Banking Collapse on the Horizon

“History doesn’t repeat itself, but it often rhymes.” Probably not Mark Twain.

In the face of the most recent election it seems almost ludicrous to talk about anything other than Trump per-se, and I promise I’ll make my way back to him soon. However, something ugly and possibly inevitable (regardless of who was elected) may be looming on the horizon, an economic collapse. There are many dire indicators for the economy including commodities shipping hitting its worst slump in decades, household debt seems to have set itself at a persistent 78% of GDP, and national foreclosure filings spiked 27% from September to October, but the most troubling problem looks to be a 2007 style banking collapse. This impending collapse has all of the same features including risky underlying assets, wildly over leveraged banks, and even what looks like widespread accounting control fraud.

Deutsche Bank appears to be the worst offender in terms of generating systemic risk for the world’s economies, but it’s worth noting that it appears unique mostly in scale rather than behavior. Right now the bank is disputing the full sum of a $14 billion fine from the SEC for mortgage fraud, a type of fine that many major banks including JP Morgan, Bank of America, and more have payed. However, most banks payed the fine as a way to avoid possible criminal proceedings and admissions of wrongdoing, Deutsche Bank isn’t.

If a bank is disputing a fine it usually means one of two things. Either the bank doesn’t believe that they have committed any or sufficient wrongdoing to warrant the fine, or the bank is facing solvency issues. The second possibility appears to be the case.

As Reuters reports “Politicians in Germany are watching developments nervously. Worries that a large fine would cripple Deutsche have prompted German officials to lobby Washington officials to be lenient. “ One of the famous features of the 2007 crisis was that politicians the world over seemed to have no knowledge or foresight of the fragility of the banking sector. If German politicians are preemptively talking about bailouts (Germans are notoriously opposed to government bailouts) alarm bells should be ringing. This issue is further complicated by the bank potentially facing another $9 billion in charges for money laundering.

These solvency issues are more troubling than Reuters is letting on. A paper from the Treasury Departments Office of Financial Research shows that Deutsche is likely to be misrepresenting its financial health to the tune of $170 billion by using a form of accounting trickery called the Lehman Repo 105. This financial deceit works by selling assets on to repo markets with re-buy agreements so as to make the bank look much better capitalized than it actually is. Essentially it would be like the average citizen selling their house before applying for a loan so that they would appear to be solvent then buying back the house the day after the loan was cleared. This trick was instrumental in Lehman hiding it’s huge capitalization problems up until the brink of the financial crisis in 2007 and it would be of no surprise if the if Deutsche was doing the same right now.

It’s worth noting however, that this paper isn’t saying that this sort of accounting control fraud is isolated to one bank, but instead, the $170 billion figure is the average amount of fraud committed by many banks simultaneously, Deutsche just appears to be the worst offender in terms of leveraging behaviors. This is all profoundly ugly, and as the late great Billy Mays would say, “But wait, there’s more!”

Deutsche bank is sitting on roughly $50 trillion in derivatives. A few percentage points of lost value on derivatives on a heavily leveraged banks books is enough to render a bank insolvent, and right now, if the bank’s woes over a $14 billion fine are any indication, Deutsche is one such bank. As professor of political economy at Brown Mark Blyth routinely mentions, “When the 2007 crisis hit, the combined assets of the six largest banks in the united states represented 61% of GDP.” Right now the German Economy has a rough GDP of $3.73 trillion, the entire Eurozone has a GDP of roughly $13 trillion, the entire worlds GDP is around $73 Trillion, and Deutsche is sitting on a derivatives bomb of $50 trillion.

This gets uglier if one looks at the whole Euro Zone. Mark Blyth stresses major British banks have asset pools equal to about 530% of GDP, French banks have asset footprints that are about 450% of GDP, and the list goes on. Even more frightening still is that these asset figures don’t include derivatives. Even worse still is that much of the basis for these assets and derivatives includes real estate markets and Eurozone bonds. Foreclosures are high and the real rate on many bond yields have turned negative.

So let’s take some time to sum this all up. Deutsche can’t afford $14 billion in fines (let alone a potential additional $9 billion for money laundering). Deutsche along with many other systemically crucial European banks are probably lying about $170 billion each on their recorded books, derivatives which are even more dangerous still don’t have to be reported on asset/debt profiles, and to top it all off there is a pile of potentially explosive derivatives valued by some at around $550 trillion (compared to a world economy of about $73 trillion) lodged in the collective banking colon of Europe. This is not encouraging for a world economy that is still suffering from the damage wrought by the collapse of the comparatively insignificant Lehman in 2007.

How Deutsche and the greater financial system extricate themselves from this situation is anybody’s guess at this point. Banks are being continually fined for fraud, lending is sclerotic, foreclosures are up, wages are stagnant, and at the center of it all is the Ouroboros of derivatives that the financial sector is growing with no heed to the systemic risks it poses. As the whole edifice seems to be ready to crumble the CEO of Deutsche bank is complaining about the damage speculators are doing to its share prices. Pot, meet kettle.

The original of the image above is courtesy of “© Raimond Spekking / CC BY-SA 4.0 (via Wikimedia Commons)”