I may be late writing about the movie ‘The Big Short’ but it somehow makes sense to have watched it in the week that Deutsche Bank suffered an unprecedented exodus of investors.
Leaving aside the maverick hedge fund managers whom Michael Lewis (and this film) have made famous, Deutsche Bank sits at the heart of the story, via its former mortgage derivative trader Greg Lippmann. Ryan Gosling plays the character based on Lippmann in the film, depicting him as a smooth, amoral facilitator for the other characters.
Having met Lippmann and written about him in “The Devil’s Derivatives”, I was left wanting more. While the film hints about Lippmann’s proprietary position against subprime, which was greater than all the other characters’ positions put together, it doesn’t tell us that Lippmann used his short trade to create built-to-fail synthetic CDOs that Deutsche Bank sold to investors around the world, amplifying the financial crisis.
While I don’t expect a Hollywood movie to scrimp on entertainment, perhaps a horror movie is better suited to depicting the awfulness of this process. And while ‘The Big Short’ gives us an almost nostalgic take on the subprime bubble with its NINJA strippers, the toxicity of Deutsche’s activity and culture continue to infect the bank and broader financial system today.
Start with the balance sheet. Deutsche is the most leveraged big bank in the world, with assets 37 times core equity tier one capital. Half of these assets – $762 billion – are over-the-counter derivatives, the legacy of its growth before the crisis. Deutsche’s trading book securitisation exposure is the second biggest in the world after Goldman Sachs (which has a lot more capital). And this is the stuff that we can actually see in the bank’s financial reports.
Does this explain why investors turned against the bank so decisively? China, the collapse in oil prices, negative interest rates imposed by central banks, tougher regulations? There are many potential drivers. But why Deutsche?
Perhaps there is something else going on, which is at the heart of the bank’s culture. Greg Lippmann may have enshrined that, but he was only a mid-level functionary. The driving force was Anshu Jain, the CEO who left the bank six months ago. Before becoming CEO, Jain ran Deutsche’s global markets business, industrialising financial innovations such as synthetic CDOs, setting the compass for his division.
As we learned from a leaked Bafin report last year, Deutsche also industrialised interest rate benchmark rigging by its traders, by creating a business environment that encouraged rigging, or ‘even made it possible in the first place’. Jain and his fellow Deutsche board members behaved ‘negligently’ , the report said, while members of the group executive committee immediately below the board may have actually been complicit in rigging.
The report blames management for the bank’s $3.5 billion of interest rate rigging fines last year, a number inflated by Deutsche’s casual approach to regulators. Although the bank got away relatively lightly over its Lippmann-era activity with about $2 billion of US mortgage-related settlements, Deutsche is still being investigated over foreign exchange rigging, Russian sanctions-busting while Bafin’s final report on interest rate rigging is yet to be published. Although Jain has gone, Deutsche now has a target painted on its back.
Sure, the bank seems to have plenty of liquidity, hence its plan to buy back $5 billion of unsecured bonds. Then again, we don’t know how much liquidity would be needed if Deutsche’s derivative counterparties decided to novate their contracts. As for CEO John Cryan, he may be a clean pair of hands, but is he capable of lancing the boils that still may lurk inside Deutsche Bank? Who can blame investors for wondering what is still to come?
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Well said, Nick. As a seasoned Deutsche-watcher, I am of the opinion that there is far more to come. This bank is not viable in its present form. Needs to be broken up.
DB is the largest, most powerful bank in Germany. The government of the country is likely to support it in various ways if it is ever needed. Have no doubts about it.
Yes, absolutely. But any government recapitalisation wouldn’t be politically acceptable unless it wiped out shareholders and bailed in subordinated debtholders as well.
The EU “national competent authorities” continue to be “very nice” with their own banks in defense of their own perceived national interests. This stance is likely to perpetuate a weak and vulnerable EU banking system that will continue to be prone to financial instability. Compare the BIS leverage ratios of U.S. and EU banks. The lower capital levels in the EU banks is particularly concerning in the context of the EU’s primarily reliance on banks for credit supply. A strong EU economy requires a strong, well capitalized banking system. We are not there yet and this is a massive problem for economic growth.
Forgive my ignorance, but to what extent can counterparties ‘novate their contracts’
It depends on the contracts themselves (see http://www.isda.org/isdanovationprotII/isdanovationprotII.html for instance) but is something that happened in the case of Bear Stearns and Lehman.
Thanks Nick – but if the counterparties novate, then DB will face someone else – whoever the erstwhile counterparties have novated to. So how is this additional risk for DB?
And is there a bigger story in that it is not just DB. Is there merit to an idea of creating a european derivatives bank by taking out the derivs from Barclays Credit Suisse and DB?
I will try and explain how novation might work. Imagine that DB bought an oil derivative from an energy company and sold it on to a hedge fund. You have two separate, economically-opposed OTC contracts with DB in the middle. Then oil goes down and the energy company owes DB on the derivative while the hedge fund is owed by DB on the other side. To novate you need to find a new counterparty – say JP Morgan – to step into the shoes of DB, assuming the credit exposure. If done successfully, then DB is removed from the picture. However, it gets tricky if there is a credit imbalance: for example, if DB has posted collateral to the HF but doesn’t receive collateral from the energy company.
Wouldn’t DB have to agree to a novation of an OTC? It presumably wouldn’t agree to novate a trade/portfolio where it is out of the money? (Leaving aside collateralised positions which might be more complicated I guess).
In principle yes. ISDA’s statement on assignment strongly encourages it. But at the end of the day it depends on the documentation, and a bank may agree to novate/assign because to refuse would look desperate.
I worked at DB trading credit derivatives and left in 2003 certain they would soon blow up. Thankfully my timing on the 2008 crisis was much better. Even back then it was anything goes.
I heard Deutsche still has exposure from its acquisition of Bankers Trust. Given this was in 1998, how likely is it that derivative contracts from 18 years ago would still be in force? Or rolled over?
Also, a certain Taurus Holding pops up. Any idea what they put in that one? Tx vm.
There are a lot of OTC derivative contracts out there with maturities of 30,40 or even 50 years (see http://nickdunbar.net/2014/10/24/lost-lobos/). Bankers Trust did plenty of long-term derivatives, for example complex interest rate deals with Gen Re Financial Products that Warren Buffett later called ‘financial products of mass destruction’ because he was unable to unwind them. So Deutsche Bank would still have such contracts on its books. As for Taurus, I’ve never heard of it. Are you sure you don’t mean the former DB US holding company Taunus Corp?