Whither Europe? Towards The German Banks

Includes: DB
by: Michael Shulman

This weekend another non-event will take place in Europe. France and Germany, Sarkozy and Merkel, will agree to disagree, will say everything is moving along, and the political situation will be a bit worse by Monday – and it is the worsening of the politics of the European debt crisis that is now driving this crisis. And over time that means Germany decides, and what it will decide is that its banks need more money, some of it from private investors.

The entire mess was best summarized in a piece in Friday’s Wall Street Journal. Simply put, the resolution of the debt crisis is in the hands of German voters “tired” of bailing out “those profligate Greeks.” What they're really doing and will be asked to do, in code or in secret, is bail out their own busted banking system.

Germans, you see, those paragons of virtue, frugality and money management, have prospered in part due to the bloated and now unsustainable balance sheets of their banks. These balance sheets are not only opaque; when you get a glimpse here and there you realize they still hold their fair share of toxic assets never written off, they hold pounds and pounds of sovereign debt, they hold pounds and pounds of bank debt of banks exposed to the sovereign debt crisis, and they hold each others’ bonds. I am being vague about numbers because they are as well.

So forget my numbers – let’s start with some numbers from people who know more than I do (supposedly) – the German Institute for Economic research. They recently published a report stating German banks need $175 billion in new capital. This is the number they say would be needed to raise their equity capital to 5% of the assets they hold on their balance sheet.

What if they needed to increase their equity ratios to, let’s say, 8%? That $175 billion becomes $280 billion. That is more than twice what the nine largest US banks were forced to accept from Hank Paulson when he began to dispense TARP money. And since the Germans like to brag – truly – about how conservative they are, what if they wanted their system to compete with the “World’s Safest Banks” as reported by CNBC? Double that $280 billion to more than half a trillion.

Interesting. What to do? Assume some bank re-capitalization will take place. Assume the German taxpayers will eventually break through the coziness between German politicians and banks and the banks will partially re-capitalize with private money. And the big boy, Deutschebank (NYSE:DB), is gong to have to raise money and dilute shareholders as well as sell off assets, reducing future profits. Translation – buy longer term puts on DB; in my view, the stock is worth no more than $20 on a good day.