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According to Wikipedia, Oktoberfest is the world’s largest beer festival and funfair. It is held annually in Munich, Germany from mid or late September to the first weekend in October. It’s been held since 1810 with current attendance around 6 million people per year.
This year the normal schedule just won’t do – it needs to be extended. After all, if there was ever a time that we needed more beer, it’s 2016. The U.S. presidential election, Brexit, negative interest rates and the disappointing New York Jets are just a few of the maddening events that we are suffering through.
Of course, Germany (and Europe) are facing similar election woes and economic challenges of their own. Italy has an important referendum upcoming which may result in more momentum for dismantling the EU. On top of this, the banking system received another bruise when new worries arose over Deutsch Bank’s financial condition. How do you say “another round, please” in German?
The financial fragility of global banks has been a market and regulator focus since the financial crisis. So at some level there is an awareness of the risks associated with the world’s financial institutions. The latest developments surrounding Deutsch Bank involve a U.S. Justice Department fine, which is expected to be negotiated lower, and renewed worries over continued margin deterioration because of the widespread negative interest rates across Europe.
As part of this latest market indigestion, Wall Street vexed over Deutsch Bank’s portfolio of derivative instruments. Common derivatives include options, futures, forward contracts, and swaps. The general purpose of these is to hedge risk, but some traders use them for speculation. Derivatives commonly enable the buyer to establish an investment position linked to another asset or investment for a much smaller dollar amount. This is the leverage component common to most derivatives.
According to Deutsch Bank’s 2015 annual report, their derivative book totaled €41.94 trillion ($46.994 trillion). As a point of comparison, 2015 German GDP totaled €3.032 trillion. This €42 trillion measures the notional value or the amount of the underlying asset (stock, bond, etc.) that the derivative contract represents. The actual invested capital is a fraction of this amount. It is likely that a high percentage of Deutsch’s derivatives are used to hedge interest rate risk – a large risk for any lending institution. Also, the amount of Deutsch’s derivatives has fallen from €59.195 trillion in 2011.
This is not to imply that the markets’ anxiety over these derivatives is misplaced. In addition to size of this portfolio, some of the positions as well as the underlying assets are illiquid and hard to value. This could be a problem if markets were to encounter future disruptions.
Another risk is counterparty risk. Some derivatives are not traded on an exchange but are contracts between two financial institutions. In these situations, there is risk that one of the parties in the contract is impaired and unable to deliver their part of the agreement.
In the case of Deutsch Bank, the size and breadth of their global operations could result in systemic fallout if they could not honor their derivative positions. If this happened, it might impair other organizations who then could not fulfill their contracts which could damage their counterparties. It is hard to predict how far the damage would travel if Deutsch Bank were to fail.
Keep in mind that Deutsch Bank is just one bank with this issue as many other financial institutions have similar sized derivative books. An important difference, however, is that the other organizations are better capitalized to withstand problems. The worries with Deutsch Bank is that they can’t raise capital at a reasonable cost and that negative interest rates are squeezing their profit margins. The recent dialogue has centered on possible bailouts if that is needed. The German government originally pushed against this but has softened their opposition.
While Deutsch Bank’s problems have weighed on the markets, U.S. stocks have chopped sideways in a narrow range and moving from one end to the other in a single day. Since the Dow’s 395-point drop on September 9th, we have had 3 daily moves exceeding 200 points and 6 days + or – 100 points. In the meantime, the Dow has traded between 18,000 and 18,400.
This frustrating back and forth bounce seems to be a function of a lack of investor commitment ahead of the U.S. elections. No one wants to take positions for more than a few hours let alone a few days. Seemingly, no one wants to be left holding the bag.
Also, it could be related to the large influence of computer trading. Algorithms play a big part of the current trading landscape and their approach is largely short-term, trend following. For the time being, this environment is unlikely to change.
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