Traders of bank obligations must determine the rule book by which each bank plays. Do not buy the presently screaming Credit Default Swaps (CDS) of some Deutsche Bank (NYSEARCA: DB) debt. These CDS´ are a bet that Deutsche Bank debt will default. The debt will not default.
Banks play by one of two alternative sets of rules. Some play by global rules; some, by local rules. Bank of America (NYSE: BAC), Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), JP Morgan Chase (NYSE: JPM), Morgan Stanley (NYSE: MS), and Wells Fargo (NYSE: WFC) play by global rules. The Continental European large banks play by local rules, but pretend to play by global rules.
But in reality, DB debt will not default since Deutsche Bank, unlike real global banks, will not be permitted to default. Dump those Deutsche Bank CDS if you can.
Banking by global rules is highly lucrative and very risky. But banking by global rules is extremely productive, at its best. In two previous articles, here and here, I argue that the risky global financial system is the central mechanism by which most important commercial innovation is funded.
Global Banking at Its Best.
But I also argue that these global banks can, and inevitably do get it wrong, with devastating consequences. I also lament the absence of competition for these banks. The global banks can be particularly toxic when they are without competition from passive foreign banks that simply buy the offerings of global banks without due diligence of their own.
Global Banking at Its Worst.
Furthermore, global bankers are single-minded entrepreneurs under stress. They are often not likable.
But the global bank bashers, such as Bernie Sanders, by their stereotyping of some of these productive participants in the financial system - risk a return to the economic-value-destroying doldrums of the post-World War II, pre-1970, system.
Banking global pretentiousness by bankers who play by local rules, on the other hand, is not productive. But banking pretense has a benefit. The debt of banks that play by local rules will not default.
Every now and then I am shocked to discover that the money Continental European banks pour into their efforts to pose as global financial institutions, such as apparent compliance with the Basel Accords, creation of large investment banking operations, joining of derivatives clearing houses, and other inherently dangerous activities, is heeded by investors. These pretenses bear fruit.
Investors mistake local rules banks for real global banks. I am not so surprised however, that the fruit is usually poisoned.
The current poison fruit of Continental banking pretense is the skyrocketing price of Credit Default Swaps on Deutsche Bank debt. Buying these CDS', or securities linked to them, is not a good plan.
Deutsche Bank CDS Prices.
This article warns off bets against Continental European bank debt. The debt will perform.
But the high profile days of the Continental dealing banks may be at an end. There is a single reason for both predictions. These banks' governments have an implicit, irrevocable, commitment to the banks' solvency from their governments.
But these governments are learning something. The Continental banks cannot imitate the wheeling, dealing - highly productive - operators of the US (Maybe the UK. It is too soon to say just how hard the regulatory whip will fall on dealer banks in the UK) without risking extinction. And the Continental governments do not intend to risk the extinction of their flagship national banks.
Somehow, the governments of Continental Europe misunderstood the reality of banking in the UK and US until quite recently. That reality is symbolized thus: the names of the large US banks are familiar, but a cursory glance at the history of these banks tells you that the future of a global dealer bank is not as safe as its unchanging name suggests.
Bank of America is more aptly named North Carolina National Bank. Citigroup should be named Shearson. JP Morgan Chase, Bank One of Ohio; Credit Suisse, First Boston; Deutsche Bank; Banker's Trust, HSBC (NYSEARCA: HSBC) is Hong Kong Shanghai Bank, a Chinese-headquartered bank that lost its home because of the Communist Revolution.
The point is, the names of the dealer banks are stable, not the dealer banks themselves. When two teetering banks merge, they adopt the coolest name, not the winner's name.
A DB Credit Default Swap is a bet on a DB default. Betting on this default is dumb for many, many reasons. Let me list my two favorites:
- An event of default occurs only if the International Swaps Dealers Association says it does. The votes for default are cast by Deutsche Bank and several other dealer banks. Won't happen.
- The German Government would be presiding over the default of the nation's only remaining important financial institution. Won't happen.
I can't imagine who is making this bet, but I wish them good luck. It would be good for the financial system's long run health if there were real global banks on the Continent. The financial system would be far more efficient. But don't be confused - DB is a government agency in dress-up banking clothes, playing by local rules.
Confusing DB with a real global bank misses the fundamental fact of life for employees in the global banking business since the end of Bretton Woods. Real global bankers are in a voluntary fight for their financial survival. Granted, the financial prize if you survive this business is huge beyond all reason, but few individual bankers last the 20 years necessary to make the money one reads about - at least in real banks.
At Deutsche Bank, no matter how many mistakes and crimes are committed, the bank will survive. There will be local rules for at least two large French banks, two British banks, a Swiss bank, and a German bank for the foreseeable future. These banks' governments will never permit them to fail. The banks may be nationalized from time to time. Embarrassing, but not life-threatening. And the debtors will be paid.
And that is why Continental European banks will never be real, modern banks. In the Darwinian world of capitalism, if you are a bank that cannot fail, you simply do not face enough stress and competition to produce the next big idea. Therefore, you cannot succeed as a real banker. (Yes, OK. There are a few total dolts who do last the necessary 20 years employed by a real bank to hit the jackpot. There is luck. There is politics.) But outside this crucible, the risk-taking needed for real innovation doesn't happen.
American bank bashing, never out of style, has once again become a favorite sport in the United States. It has produced the winner of the Democratic Party primary in New Hampshire. Don't doubt the virility of this point of view.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.