55% Gains From The Scariest Thing a Politician’s Said This Year
The scariest words uttered by any politician this year didn’t come from either Hillary Clinton or Donald Trump.
Rather, they came from 3,000 miles away and they stopped me in my tracks.
Madam “No” Has Spoken
The United States Department of Justice announced last week that it’s seeking a record $14 billion penalty against Deutsche Bank related to mortgage securities fraud leading up to the global Financial Crisis that has roiled markets since 2007.
Ordinarily, that’s nothing serious.
Unbeknown to most investors, regulators charge banks and financial institutions with rules and policy violations all the time. Most are quietly settled after a bunch of legal wrangling and never see the light of day.
In this case, though, we’re talking about a $14 billion penalty at a time when the bank has litigation reserves of only €5.5 billion. That means the bank hasn’t got enough money on hand to even pay just the penalties sought by US regulators as they stand today.
According to The Guardian, the bank is actually fighting more than 7,000 legal cases, including a particularly nasty set of “mirror” trades in Russia where it’s alleged that the bank circumvented international sanctions against Russia by simultaneously buying and selling shares inside and outside of that country – a move referred to as “mirroring” because it turns Russian-held rubles into U.S. dollars.
As bad as these things are, they pale in comparison to what actually stopped me cold.
Over the weekend, German Chancellor Angela Merkel told Focus magazine there will be no bailouts if Deutsche Bank goes down.
Deutsche Bank has more than $42 trillion worth of derivatives on its books. With a capital “T.”
To put this into perspective, Germany’s Gross Domestic Product, or GDP for short, is only €3 trillion. The entire EU has a GDP of only €14.6 trillion.
No bailouts means Deutsche Bank hits the skids. It also means Italian, Spanish, and French banks are next. Then the EU, and when that’s run its course, US banks.
My point is that Lehman Brothers was a sideshow compared to what could happen with Deutsche Bank, because it is deemed “systemically” important.
Never mind that that’s a euphemism created by bankers who want you to believe that Deutsche Bank is so essential to the German financial system that it cannot be allowed to fail. What it really means is that regulators have no idea how to quantify the risks.
And that’s what stopped me in my tracks.
I have argued forcefully since the Financial Crisis began that the markets have rallied because of central banking support and NOT on their own merits, as delusional politicians and central bankers around the world would have you believe. I’ve also repeatedly recommended that you avoid the financial sector because they were but “one comment away” from financial oblivion.
I think Merkel’s just made “that comment.”
By saying that she’s not going to bail out Deutsche Bank, she has singlehandedly put the entire global financial system at risk while also demonstrating a complete lack of understanding with regard to how the global financial system actually works.
Again, we are talking about a bank with $42 trillion in derivatives exposure and a bank that is linked to nearly every other bank deemed systemically important, according to the IMF.
Naturally, CEO John Cryan doesn’t see things this way. He’s repeatedly insisted to anybody who would listen that the bank’s balance sheet is “rock solid”.
Yeah… if you consider hiding trillions in counter-party risk acceptable.
German banks do not get to “net” positions like US banks do. This means that their exposure is orders of magnitude higher than other global peers.
Say, for example, a DB trader is long a Euro contract with Citi but another is short the very same trade with JPMorgan. A US bank could net the exposure between the trades under the International Swaps and Derivatives Association agreement which US courts have recognized as being a valid accounting methodology. But a German bank – i.e. Deutsche Bank – would have to mark one side of the trade or the other as “exposure,” but not both.
If you’re on the right side of the trade, this is an asset… but get things wrong and you’re talking about unsecured liabilities that count against you as is the case here.
In fact, I called attention to this very scenario on April 10, 2015, when I put forth a list of top banking stocks to short because of their wildly irresponsible behavior with derivatives. I even went so far as to label Deutsche Bank as my No. 1 “Banking Stock to Drop.”
Since then, the stock is off 55% and any investor following along is laughing all the way to the proverbial bank… just not Deutsche Bank, I trust!
Now let me tell you what’s next.
I brought this trade to your attention at a time when Deutsche Bank and its problems were back page news, and very few people recognized the potential we did.
Now, though, it’s front page news and that means everybody knows about the trade. So there’s no sense in playing it further, nor is there an exploitable advantage even if the stock tanks from here.
Instead, think about establishing a speculative “short” against the United States banking industry, which, unbelievably, most investors believe is immune to any crisis “over there” – as in the Deutsche Bank situation, which they perceive as a largely European and German problem.
There are a couple of easy ways to do this.
Shorting individual banking stocks is the most straightforward. However, that requires gobs of margin, strict risk management discipline, and some real guts. Survival is the most basic of all instincts, and that means the trade could spiral out of control in a real hurry.
I can think of a couple of ways that could happen. For example, Merkel could change her mind or Yellen could counter by saying she’ll back everybody “just in case.” Either way, banking stocks take off like a rocket, causing a “short burn” and a good deal of financial pain for the unprepared.
More sophisticated investors could purchase put options or even sell calls or call spreads that accomplish the same thing. This involves limited margin and, depending on how you do it, somewhat structured returns.
If you’re inclined to paint with a broad brush instead of the two laser-like alternatives I’ve just outlined, consider buying the ProShares Short Financials ETF (SEF), which provides unleveraged exposure to the Dow Jones US Financials Index. It’ll appreciate as financial stocks decline.
I’d stay away, though, from the leveraged alternatives that also short the financial sector because tracking error could really eat into any potential returns while you wait for the stuff to hit the fan.
As always, pay very careful attention to 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.
Until next time,