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Deutsche Bank Adopting Monte dei Paschi’s Formula for Insolvency?

Sept. 23, 2016 (EIRNS)—Bloomberg reported in a Sept. 22 column that Deutsche Bank is going to sell synthetic collateralized loan obligations (CLOs) to try to get investors to commit to taking some of their riskier assets off their hands. The move, if accurately reported, represents an attempt to escape the capital squeeze which is bringing the bank to insolvency. Deutsche Bank, as just publicized by the U.S. FDIC, has a capital ratio of only 2.68%—end-of-Lehman level—and is negotiating on a large fine for mortgage securities fraud, which will just about wipe out the 18 billion euros equity capital it has. Probably unable to raise more equity capital, the bank through the gambit reported by Bloomberg would raise "near-capital"—something which regulators might accept to mean that Deutsche Bank has less in risk-based assets, and therefore a better capital ratio.

The something, however, is a very complex derivative contract.

Bloomberg’s column presents the synthetic CLOs as essentially safe complex securities which regulators now want banks to create and issue. Nuts. Deutsche will be paying 11-12% interest—in a zero-rate environment—for this conditional agreement of hedge funds, other banks, other funds, etc. to absorb any losses on riskier assets on Deutsche Bank’s books. That will rapidly increase DBs interest charges which will increase its debt. The buyers of these tranches of CLOs will put up collateral to back their agreement to absorb these losses; and DB will pretend those risky assets should no longer "count" for its suffering capital ratio. But sophisticated counterparties like other banks have shown that they will—and probably can— find ways to devalue the CLOs and run with the collateral when they suspect Deutsche Bank is nearing insolvency.

The danger to the bank is shown by recent history: This derivatives play is similar to what Lehman did each quarter, to shed risky assets from its books at the end of a quarter; and it helped trigger the bank’s implosion. They are similar to the derivatives Monte dei Paschi bought from Goldman Sachs and Nomura Securities, which drove that bank into insolvency and bailout.