal cases.  It is well appreciated that European bank business model has broken down and the low, and now, negative interest rate environment is exacerbating the problems.  An important distinction, however, is that while European banking problems, as in Greece, Italy, Portugal and Spain, are often made acute by their nonperforming loans, this is not Deutsche Bank's issue.  Only a quarter of its assets are tied to loans, according to reports.   

The bank had what accounts euphemistically call negative revenue last year, which means it lost money (~7.7 bln euros or ~$8.6 bln).  There is a 35 bln euro (~$39.4 bln) gap between the market value of the bank and the bank's value of its tangible assets.  The bank failed to pass two consecutive stress tests conducted by the Federal Reserve.  Earlier this year, the IMF identified the bank as the single largest source of global financial systemic risk. 

It is the bank's legal problems that are the source of the immediate pressure, and roiling the market. There are three numbers that have caught investors' attention: 6, 14, and 16.   The bank's litigation reserves are reportedly near 6 bln euros (~$6.75 bln) The Department of Justice has proposed $14 bln fine for fraudulent practices relating to the issuance packaging, securitization, and sales of residential mortgage-backed securities. The market capitalization of the bank is roughly 16 bln euros (~$18 bln). 

For the wrongdoing in the residential mortgage space, some banks have been fined more and some less than the Deutsche Bank's $14 bln fine.  Reports suggest that the level of the fine is not simply a function of the damage inflicted, but also the bank's cooperation.   In addition, Deutsche Bank has been involved in several other cases, and according to Bloomberg, has paid more fines than any other bank since 2008. 

An unconfirmed report before the weekend, claiming that Deutsche Bank's fine would be negotiated down to $5.4 bln, saw a dramatic collective sigh of relief.  Risk assets, including Deutsche Bank stock, financials and equity markets, were propelled higher.  The dollar reversed earlier gains that had sent the euro to new lows for the week.  Investors will be sensitive to whether this report is confirmed. 

Investors are particularly concerned about the systemic risks posed by Deutsche Bank.  Reports suggest that the gross notional value of its derivatives book is 46 trillion euros.  Many have warned of a potential Lehman-like event.  Contributing to this sense was a sudden jump in the demand for dollar funding.  Since the financial crisis, several central banks have been auctioning dollars, and there is quasi-permanent swap line between the Federal Reserve and five central banks (ECB, BOJ, BOE, BOC, and SNB).  

These swap lines remain largely dormant.  Last week, the ECB tapped the line for a $29 mln (paying 0.95%).  The BOJ took one million dollars.    Earlier this year the BOJ had doubled the size of its dollar auctions.   Last week, a dozen European banks borrowed $6.35 bln at the ECB's dollar auction.  This is the most in four years.  Unconfirmed reports indicated that none of the banks were German.   

The implications seem exaggerated by the investors' sensitivity and the some media accounts.  First, the average of dollar borrowing per bank at the ECB has been higher.  Even the cumulative amount is not indicative of a crisis.  Second, the borrowings cover quarter-end.  There was an increase in borrowings and participation in June as well, just on a smaller magnitude.    
Third, part of the demand for dollar funding may be a function of the dislocation being caused by the new rules regarding US money markets.  The preference for funds that invest solely in government securities appears to have driven up LIBOR yields.  In turn, this is exacerbating extreme pricing in the commonly used cross-currency swap market, where the cost of transferring liquidity or hedging euro and yen exposure into dollar has risen dramatically....MORE
So, What's the Worst Case Scenario With Deutsche Bank?