Independent Financial Analysis and the Case of Deutsche Bank

Reggie Middleton explains why his process delivers better results than Wall Street and why Deutsche Bank is an accident waiting to happen

Valentin Schmid

To make outsized returns or avoid some nasty losses in investing, you have to go against the grain.

There are few people who live that principle more than Reggie Middleton, the CEO of fintech (financial technology) company Veritaseum.

On his independent research website BoomBustBlog, he called the demise of Bear Stearns, Lehman Brothers, the subprime market, and Blackberry maker Research in Motion, as well as a correction in Apple.

Epoch Times spoke to Mr. Middleton about his unique way of distilling information into useful knowledge, the powder keg that is Deutsche Bank, and why central bank intervention can ruin financial markets.

Epoch Times: You have been very successful in slicing through balance sheets to spot weaknesses in banks like Bear Stearns and Lehman Brothers. What makes you different?

Reggie Middleton: I'm a contrarian: When the whole world goes this way, I by nature go that way. The masses are always wrong which is why you have the famed one percent. The reason why they are the one percent is that they benefit from the mistakes of everybody else.

The average person rarely has access to the information and knowledge that will allow them to succeed in financial markets. You can surf the internet, and you're swamped with information everywhere. Most people can't process information at that level. Even if they could, it's hard to make use of it.

So let's say Amy and Frank are an engineer and a business manager and they can read the Deutsche Bank balance sheet, and they say Deutsche Bank has this much in cash, this much in liabilities, etc.

People understand how to put together the income statement and the balance sheet statement, but they don't understand how that equates to actual corporate value. What makes this entity worth more than that? What makes this entity risky compared to the other?

Reggie Middleton at an interview with Epoch Times in New York, Aug. 31, 2016 (Oliver Trey/NTDTV)
Reggie Middleton at an interview with Epoch Times in New York, Aug. 31, 2016 (Oliver Trey/NTDTV)

All the business schools purport to teach this, and all of the brokers' analytical community groups allegedly report on this. But why is it that we've had, over the past ten years, multiple booms and busts taking almost the entire community by surprise? The real estate market crash, commercial real estate, the banking crisis, the mortgage-backed securities, the euro crisis, which is ongoing.

The reason is: The broker community and academia simply regurgitate management guidance. That's not analysis; that's not knowledge. Basically that's like a parrot. Often they beat earnings expectations only because these expectations were managed down.

So I challenge anybody and everybody in the entire broker community, Goldman Sachs, Merrill Lynch, you name it. I challenge everybody in academia, Harvard, London Business School, Yale: come and get me.

I will name banking institutions that are very likely to fail and say why they will fail. And I challenge everybody else to do the same. I can guarantee you that I will probably be the only taker in this challenge, and I will most likely be the most accurate and precise.

Banking Challenge

Epoch Times: Do you think a lot of people will take you up on the challenge?

Mr. Middleton: It's a trick challenge because most of the sell side and the broker community, I allege, is really marketing and sales for the transaction business behind them. If that's the case, then they can't go against their bosses and their largest clients because then they lose the business.

But if that is also true, they're not analysts; they're sales people. Here's a challenge, prove me wrong.

Epoch Times: I know you haven't named these banks yet, but I know you have taken a closer look at Deutsche Bank. What do you think about the company?

Mr. Middleton: Deutsche Bank is the equivalent of an American B-rated horror movie. Not A-rated, with the fancy stars like Robert De Niro.

If you go through a lot of the European bank reports, a lot of stuff reads like a horror story literally. You read what I have my analysts go through, and I say nobody could have possibly read this without having a lot of worries.

You have thousands of analysts making millions of dollars with staffs of twenty, thirty, forty people and yet this stuff is unrecognized. Deutsche bank's annual report for 2015 is about 420 pages plus appendices, which add up maybe to another hundred and so. It doesn't take four or five hundred pages for any company, no matter how big you are, to explain what they did the year before.

The reason why you have hundreds of pages is it makes it much easier to bury information in the text. It takes my small team of analysts days to go through this for each entity, just reading. And then after going through this for days, they have to go through the notes and run calculations.

Not everybody has the wherewithal, the ability or the time and resources to do it. But those entities who are tasked and paid to do it should do it.  What entities am I talking about? Rating agencies, analysts, brokers, hedge fund managers.

I look at it, and I'm in shock. We don't have an ax to grind. I could care less whether this institution shoots to the moon or falls to zero. So, we're very objective, very analytical, and we do deep dive forensic research. The old-school fashion where we go through and read through every footnote. We build our own models from scratch and we don't rely on any outside interpretation whatsoever. We look at something, and we get a totally different result or perspective than practically the rest of Wall Street.

Deutsche Bank Example

Epoch Times: What are some of the specifics you have seen with Deutsche Bank?

Mr. Middleton: Deutsche Bank's accounting interpretations are ridiculous. They have certain assets, loans, and obligations that are backed by collateral.

These obligations have counterparties, but they don't rate the risk of these counterparties, and they don't adjust the valuation of these transactions. If you have a transaction with a medium sized business that's in the shipping business. Okay, and we back it with collateral, let's say ships.

Now if the shipping business declines in activity, then the assets of the shipping business are going decline in value. It's common sense because the business, the industry is worth less. When shipping activity increases, the assets behind the shipping business, ships, etc., increase in value. 

The same thing goes for almost any other business or asset. We put a mortgage on a house. If mortgages drop significantly in value because they're not being paid, chances are the houses are going to drop as well.

Deutsche Bank is saying there's no need to change their risk rating for counterparties or adjust any valuations because it's collateralized.

(Google Finance)
(Google Finance)

So this circular argument has no basis in economic reality. It's is one of the many instances that Deutsche Bank is most likely overstating value without anybody picking it up. 

Other instances are they're taking losses on derivatives which they're putting on a statement and admitting through reporting, but again it's not being admitted to the media at all. I don't see it in too many reports.

They went through several C.E.O.'s. When top management changes and then changes again, that's a problem. These are three small problems out of easily a dozen.

Epoch Times: When will those problems come to the surface and wipe out the rest of the equity the bank still has?

Mr. Middleton: I don't think Deutsche Bank has a large amount of equity left at all. From an accounting perspective, it's malleable because it's a matter of interpretation.

Deutsche Bank is running out of space. Their operations are becoming less and less profitable, their fee operations, their trading and transaction operations. Actual banking has not been profitable for a while because their macro environment is immersed in negative interest rates.

So if you are a bank, and you make money making loans, and you can charge but so much for the loans, then you can only make but so much money. So their lending business has minimal margin, they are shrinking, their transaction business has minimal margin, and its shrinking and their fee business has minimal margin and its shrinking. Combine that with the fact that the macroeconomic environment in Germany, which is their largest market, is also shrinking.

Contagion Effect

Epoch Times: Can that affect other institutions in Europe?

Mr. Middleton: I am very bearish on the E.U. financial situation. You have significant contagion risk. If Deutsche Bank goes, this would reverberate through many other banks in the E.U. And not just the banks but insurance companies as well because any entities that rely heavily on fixed income will have significant contagion, spill over risk in and out. Deutsche Bank is ground zero for a kaboom.

So counterparties are all wary of Deutsche Bank. The European Central Bank [ECB] is backstopping Deutsche Bank almost guaranteed and they also say they have lassos out to save Deutsche Bank from drowning.

The negative interest rate policy is there to keep the banks afloat. They're lifelines where the banks can borrow money from the ECB and get paid for borrowing money.

When you do that you save the bank's assets, you save the balance sheets, but you destroy the income statement because the banks can't make money lending in a negative interest environment. 

So, think of trying to save somebody by picking them up from the water by their neck by their throat so you get them out of the water so they don't drown immediately, but you suffocate them over time because they can't breathe and that's what's happening with European banks.

Now as counterparties lose confidence with Deutsche Bank, the ECB says we'll step in as lender of last resort. That works until enough counterparties leave or until the other counterparties get into trouble. The ECB, even though it's attempting to, cannot be the entire market. Right now the ECB is the buyer of last resort and the largest buyer of European sovereign debt.

Epoch Times: They are also buying corporate debt. What effect does this central bank intervention have on markets?

Mr. Middleton: The fact that a central bank will buy private debt is ridiculous. Why is this justified? Are they looking for price stability? Price stability is very different from price control.

It seems absurd to me. Maybe there's information I don't know; I just don't get it. But at the end of the day, you can stabilize prices on corporate debt by buying all of it. But at what point do you have a market? In a market, you usually have several participants, and they are buying and selling from and to each other.

In Europe, you have several participants, and they all sell to the central bank. And the central bank is not using true economic value; the central bank is digitally printing money to buy these assets, so they are creating nano-money to buy the assets, but the economic value was never there.

Economic value cannot be created by the central bank. Economic value can only be created by men and women who work at the E.C.B and create things and sell things like services, widgets, products, etc. That is the only way to create economic value.

So instead of creating more economic value they are debasing the value of the Euro, making it worth less and less, and that's exactly what happens when they print money.

They're stuck in a circular value trap now because they have to flush out the bad parts of the system, which will, of course, drag many of the banks down, which the ECB apparently does not want to happen.

So as long as you have insolvent players in the system, you have a value trap where you cannot create economic value in the short to medium term.

I suggest a shorter solution so let the players collapse. In the longer term they collapse because the ECB can't save them. In the short term, the ECB could allow anything that is not truly self-sufficient and solvent to go.

An Alternative Solution

Epoch Times: How would you manage that situation?

Mr. Middleton: Now there has to be some regulatory and government intervention. Or it doesn't have to be, of course. For two thousand years banks have been going out of business, and every day the sun rose.

But if the ECB wants to keep its semi-dominant position in the world order where Europe is behind the United States but Europe is competing with Asia, they don't want true market forces to come into play.

So to prevent a fall, what they should do is simply ringfence all the necessary banking functions. What you would consider utilities, the things that are necessary, just like water electricity and heat. Ringfence savings, checking, credit cards, basic banking functions.

All risky transactions are simply out to the market. When you do that, the market automatically attributes a higher risk factor to them, and they have to pay more for their money.

It makes the businesses much more responsible cause they don't take the outsized risk, because they have to pay eighteen percent for the money versus one and a half percent that the ECB charges.

Now if you have to pay eighteen percent interest, you're not going to do any business on a risk-adjusted basis that gets you ten percent, eleven percent. So the banks are doing business that might net twenty-five percent. But there may be a 15 percent risk attached to it, so it nets out to 10 percent. If you pay eighteen percent, that's an economic loss.

That's the type of thinking that all bankers in all businesses should do. That's the type of thinking that businesses do if they have to survive on their own without corporate welfare life support from the ECB. But when you have corporate life support and welfare, then you don't need to think regarding revenue minus cost equals profit, because there is no cost. Money's free. So, revenue equals profit because I have no expenses, the ECB carries it. 

The market is gone. Market manipulation is the way of the day now. The ECB has destroyed European markets, absolutely destroyed it.


Valentin Schmid is the business editor of the Epoch Times. His areas of expertise include global macroeconomic trends and financial markets, China, and Bitcoin. Before joining the paper in 2012, he worked as a portfolio manager for BNP Paribas in Amsterdam, London, Paris, and Hong Kong.