DB: end of the beginning or beginning of the end?

So, Deutsche Bank.

Macro Man wrote on Tuesday that he had "yet to hear any of the 2008-style 'x is no longer trading with y' rumours vis-a-vis DB", and while that's still the case yesterday brought the next-worst thing.  The Bloomberg story that around 10 prominent hedge funds had reduced collateral exposure to DB and swept away excess cash suggests that some counterparties are concerned enough to act; one would presume that they are also probably not looking to add fresh trading exposures to DB.

Confidence is one of a bank's most important assets, and once it begins to erode then things can go downhill swiftly.  Deutsche ADRs took a bath in New York after the headlines hit the tape, and while John Cryan may well step up the PR offensive today it seems like only a matter of time before the share price enters the event horizon of the single digit black hole.

Let's be clear, however.  This is not a Lehman moment and will not become a Lehman moment.   For one thing, there is a veritable ocean of liquidity available today through various programs (LTROs, etc.) that were not in place during 2008.  It is therefore difficult to see DB running out of money as swiftly as Lehman did.  More importantly, there has been a change in the structure of the market that makes it more difficult for a systemically-important bank to be as systemically important as Lehman was.

The reason for this is the decline in the velocity of collateral.  When two parties enter into a derivatives transaction collateral is posted, with the size of the collateral changing as the market value of the derivatives contract changes.   Prior to the financial crisis, if a hedge fund (Hedge Fund 1) owned a Treasury bond, it might post that bond as collateral to Bank A when they enter into a swap trade.  Bank A might then take that same bond and post it as collateral to Hedge Fund 2 for another trade.   This is known as "re-hypothecation."  Hedge Fund 2 could post the bond to Bank B, who in turn might post it to Bank C.  After this series of transactions, the bond is still owned by Hedge Fund 1 but in the hands of Bank C.

Now imagine that Bank B was Lehman Brothers.  In this stylized example, If HF1 wants their collateral back, they close their trade with Bank A.   Bank A goes after HF2 for the collateral, who in turn goes to Bank B....but whoops.   Bank B was Lehman, and there are no bonds to be had from them.  So HFs 1 and 2 and Bank A all have a hole now where a Treasury bond should be.  Now multiply this simple scenario by the virtually countless numbers of transactions that Lehman had on its books, and you can see why 2008 was such a disaster.

These days, however, the practice of re-hypothecation is not nearly as prevalent as it used to be, and as we have already seen some sophisticated investors are taking every precaution to safeguard their collateral.  As a result, any failure of Deutsche Bank would not result in the complete freezing up of the financial system that we observed eight years ago.

However, there is a pretty wide gulf between "not Lehman redux" and "pony rides and lemonade for everyone."  Just because DB isn't Lehman doesn't mean that a failure wouldn't hurt, particularly given that other banks are looking ropy on their own accord.   (As an aside, isn't creating phony accounts and charging customers for them a more egregious offense than trying to make money trading on a principal basis with client accounts that actually exist?)

Since February dips have been so shallow that it feels like some punters and observers have been sucked into a false dichotomy of "crash" or "all time highs."   In reality, prices are a continuum, and it would be eminently reasonable for equities to slide further than they've recently done if a major global bank goes to the wall.

Meanwhile, to add spice to short term money markets, Treasury GC repo rates have climbed sharply for quarter end, registering their highest levels since October 2008.   Whether this simply represents a surfeit of Treasuries on the street or is symptomatic of a general squeeze in short term interest rates given the money fund reform is perhaps open for debate; either way it won't do much to help sentiment, particularly if and when DB slides to single digits.

In the end, it is starting to look likely that DB will require (and probably receive) some sort of rescue operation from the authorities.  Whether yesterday's headlines were the beginning of the end or the end of the beginning remains to be seen, but it's worth bearing in mind that the descent into the vortex is rarely slow and measured.