Is Deutsche Bank the Next Lehman Brothers?

Yes from an accounting perspective, but central banks won't allow a collapse
September 9, 2016 Updated: September 11, 2016

During the financial crisis of 2008, Deutsche Bank AG was one of the few banks that proudly refused to take bailout money from the government. Eight years later, its stock price down almost 90 percent from the peak, one of Europe’s biggest banks is staring into the abyss.

Similar to Lehman Brothers in 2008, very few if any analysts think Deutsche Bank could go bankrupt. Although investment bank Citigroup rates the stock “high risk,” it thinks the company is worth 13 euros ($14.3) per share, or 18 billion euros in total ($19.8 billion).

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

Reggie Middleton, CEO of the fintech (financial technology) company Veritaseum, was one of the few people who saw the risk and warned about the collapse of Lehman Brothers and Bear Stearns on his research website BoomBustBlog.

Today he thinks Deutsche Bank poses a similar risk to the world financial system, which was almost brought to its knees by the failure of Lehman, although he says central banks and governments won’t let the situation spiral out of control this time.

Reggie Middleton
Reggie Middleton, CEO of Veritaseum, in New York on Aug. 31, 2016. (Oliver Trey/NTD Television)

“Deutsche Bank is the equivalent of an American B-rated horror movie. Not A-rated with the fancy stars like Robert De Niro,” he said in an interview with Epoch Times. “I read the Deutsche Bank balance sheet, and I say Deutsche Bank has an excess amount of balance sheet liabilities, and their derivative exposure is extremely dangerous.”

Derivatives are private contracts among banks or other participants in financial markets. Derivatives help institutions make bets on currencies and stocks, for example, without using a lot of cash.

The Citigroup analysts do mention several risk factors, such as litigation—Deutsche Bank was involved in several banking scandals, including collusion to rig the interest rate benchmark LIBOR—but do not mention the bank’s derivative exposure in their latest report from Aug. 9.

According to the bank’s April 2016 earnings report, the gross notional derivative exposure was $72.8 trillion, or 35 times the bank’s balance sheet.

Analyst or Sales?

Middleton said analysts from big investment banks are limited in their ability to express negative views because they make money through their trading business. Saying that one of the biggest banks in the world will go bankrupt is not conducive to that business.

Middleton has detected another flaw in Deutsche Bank that few people talk about.

“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 salespeople,” he said.

Citigroup analyst Matt King featured this chart in his 2008 report “Are the Brokers Broken” to show that other companies stopped doing business with Lehman Brothers. (Citigroup)

Middleton has detected another flaw in Deutsche Bank that few people talk about. According to him, the bank is overstating the value of collateral behind the loans it is making.

“These obligations have counterparties, but they don’t rate the risk of these counterparties. Because these transactions are backed by collateral, that’s absolutely ridiculous,” he said.

If for example, Deutsche Bank gives a loan to a shipping company and the company pledges ships as collateral, then the risk of the loan increases if shipping prices fall. The process is similar to what happened with mortgages and house prices during the last crisis, and Deutsche Bank should account for it in its annual report.

“You get a house, and we put a mortgage on a house. If mortgages drop in value because they’re not being paid, chances are the house prices are going to drop as well,” he said.

Independent Analysis

Why does Middleton see the things other people don’t? As an independent analyst, he doesn’t benefit from rising or falling securities.

“We don’t have an ax to grind. I could care less whether these institutions shoot to the moon or fall to zero,” Middleton said. “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.”

He said it took his small team of analysts days to go through Deutsche’s 500-page annual report.

Ironically, the last time investment bank Citigroup did something similar, Lehman Brothers went bankrupt a few weeks later, hurting not only Citigroup but also the rest of the global financial system. In a note called “Are the Brokers Broken” Citi analyst Matt King went through the footnotes of Lehman Brothers’ financial statements to conclude that it was too reliant on short-term institutional funding through repurchase agreements.

Furthermore, he found that companies trading with Lehman had started to withdraw collateral from the company at an alarming rate. After his report was published on Sept. 5, 2008, other counterparties started to pull that funding, and Lehman Brothers was bankrupt. Neither the Treasury nor the Federal Reserve intervened to save the company.

(Google Finance)

Chances are that Citigroup would like to avoid repeating the same exercise with Deutsche Bank this year.

Because of the fallout after Lehman, Middleton and other analysts think Deutsche Bank will not be allowed to go bankrupt. “If Deutsche Bank goes, this would break many other banks in the European Union, and not just the banks but insurance companies as well.”

There’s something about single-digit stocks that sound like the pink sheets. You’re not really an investment-quality entity anymore if you’re trading for pennies on the dollar.
— Jeffrey Gundlach, CEO, DoubleLine Capital

Bailout or Bust

Jeffrey Gundlach, CEO of DoubleLine Capital, told RealVisionTV: “It’s pretty clear investors will be on edge with the next down move in Deutsche Bank … I said when Deutsche Bank goes to single digits, that’s when the panic will really be palpable.”

“When Bank of America went to single digits back at the end of 2008 and early 2009 … then they said, we really do have to do something. There’s something about single-digit stocks that sound like the pink sheets. You’re not really an investment-quality entity anymore if you’re trading for pennies on the dollar.”

The pink sheets are lists of stocks traded over the counter that often do not meet minimum requirements or file with the Securities and Exchange Commission.

Middleton thinks a stealth bailout through the European Central Bank (ECB) has already begun, but not without some unpleasant consequences.

“Think of trying to save somebody from drowning by picking them up from the water 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,” he said.

He said the negative interest rate policy of the ECB and its continuous intervention in asset markets saves the bank’s balance sheet but hurts its income. The higher the interest rate, the higher the margins banks can charge for lending money to companies. The reverse is true for zero or negative interest rates.

“Their lending business has minimal margin; they are shrinking. Their transaction business has minimal margin, and it’s shrinking. Their fee business, such as asset management, has minimal margin, and they’re shrinking,” Middleton said.

Even the Citigroup of today picked up on this point. The analysts reduced their earnings-per-share estimate for 2016 by 34 percent, mainly because of a weaker outlook for the transaction-driven markets division.

So if Deutsche “doesn’t have a large amount of equity left” according to Middleton, but the ECB doesn’t want it to go bankrupt, what is going to happen?

“As long as you have insolvent players in the system, you have a value trap where you cannot create economic value in the short or medium term. I suggest short-term pain, so let some players collapse. To prevent a fall, they should simply ring-fence the necessary banking functions. What you would consider utilities, the things that are necessary, just like water, electricity, and heat: savings, checking, basic banking functions.”