re: Deutsche Bank Litigation / Bailout Watch

Not much has happened lately, but here's the news for the day: " Deutsche Bank's Bond Gambit Backfires".

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Let's take a step back for a moment to understand just how significant this is. Since August 2015, developed-market government bond yields globally have plunged almost in half, to an average 0.6 percent. Yields on dollar-denominated bank bonds have dropped on average while those on investment-grade bonds globally recently plunged to the lowest on record. This has been a historically terrific year for bonds and almost anyone who wanted to borrow money.

Blockbuster Bond Year

Most bonds have gained value this year as analysts lowered their economic forecasts.

It's quite different for Deutsche Bank, however. It's getting materially more expensive for the lender to borrow as it negotiates a settlement with the U.S. Department of Justice related to its handling of mortgage-backed securities.

This just showcases how much credibility the bank has lost in credit markets. Its bonds have the highest average yield among the top 50 bank-bond issuers in the U.S. as well as Europe, according to Bank of America Merrill Lynch index data.

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Perhaps what I haven't emphasized enough yet, is how much bigger Deutsche Bank's balance sheet is when compared to Lehman Brothers in 2008, and how much bigger it is relative to the GDP of its domestic economy. See e.g., " How Deutsche Bank is Lehman Brothers and how it isn’t":

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That was my initial guess, but after I sat down to write this column, I realized I had underestimated the importance of Deutsche Bank. Lehman Brothers on May 31, 2008, (the last 10-Q it had filed before it went bust) showed assets on its balance sheet of $639.4 billion and stockholders' equity of $26.3 billion. By comparison, Deutsche Bank, as of June 30, 2016, has assets of €1.8 trillion and stockholders' equity of €66.5 billion. Given the size of Deutsche's balance sheet, it is three times as large as Lehman Brothers was.

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But Germany's GDP is less than 19% of that of the U.S. (about $3.5t compared to $18.6t), so as a Bloomberg article from October 5 (" Deutsche Bank, Lehman and the End-of-Days Debate") notes:

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In 2003, Germany's gross domestic product was three times the size of the assets of its biggest bank. By last year, Deutsche Bank's balance sheet was worth more than half of the entire German economy; put another way, if the Deutsche Bank asset book was the GDP of a country, it would rival Italy's entire annual output:

A bank with assets of 1.8 trillion euros ($2 trillion) shouldn't much care whether the U.S. Justice Department fines it $5 billion, $10 billion or $20 billion. No matter how big the eventual punishment, it certainly shouldn't be an existential threat for an institution of Deutsche Bank's size. The fact that it is testifies to the failure of European banks to sock away sufficient capital for a rainy day.

Part of the problem, though, is that bank accounting statements remain scarily opaque. So no-one really knows what lies beneath Deutsche Bank's headline figure of about 46 trillion euros (yes, trillion) of gross notional exposure to the derivatives market or whether, as my Bloomberg Intelligence colleague Jonathan Tyce calculates, that figure genuinely plummets to just 41 billion euros (still a very big number) after counting pledged collateral and netting off what the bank owes other versus what other owe it.

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So it might not be on par with a situation like Iceland or Ireland, or even the U.K., but its imperative for Germany to rescue Deutsche Bank if necessary, and so Merkel obviously will if forced to do so.

Deutsche Bank is acting much more responsibly than Lehman Brothers did. I admit that it's kind of an apples-and-oranges comparison, but whereas Fuld & Callan tried to sweep everything under the rug and bluff to creditors that everything was fine, Deutsche Bank has been working very hard to spin off subsidiaries, negotiate lower legal settlements, and raise bonds in the capital markets.

The political fallout could feed the populist anti-Merkel backlash already brewing in Germany, and futhermore, prod the ECB to shovel more bailouts to Italy and other southern countries in the name of fairness. All while acrimony between the U.K. and the EU continues to grow, and the GBP continues to sink like a rock.

Europe may be getting closer to raising its own protectionist walls even higher.