Deutsche Bank AG (NYSE: DB) Will Be Crushed Under the Weight of Europe's Debt

Frankfurt-based Deutsche Bank AG (NYSE: DB) is about to be critically wounded by the European banking crisis.

Don't get me wrong - it will survive the spiraling financial mess. Germany will defend it because it's the bellwether of big banking in Europe. It's their version of "too big to fail."

But as the continent's largest bank, it won't be able to escape unscathed from the capital crunch about to take over the European banking system.

So it's time to sell Deutsche Bank AG (**), before the region's financial system falls apart.

Europe's Coming Capital Crunch

Many European banks don't have enough money to survive a Greek default. They hold huge amounts of their home sovereign's debt, as well as debt of their troubled Eurozone neighbors. Any write-down of those holdings will slam their balance sheets.

These banks were already overleveraged when the financial crisis started in 2007, and they have relied on outside sources like the United States to maintain core capital ratios.

In the 2008 crash, the European banks turned to the U.S. Federal Reserve for trillions of dollars of liquidity injections. They also used sources like U.S. money market funds for short-term loans - commercial paper that matures in less than 270 days - to cover capital loaned out at longer maturities. In May 2011, U.S. money market funds had an average 40% of holdings in European commercial bank paper.

But then U.S. banks, afraid of the unfolding European sovereign debt drama, let these short-term loans mature. This brought the capital back home and took an estimated $350 billion in liquidity out of the European banking system.

Now Europe's real levels of available capital are by far the weakest link in the world's interwoven financial system, and banks are struggling to find new funding sources.

This capital crunch prompted a former Chinese central bank official to say the debt crisis will spread across Europe like the "Black Death of the fourteenth century."

The banks most exposed to sovereign debt will crumble, and will share some damage with the region's biggest institutions - especially Deutsche Bank.

Why Deutsche Bank AG is a "Sell"

Deutsche Bank's position as Germany's financial powerhouse makes it highly vulnerable to this crisis for three reasons.

First, Deutsche Bank will be highly exposed to its smaller, troubled counterparts when they start the recapitalization process. It will have to absorb some of Germany's undercapitalized banks if they don't raise enough money to protect themselves from a Greek default.

And at the rate they're going, they won't.

Second, due to its integral role in the region's banking system Deutsche Bank will be affected by firms refusing to do business with each other. Funds will almost certainly freeze up as fear regarding overnight funding risks increases.

Third, since Deutsche Bank represents Europe's biggest economy, it could be pressured to take political actions that might not be in its best economic interest. And Deutsche Bank needs the ruling body's support because even though it has raised some capital, it'll likely need to access the German government's emergency capital fund for more help.

The company's $32 billion market capitalization is down 31% from a year ago, compared to a 3.2% rise in the Standard & Poor's 500 Index. The stock hit a 52-week high of $66.00 per share on May 2, 2011. It fell to hit a new 52-week low of $28.57on Sept. 12.

The stock tumbled 5.00% on Friday to close at $35.15.

Action to Take: Sell Deutsche Bank AG (NYSE: DB) (**).

Deutsche Bank has had a short bounce up from the 52-week low it set a few weeks ago. Let's use this near-term strength to unload any exposure you might have to the bank.

The stock has a liquid market in the United States, and you can use market orders to get out without having to place a lot of limit orders.

If an investor is currently flat, it's a good time to buy at-the-money long puts for January 2012 to play the downside that's likely to resurface this fall, as the capital crunch hits Europe's big banks.

(**) Special Note of Disclosure: Jack Barnes has no interest in Deutsche Bank AG (NYSE: DB).

About the Writer: Columnist Jack Barnes started his career at Franklin Templeton in 1997. He started out in the company's fund-information department - just as the Asian contagion infected the Asian tiger countries.

Barnes launched his own shop, RIA, in 2003, just as the second Gulf War was breaking out. In early 2006, after logging a one-year return of nearly 83%, Forbes named Barnes the top stock picker in its "Armchair Investors Who Beat the Pros" competition. His two audited hedge funds generated double-digit returns in 2008.

Barnes retired to the beach in the summer of 2009, and continues to write from there. He's now the author of the popular blog, "Confessions of a Macro Contrarian," and his "Buy, Sell or Hold" column appears in Money Morning twice a week. In his previous BSH column, Barnes analyzed Yamana Gold Inc. (NYSE: AUY).

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