The U.S. Department of Justice announced it's seeking a record $14 billion penalty against Deutsche Bank AG USA (NYSE: DB) in relation to mortgage securities fraud in the run up to the global financial crisis that's roiled markets since 2007.
Another naughty bank, another big fine. Regulators quietly charge banks and financial institutions with rules and policy violations all the time. Unbeknownst to most investors, the majority of infractions are quietly settled after a bunch of legal wrangling, without causing so much as a blip in the headlines.
So what's the big deal?
Deutsche Bank is facing a $14 billion fine at a time when the bank has "litigation reserves" of just €5.5 billion ($6.17 billion). It simply doesn't have the cash on hand to pay just the penalties sought by just U.S. regulators as it stands today.
The bank is actually fighting more than 7,000 ongoing legal cases, according to The Guardian.
As bad as those problems are, they pale in comparison to the problem no one's talking about...
Even by Deutsche Bank's standards, this has been a bad week.
The company has lost one-fifth of its market capitalization in less than two weeks, and if my calculations are correct, roughly half its value since the beginning of 2016.
Again, you may ask, "So, what's the big deal? Stocks tank all the time - even banks."
Well, this isn't just a big deal, it's the big deal. I'll show you why.
It doesn't advertise it, but Deutsche Bank has more than $42 trillion-with-a-T in derivatives on its books. That's nearly 14 times the size of Germany's $3.3 trillion economy, and much more than twice the size of the European Union's $16.3 trillion GDP.
To put this in perspective, that's roughly 20 times the derivatives exposure that Lehman Brothers had... and we all know how that ended.
Put bluntly, Deutsche Bank doesn't have the cash to settle its own legal troubles, let alone any "surprises" that might come its way.
Surprises like the one that caught markets this week.
This weekend, speaking in response to the Justice Department's $14 billion fine and questions over the bank's ability to pay, German Chancellor Angela "Madame No" Merkel apparently said emphatically that there will be no bailouts when it comes to Deutsche Bank, according to Focus magazine.
If Merkel sticks to her guns and lets Deutsche Bank fail, her actions will make it virtually impossible for the world's central bankers and their political masters not to do the same with other big banks.
The way I see it, she’s singlehandedly put the world’s entire financial system at risk. Not only that, but she’s potentially burned the euro, too.
If Deutsche Bank goes, then Italian, Spanish, and French banks go next. Then EU and U.S. banks will go.
So now what?
I’m glad you asked.
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Since the crisis began, I've argued forcefully that the markets have rallied because of central bank support, and not their own merits. And, in fact, have recommended against investing in the financial sector; since the crisis, it’s always been “one comment” away from disaster.
And with her “Nein,” I think Angela Merkel’s just made that comment.
So here's what I recommend you do (and don't do) right now.
For starters, I don't recommend shorting Deutsche Bank at the moment.
The time to do that was back in April 2015, when that’s exactly what I suggested.
At the time, Deutsche Bank was back-page news and very few people saw the same potential we did in shorting those shares. Everybody who’s followed along has had the opportunity to profit considering the stock has dropped 55% since.
But now the story is all over the headlines, so the short side will be crowded. There's simply no advantage even if the stock tanks from here.
The other thing to consider is that survival is the most powerful instinct - which means that a lot of late shorts could get burned if Merkel and her cronies change course to "work something out." Even Yellen could step in and say she'll back everyone "just in case," which would cause banking stocks to take off like a rocket, causing a short burn... and a good deal of financial pain for folks with short positions who haven't properly prepared.
The smartest move right now is to establish a speculative short against the U.S. banking industry which, unbelievably, most investors believe is immune to any crisis "over there." People who perceive this as a German or European problem are missing the point that there's nothing whatsoever to stop the Deutsche Bank contagion from crossing the Atlantic. That’s the very nature of global derivatives.
The easiest way to do that is to consider buying the ProShares Short Financials ETF (NYSE Arca: SEF), which provides unleveraged exposure to the Dow Jones U.S. Financials Index. It'll appreciate as stocks decline.
I'd recommend staying away from the leveraged alternatives that also short the financial sector, because tracking error could really eat into any potential returns as you wait for the stuff to hit the fan.
As always, sweat the details on a trade like this. Never, ever invest money you can't afford to lose, and don't bet the ranch on this or any other trade - ever.
Keith just hit his Money Map Report readers with two plays for protection and profit in the face of Deutsche Bank's deepening troubles. They'll get the latest on the bank's situation and any government or central bank responses, too. Click here to learn how to get his research for yourself.
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