Finance

Michael P. Regan is a Bloomberg Gadfly columnist covering equities and financial services. He has covered stocks for Bloomberg News as a columnist and editor since 2007. He previously worked for the Associated Press.

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

It's no secret Deutsche Bank has struggled with U.S. demands to pay $14 billion to settle mortgage claims from the financial crisis.

So why did the bank suddenly become the center of attention in U.S. financial markets on Thursday? 

Mainly because about 10 hedge funds that are Deutsche Bank clients have decided to withdraw some cash and listed derivatives positions from the bank, according to a Bloomberg News report. Listed derivatives positions refer to things like equity options and futures contracts, not the more esoteric over-the-counter contracts that caused so much trouble in the financial crisis. 

Ich Bin Ein Contagion
News that some hedge funds were pulling positions and excess collateral from Deutsche Bank caused shares of U.S. banks to quickly reverse early gains
Source: Bloomberg data

These funds use Deutsche Bank's prime brokerage to clear their derivatives trades. They post collateral as a sort of insurance in case they run into trouble -- but now they appear to worry Deutsche Bank is the one in trouble. So they are withdrawing some of their derivatives holdings and excess collateral above what Deutsche Bank requires them to hold.

This may sound like a weird reason for U.S. stocks to sell off, led by a plunge in financial shares. But aversion to counterparty risk is the type of thing that threw gasoline on the fire during the financial crisis. Back then, hints that some clients feared doing business with a firm caused a snowball effect by essentially sparking a run on investment banks.

The situation doesn't appear to be that dire for Deutsche Bank at the moment. But it's clear the lender's problems are escalating rapidly. Should the lack of confidence in the bank spread to its global transactions business involving major corporations, then the problem will become more acute, Dan Davies, senior research adviser at Frontline Analysts, told Bloomberg Television. 

Steep Fall
While Deutsche Bank has dismissed some market moves, even its senior bonds are now plunging
Source: Bloomberg

The news has obviously caused a knee-jerk reaction among investors to shed riskier assets such as stocks and turn to safer securities such as Treasuries.

Comparisons to the collapse of Lehman Brothers or Bear Stearns should probably not be taken too far. U.S. banks are much safer now. As a result of regulations passed in the wake of the financial crisis, they aren't running internal hedge funds and proprietary trading desks, and they have much more capital on hand to weather storms in financial markets.  

That's not to say that there's no reason for alarm. The significance of Deutsche Bank's connections to the rest of the financial system can hardly be overstated. The International Monetary Fund put the world on notice in June about Deutsche Bank's importance, saying it may be the biggest contributor to risk among global banks.

The German bank has notional exposure to $51 trillion worth of derivatives, compared to about $49.79 trillion at JPMorgan Chase and $49.83 trillion at Citigroup. No one can really say for sure how much damage would be caused by Deutsche Bank's failure, which was once thought unthinkable but now seems to have a non-zero probability.

Also what remains to be seen is how much concern about Deutsche Bank will spread to other European banks, which aren't in the strongest position. Commerzbank, for example, another big German bank, said Thursday it plans to cut about one in five jobs, its biggest overhaul since its bailout.

Deutsche Bank is caught in a game of three-way chicken. On one side, it's playing with a German government reluctant to bail it out. On the other side is the U.S. government, which may be reluctant to reduce the price of a mortgage settlement. 

Wall Street had appeared confident that some player other than Deutsche Bank would lose this game, as the bank's failure would open a Pandora's box of problems for the global financial system that no one wants to see.

One solution would be for the German government or some foreign sovereign wealth fund to buy a big chunk of equity in the bank, which would severely dilute the holdings of current shareholders, as the shares have plunged to record lows. 

"You're into that trust and credibility phase, where you've been saying all along that you don't need to raise capital," said Charles Peabody, managing director at Compass Point Research & Trading. "Now you're getting to the point where it's getting more expensive to raise capital."

A capital infusion through an equity offering would be painful for shareholders but could save the rest of the world the turmoil of a messy failure of such a systematically important bank.

The bottom line is that someone needs to solve this problem quickly. The fact that some hedge funds aren't taking any chances and slowly backing away from Deutsche Bank is ratcheting up the urgency of this game of chicken.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Michael P. Regan in New York at mregan12@bloomberg.net
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net