“How did you go bankrupt?" Two ways. Gradually, then suddenly." Ernest Hemingway
This week a major focus from financial market participants has been on Deutsche Bank out of Germany. They are the largest bank in Germany and the 11th largest bank in the world. Deutsche Bank is one of the most systemically important banks globally. There is speculation that Deutsche Bank is on the verge of collapsing.
Chart Courtesy of StockCharts.com
Chart Courtesy of Globeadvisor.com
What concerns me most is their $61 trillion in derivatives exposure that is sitting on their books. To put Deutsche Bank’s derivatives exposure into perspective it is important to understand that the world economy is approximately $73 trillion in size. At this point you may be wondering what the heck are derivatives and why should I care? For a relatively easy to understand video on derivatives click here. Derivative contracts involve one or more people (or institutions) and if one party fails to deliver on their obligations a domino effect transpires. The banking system in Europe is in a crisis right now. The EU is mired in debt (like most regions in our world today) and economies are contracting drastically. To make matters worse, political upheaval is intensifying.
When Lehman Brothers collapsed in 2008 they were leveraged 30 to 1. Estimates peg Deutsche Bank’s leverage to be around 40 to 1. The European Union banking system is currently leveraged 26 to 1 and is approximately $46 trillion in size (Source: ZeroHedge & Phoenix Capital) (3 times the size of the US banking system). For years I have been writing about the unsustainable nature of debt in our world. Debt keeps ticking higher as fundamentals continue to deteriorate. This is a process that takes a time to play out. All bubbles eventually pop.
The Thing About Bubbles
There are tell-tale signs of bubbles. All throughout history bubbles have been formed, popped, a depression ensued and then another bubble formed. The characteristics of bubbles are very similar. Group think is one of the key components. Rational thinking is set aside as more and more people crowd into a purchasing frenzy to buy up a sought after item. The value of the said item rapidly increases in price and in the end the price collapses and financial ruin occurs.
In the 1600's, the Dutch experienced what is now called tulip mania. People flocked into buying tulip bulbs. The masses bid up the price of tulip bulbs to prices that were in some cases 10 times the income of a craftsman or worth more than acreage of property.
The history of the South Sea Company is another example of an extreme bubble that occurred in the 1700's. England was deep in debt and had devised a plan to convert debt into equity of a newly created trading company: The South Sea Company. The idea was to create a company that would conduct trade in South America and use the profits to pay a dividend of 6% to shareholders. There was no reasonable prospect that trade would occur, but the company expanded rapidly and the share price moved significantly higher as a herd of people scrambled to buy shares. The bubble eventually popped and fortunes were lost.
In the 1800's, Britain had passed hundreds of Parliamentary Acts to build railways. The masses bought the shares of railway companies and as the price moved higher so too did the number of people buying shares. Over a third of promised railway lines were never built and the bubble popped.
In the late 1990's, the internet was becoming much more accessible to the greater population. Financial pundits and tech gurus described the tech sector as the "new economy". Investors swarmed into any stock that was considered technology related. Initial public offerings were hitting the markets at an unsustainable rate. The valuations of companies, that had no revenue, sky rocketed. Eventually panic occurred and stock prices collapsed as investors sold off worthless shares of soon to be bankrupt companies.
The biggest bubble in human history is building right now. The first signs of this bubble occurred in the US mortgage market and it temporarily wrought havoc to the global economy in 2007 through into 2009. Instead of allowing the bubble to pop; central banks, cheered on by politicians and the media, printed money to keep the bubble from popping. In essence, the powers that be kicked the proverbial can down the road and have allowed the good times to continue for a bit longer.
The thing about bubbles is that the general population moves in concert, embraces a meme and literally buys into an unsustainable set of circumstances. The psychology of people is very fascinating. Insanity can be defined as repeating the same action over and over and expecting a different outcome. Check out this very short clip out of China (Sep 24th) that shows how people scrambled to be able to buy into a new construction development. In the early to mid 2000's there were many TV shows about flipping houses. All of a sudden, everyone was wanting to buy rental properties and fixer uppers to flip. Mortgage standards declined in most countries and people who should not have qualified for getting a mortgage were granted access to mortgages. As you know, when the mortgage bubble popped; home prices dropped significantly in many countries.
Today, if you can fog a mirror, you can be approved for car loans, credit cards and lines of credit. We are bombarded with commercials from lenders that state: "No Credit Check, No Income Verification" "Contact Us For An Instant Loan". Globally, governments are taking the lead and going further into debt. In my opinion, Western culture has become a 'buy now and worry about the consequences later' society. Much of our way of life is dependent on access to cheap credit.
Fiat currency is created through the issuance of debt. We have robbed the future in an effort to enjoy the present. When the good times end the piper will need to be paid. The unfortunate part for us is that it is impossible to pay back the mountain of debt that has been accumulated. Debt defaults and debt monetization will occur at an ever increasing rate.