It's no secret that Deutsche Bank AG (NYSE:DB) is headed downhill. The stock is now trading at a 30-year low and was recently called out by the International Money Fund as the world's riskiest financial institution. A look at its plunging stock chart (down 45% as of Q3 2016) - and a quick glance at its Q4 2015 results, which showed a record annual loss of $7.6 billion - confirms what years of shady financial engineering and mounting legal costs have already told us. DB is dying on the vine.
As usual, Wall Street's "expert" analysts are bullish, advising investors to hold their positions in the company in expectation of a dramatic turnaround.
My own forecast goes straight down - and I'll tell you why.
Yes, I'm talking about the Super Crash.
In this special report, I'll give you an overview of DB's massive systemic risk and tell you first, how to protect yourself and second, how to profit.
I want you to fully appreciate just how bad this crash could be.
The global economy in 2016 does not possess remotely enough productive capacity to generate the income required to service and/or repay the debts it has already incurred or, for that matter, the incalculable trillions of dollars of future promises it has made. The United States is just a microcosm of the rest of the world. As Figure 2 illustrates, debt has grown much faster than the U.S. economy.
Furthermore, the gap between the growth rate of debt and the growth rate of the economy has accelerated, which means that the economy can never hope to catch up and generate enough income to pay the interest or the principal on the debt.
Alarmingly, the United States is in better shape than the rest of the world.
Debt vs. U.S. economy
Debt vs. Global GDP
As I've pointed out many times before, this level of debt is simply not sustainable - either on a national or a global level. We are suffocating under the weight of massive debt, which we have a rapidly decreasing capability to support.
Just as in 2008, much of this debt problem springs from a single headwater.
Derivatives and the Crisis in 2008
In 2008, the world caught a glimpse of what happens when financial counterparties lose trust in each other and confidence in the system.
Many of them refused to meet their obligations under all types of financial contracts including derivatives contracts. This led the entire system to the brink of collapse.
The financial system has placed itself in an extremely vulnerable position by allowing a superstructure of hundreds of trillions of derivatives contracts, including at least $16 trillion of credit default swaps as of December 31, 2014, to proliferate.
Warren Buffett's famous phrase still bears repeating. One of the primary forms that this debt has assumed in the modern economy is the OTC (over-the-counter) derivatives contract... an unregulated, complex nightmare that is not investment, but pure speculation.
As you may have suspected, DB's systemic risk stems directly from derivatives. In order to understand the gravity of the situation, it's necessary to go a little deeper.
In 2008, AIG almost blew up because it had written too many derivatives contracts on collateralized bond obligations that held billions of dollars of subprime mortgages. But the derivatives problem in the market in 2008 was much broader and deeper than this - there were roughly $60 trillion of credit default swaps, written on a wide variety of underlying obligations, that posed a systemic threat.
Global OTC Derivatives vs. Gross Market Values and Gross Credit Exposure (2006-2009)
One of the stated aims of the Dodd-Frank Wall Street Reform and Consumer Protection Act was to address the "too big to fail" problem in the financial industry. Unfortunately, the legislation has left us with a much more concentrated financial industry with fewer firms that are no longer "too big to fail" but actually "too big to save."
One of the primary ways in which they have become "too big to save" is in the highly concentrated derivatives holdings of a small group of firms... which I'll discuss below.
Differences Between Exchange-Traded Derivatives (ETDs) and Over-the-Counter Derivatives (OTCs)
Exchange-traded derivatives are traded through a central exchange and well-regulated with publicly visible prices. The counterparty risk is not great, and the market is much smaller.
Over-the-counter derivatives can be traded between two parties without an exchange or intermediaries. The market is much larger but the risk is correspondingly much higher.
The OCC reported that the notional amount of outstanding derivatives stood at $192.9 trillion at Q1 2016 - up 6.6% from the $181 trillion outstanding at the end of Q4 2015, and more than enough to pose a systemic threat during the next crisis.
As of this writing, the amount of outstanding notional derivatives is more than twice the size of the global economy.
OTC Derivatives vs. World GDP
Those who like to downplay the risks of derivatives (who without exception are people who have an economic interest in their continued growth) argue that focusing on notional derivative contracts exaggerates the risks they pose. They argue that systemic risk should be measured in terms of the lower "gross credit exposures," which stood at about $4 trillion in Q1 2016.
However, the much larger notional figures (the "Earth") are the relevant ones to focus on in terms of evaluating and managing financial stability:
The London Whale: Derivatives Trading Leads to Disaster Yet Again
The derivatives risk is far from theoretical. In 2013 - a mere five years after the collapse of Lehman Brothers and near-collapse of AIG, the latter of which would have constituted an extinction-level event for the global financial system - J.P. Morgan lost more than $6 billion on trades involving credit default swap bets on high-yield bond indices in the incident infamously known as the "London Whale."
This unfortunate incident illustrated that these markets are thinly traded and therefore highly illiquid and volatile; in a crisis, counterparties would likely become unable or unwilling to perform and create systemic dislocations that would reverberate on the underlying securities held by those indices. In fact, despite their large notional volumes, credit default swap markets remain extremely illiquid - as investors learned during the 2008/9 crisis when relatively low volumes led to huge moves in the credit spreads of troubled credits such as Bear Stearns and Lehman Brothers.
In other words, lower "total gross credit exposure" or "gross market value" will only be relevant when it doesn't matter, i.e., when markets are functioning normally. In a crisis, counterparties either will be unable to and/or unwilling to perform and the volume of contracts will overwhelm these institutions and render them instantly insolvent. While large banks like J.P.Morgan, Bank of America, Citigroup and Goldman Sachs all carry significantly more derivatives than assets, one bank stands out.
Deutsche Bank is the world's single largest purveyor of derivatives.
Let that sink in for a moment.
As of Q3 2015, DB held approximately €45.7 trillion of OTC derivatives contracts on its books (over $52 trillion at current exchange rates). In DB's latest interim report (Q1 2016), they noted that OTC figures have increased 23%, or €11.5 billion, since December 2015. This poses the single biggest systemic risk of any financial institution in the world.
In fact, this one bank has derivatives exposure greater than the entire European GDP.
Derivatives Exposure Bigger than European GDP
These problems finally came into the open in July 2014 when The Wall Street Journal disclosed that the New York Fed's concerns about the bank had been growing for years....stressing "significant weaknesses in the firm's regulatory reporting framework that has remained outstanding for a decade," "material errors," and "poor data integrity" and recommending wide-ranging remedial action.
A Timeline
The report added that DB's shortcomings amounted to a "systemic breakdown" and "expose the firm to significant operational risk and misstated regulatory reports." The bank's external auditor, KPMG LLP, also identified "deficiencies" in the way the bank's U.S. entities were reporting financial data in 2013 according to an internal email reviewed by The Wall Street Journal.
Things have only gotten worse for DB since the Fed's rebuke - leaving them insolvent and hanging onto the edge of a financial cliff by Q1 2016.
DB stock: 2012-2016
People have asked how Bernie Madoff was able to escape the attention of regulators for so many years, but in that case regulators never flagged the fraud that was occurring under their noses. In DB's case, regulators have repeatedly flagged problems but have not done enough to either require them to be fixed or to rein in the bank's operations in order to protect investors and the rest of the system.
This is simply inexcusable.
Deutsche Bank holds enough derivatives on its books to inflict serious systemic harm. And it's poised on the brink of collapse, as we can see from its dramatic rise in credit default swaps in early 2016.
via zerohedge.com
Rather than reducing systemic instability, DB's trillions of dollars of derivatives significantly increase fragility and render already illiquid underlying markets far more prone to large price swings -- not only in a crisis but in even mildly volatile market conditions.
This volatility and potential for loss (particularly in leveraged portfolios) has been disguised since 2009 by the central-bank-supported bull market in equities and credit. But that can't last forever.
The system remains grotesquely overleveraged and unprepared for another crisis. When the next market dislocation arrives, as it inevitably will, these derivatives will again earn their reputation as "weapons of mass financial destruction." If counterparties are unwilling or unable to perform, all bets will be off.
In other words, Deutsche Bank could singlehandedly trigger a global "Super Crash."
And you should be prepared.
The Five Inevitable Forces Behind the Super Crash
Inevitability #1: The 30-year "Debt Supercycle" is about to end.
Over the past 30 years, the world has gorged out on debt in a massive "Debt Supercycle." Today there is almost $200 trillion of total public and private debt outstanding in the world, with over $600 trillion in derivative contracts sitting on top of that. An economy has to generate enough income to pay the interest on its debt. And today, the U.S. and global economy does not.
Inevitability #2: The global economy is stuck with sub-par growth.
The reason the global economy doesn't generate enough income to pay its debt is because most of this debt wasn't used to fund activities and assets that generate future streams of revenue. Instead, it paid for unproductive things like consumption, housing, stock buybacks, and financial speculation. The net result of more and more debt was less and less growth.
Inevitability #3: The markets will crash - big.
Since 2009, U.S. corporations bought back more than $2 trillion in stock rather than investing in R&D, new plants, and equipment, and creating new jobs. And in many cases they used borrowed money to do it. When companies run out of their own stock to buy, it will be one sign that the Debt Supercycle is coming to an end with a resounding crash.
Inevitability #4: Central banks won't be able to rescue us this time.
With interest rates barely above zero, and its balance sheet stuffed with debt, the Federal Reserve can't do much more to stimulate growth or bail out markets when they collapse. The Fed has already fatally mismanaged this credit cycle, and negligible 25-point rate hikes won't change any of the underlying issues. Central bank policy has reached its limits.
Inevitability #5: There's geopolitical trouble ahead.
The Cold War is raging across the Middle East, Eastern Europe, and parts of Africa. In the U.S., the southern border is a sieve while America's inner cities are home to intolerable levels of poverty and violence. And in an epic foreign policy disaster, the Obama administration has entered into a nuclear arms agreement with Iran. One spark could set off a deadly chain reaction - and when that happens, markets are going to plunge.
Here's what I recommend.
How to Play the Deutsche Bank Collapse - Updated 7/2016
As always, I prefer puts as a less risky way to play the short side. I'm looking at a couple of puts that are attractive based on current prices. The first has an expiration date in January 2017, the second a year later in January 2018. It's up to you how to play this based on your expectations. In my view both are good bets:
As I write this in July 2016, the DB January 20, 2017 $5 puts are trading at around $0.20 and the DB January 19, 2018 $5 puts are trading at about $0.55. Both are a cheap way to short and very profitable.
Since the beginning of the year, DB has lost over 45% - it's trading at around $12 as I write this. Sentiment around the stock is falling apart and in my view, it could get to $5 very quickly.
Denial is not a strategy for policy-makers, citizens or investors. When a system is on an unsustainable path, it is certain to experience a change in conditions - the only question is when that change will occur and how severe it will be.
While the problems I have outlined are serious, they need not be fatal. The global financial system is resilient and will make the adjustments necessary to deal with an unsustainable growth in debt and inadequate economic growth. But it is not as resilient as it could be or should be and the adjustments are going to be painful.
There are only four ways to repay debt:
In order to deal with the headwinds facing global markets in the next few years and protect their capital, investors need a plan. That plan should involve structuring a portfolio that can generate income and protect capital on both a short‐term and a long‐term basis. While reasonable men and women can differ on the proper portfolio mix, the following is one model portfolio for a typical individual investor based on the state of the post‐crisis world. Investors should discuss their investments with a professional to ensure that their portfolio is suited for their specific needs and circumstances.
My Recommended "Super Crash" Portfolio Allocation
1. Gold, precious metals, tangible assets: 10-20 percent
2. Cash: 10-20 percent
3. Absolute return strategies: 20-40 percent
4. Dividend-paying equities: 20 percent
5. Income-generating securities: 10-20 percent
You can read more about my specific recommendations for investors during the credit crisis in my upcoming book, The Committee to Destroy the World.
In the meantime, stay tuned - I'll have more recommendations for you as we navigate the volatile markets in 2016.
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