There is plenty of dysfunction in plain sight to suggest that the financial markets can’t bear the strain of unreality anymore. Between the burgeoning trade wars and the adoption in congress this week of a fiscally suicidal spending bill, you’d want to put your fingers in your ears to not be deafened by the roar of markets tumbling – James Kuntsler, “The Unspooling”
Many of you have likely seen discussions in the media about the LIBOR-OIS spread. This spread is a measure of banking system health. It was one of Alan Greenspan’s favorite benchmark indicators of systemic liquidity. LIBOR is the London Inter-Bank Offer Rate, which is the benchmark interest rate at which banks lend to other banks. The most common intervals are 1-month and 3-month. LIBOR is the most widely used reference rate globally and is commonly used as the benchmark from which bank loans, bonds and interest rate derivatives are priced. “OIS” is an the “overnight indexed swap” rate. This is an overnight inter-bank lending benchmark index – most simply, it’s the global overnight inter-bank lending rate.
The current 1-month LIBOR-OIS spread has spiked up from 10 basis points at the beginning of 2018 to nearly 60 basis points (0.60%). Many Wall Street Einsteins are rationalizing that the LIBOR-OIS spread blow-out is a result of U.S. companies repatriating off-shore cash back to the U.S. But it doesn’t matter. That particular pool of cash was there only to avoid repatriation taxes. The cash being removed from the European banking system by U.S corporations will not be replaced. The large pool of dollar liquidity being removed was simply masking underlying problems – problems rising to the surface now that the dollar liquidity is drying up.
Keep in mind that the effect of potential financial crisis trigger events as reflected by the LIBOR-OIS spread since 2009 has been hugely muted by trillions in QE, which have kept the banking system liquefied artificially. Think of this massive liquidity as having the effect of acting like a “pain killer” on systemic problems percolating like a cancer beneath the surface. The global banking system is addicted to these financial “opioids” and now these opioids are no longer working.
Before the 2008 crisis, the spread began to rise in August 2007, when it jumped from 10 basis points to 100 basis points by the end of September. From there it bounced around between 50-100 basis points until early September 2008, when it shot straight up to 350 basis points. Note that whatever caused the spread to widen in August 2007 was signaling a systemic financial problem well in advance of the actual trigger events. That also corresponds with the time period in which the stock market peaked in 2007.
What hidden financial bombs are lurking behind the curtain? There’s no way to know the answer to this until the event actually occurs. But the market action in the banks – and in Deutsche Bank specifically – could be an indicator that some ugly event is percolating in the banking system, not that this should surprise anyone.
The likely culprit causing the LIBOR-OIS spread is leveraged lending. Bank loans to companies that are rated by Moody’s/S&P 500 to be mid-investment grade to junk use banks loans that are tied to LIBOR. The rise in LIBOR since May 2017 has imposed increasing financial stress on the ability of leveraged companies to make debt payments.
But also keep in mind that there are derivatives – interest rate swaps and credit default swaps – that based on these leveraged loans. These “weapons of mass financial destruction” (Warren Buffet) are issued in notional amounts that are several multiples of the outstanding amount of underlying debt. It’s a giant casino game in which banks and hedge funds place bets on whether or not leveraged companies eventually default.
I believe this is a key “hidden” factor that is forcing the LIBOR-OIS spread to widen. This theory is manifest in the performance of Deutsche Bank’s stock:
DB’s stock price has plunged 33.8% since the beginning of January 2018. It’s dropped 11.3% in just the last three trading days (thru March 23rd). There’s a big problem behind the “curtain” at Deutsche Bank. I have the advantage of informational tidbits gleaned by a close friend of mine from our Bankers Trust days who keeps in touch with insiders at DB. DB is a mess.
DB, ever since closing its acquisition of Bankers Trust in the spring of 2000, has become the leading and, by far, the most aggressive player in the global derivatives market. During the run-up in the alternative energy mania, DB was aggressively underwriting exotic derivatives based on the massive debt being issued by energy companies. It also has been one of the most aggressive players in underwriting credit default swaps on the catastrophically leveraged EU countries like Italy and Spain.
DB is desperate to raise liquidity. Perhaps its only reliable income-generating asset is its asset management division. In order to raise needed funds, DB was forced to sell 22.3% of it to the public in a stock deal that raised US$8 billion. It was originally trying to price the deal to raise US$10 billion. But the market smells blood and DB is becoming radioactive. The deal was floated Thursday (March 22nd) and DB stock still dropped 7% on Thursday and Friday.
Several U.S. banks are not far behind in the spectrum of financial stress. Citigroup’s stock has declined 15.1% since January 29th, including a 7.5% loss Thursday/Friday. Morgan Stanley has lost 11.8% since March 12th, including an 8.8% dive Thursday/Friday. Goldman Sachs’ stock has dumped 11% since March 12th, including a 6.3% drop on Thursday/Friday. JP Morgan dumped 6.7% the last two trading days this past week (thru March 23rd).
If Deutsche Bank collapses, it will set off a catastrophic chain reaction of counter-party defaults. This would be similar to what occurred in 2008 when AIG defaulted on counter-party derivative liabilities in which Goldman Sachs was the counter-party. While it’s impossible to prove without access to the inside books at DB and at the ECB, I believe the primary driver behind the LIBOR-OIS rate spread reflects a growing reluctance by banks to lend to other banks for a duration longer than overnight. This reluctance is derived from growing fear of DB’s deteriorating financial condition, as reflected by its stock price.
The commentary above is from last week’s issue of the Short Seller’s Journal. In addition to well-researched insight into the financial system, the SSJ presents short-sell ideas each week, including ideas for using options. This week’s issue, just published, discusses why Tesla is going to zero and how to take advantage of that melt-down. You can find out more about this service here: Short Seller’s Journal information.