Mixed economic data led to weaker stock markets around the world this week. U.S. equities were down around less than 1 percent, while international benchmarks were modestly negative as well. One would expect with negative equity markets that interest rates would have dropped as well, but that was not the case with 10-year Treasury yields rising to 1.73 percent from 1.56 percent.
The Contagion of Scary Clowns
This week we have been following the “scary clown story” with great interest although it seems to be more of hysteria than an actual threat. Allegedly, menacing people dressed as clowns are being sighted across the nation, causing an uproar in various communities. The more attention the story gets in the media, the more scary clowns will be sighted as is seems to feed on itself. Financial contagion can also feed on itself. We have been receiving questions about what is going on at Deutsche Bank and whether the situation will cause a broader contagion akin to Lehman Brothers, which helped to start the great recession in 2008. Deutsche Bank’s stock is down more than 50 percent this year and it is causing some anxiety in the European financial markets. Deutsche Bank was founded 146 years ago in 1870 with approval of the King of Prussia and has $2 trillion in assets. What has happened to this bank that has survived two world wars and the most recent financial crisis is a combination of events that has shaken the confidence of investors. Profitability for Deutsche Bank has been challenged recently due to low or negative interest rates and sluggish growth in Europe. One of the ways that banks make money is to loan out deposits and earn an interest rate spread between the money paid on deposits and the interest earned from the loan. This manifests in a metric called the net interest margin which is the aggregate profits earned by the bank from lending. With negative or zero interest rates this spread gets compressed and the earnings of the bank drop, which in turn causes the stock price to fall.
When a bank’s stock price is in a freefall it erodes confidence in the bank and can cause a run on assets in various ways. Just like the fictional bank in the movie, "It’s a Wonderful Life," depositors can line up to withdraw their assets, causing a liquidity issue. This is not currently happening at Deutsche Bank and we do not expect it to. However, if a bank needs additional capital, a falling stock price can make it more difficult to get the necessary funds via an additional stock sale.
Adding fuel to this fire has been a proposal by the U.S. Department of Justice that Deutsche Bank pay a $14 billion fine to settle charges a surrounding mortgage-backed securities issued by the bank. The alleged wrongdoing occurred as a result of mortgage-backed securities that were issued around the time of the financial crisis and had credit quality issues. While Deutsche Bank has said they will not settle at this amount, it is strange irony that a fine from alleged wrongdoing in the financial crisis is now causing Deutsche Bank additional stress and in turn citing some to question the viability of the bank.
Ultimately, the German Government would most likely step in to save the bank if the crisis at hand deepens. While this would be wildly unpopular in Germany, the bank is indeed too big to fail and allowing it to fail would benefit no one. The upside to this crisis is that it is shining a light on one of the pitfalls of negative interest rates and the European Central Bank is starting to rethink the policy.
Our Takeaway for the Week:
- Slow growth and low rates continues to challenge global banking profitability
- Rates seem to be rising in the U.S. in anticipation of Fed tightening in December
- We are continuing to monitor the situation with Deutsche Bank