Bracing for the next financial crisis

Deutsche Bank’s troubles are just beginning

Morici-Column-SigTo listen to Barack Obama and Hillary Clinton, the U.S. economy has recovered miraculously from the financial crisis, and another jolt of left-wing economics will hoist Americans into a new golden age.

Yet, growth remains an anemic 2 percent at best. In Europe, prospects are even worse and downright menacing.

The U.S. Justice Department has proposed Deutsche Bank pay US$14 billion to settle its role in a mortgage securities scandal that contributed to the 2008-09 financial meltdown, and other European banks still await their medicine. Even a settlement one-third that size would require the bank to sell stock to replace lost capital, and it is not well positioned to do so.

The most fundamental problem is that the largest bank in Europe’s largest economy is not run well or very profitably. It keeps dodgy books and has wide interconnections that threaten other banks in Europe and around the globe – including in the United States.

Virtually all European banks are suffering from slow-growing economies and ultra-low interest rates that make moving bad loans off their books tough and earning profits on new loans even tougher.

About 17 percent of loans held by Italian banks are underwater, whereas at the height of the financial crisis the figure for U.S. banks was only 5 percent. The picture is pretty bleak elsewhere on the continent, too.

We are told over and over again, Deutsche Bank is no Lehman Brothers – it can’t pull down the global financial system, because the European Central Bank stands ready to lend virtually unlimited amounts of cash against the bank’s assets.

However, as was the case with Greek banks during their recent crisis, the European Central Bank likely will require the German government to cosign for those loans – that is, underwrite the kind of bailout Chancellor Angela Merkel and her finance minister, Wolfgang Schauble, have railed against. More importantly, many of Deutsche Bank’s assets are derivatives and securities that may not count for much in a crisis.

In the end, Deutsche Bank may have to resort to a “bail-in,” as recent European bank reforms more generally require – namely forcing bondholders to accept much-depreciated stock to replace their claims and take huge losses in the bargain.

As panic spreads among bondholders elsewhere in Europe – and don’t think it can’t – the potential for economic collapse is enormous. In Italy, ordinary depositors have been encouraged to purchase bonds in the manner that Americans invest in certificates of deposits. Similar bail-ins there would impose huge losses of savings and purchasing power, and a contagious recession that could easily undo Europe’s fragile welfare state economy once and for all.

At the core of this mess is Europe’s inability to accomplish meaningful growth and clean up both the books and practices of its chronically shaky banks.

Economic leaders on the Continent and in the United States preach, as if to convince themselves as much as voters, that getting the right mix of monetary stimulus and new government spending could somehow restore more robust growth and eventually return banks to good health.

However, Europe’s extensive and America’s growing social safety nets discourage citizens from improving their skills and filling jobs in emerging industries. Along with governments’ blind faith in free trade, those schemes send investment and jobs to Asia.

Regarding European bank practices, fraud may be endemic as German bank executives appear intent on exporting their bogus practices. For example, former and sitting Deutsche Bank executives were recently indicted by Italian prosecutors for helping Banca Monte dei Paschi, the world’s oldest bank, grossly overstate 2008-12 profits.

In the United States, new regulations require big banks to write living wills that specify how they would sell off assets in a crisis and to build up capital to help cushion the process. But like Deutsche Bank and U.S. banks in 2008-09, most of their assets and capital would prove unmarketable and nearly worthless should the economy turn south.

Mrs. Clinton, quick to ensure Mr. Obama’s legacy, promises even more social programs and bogus bank reforms, and will likely revert to free trade once elected.

We are told the great financial crisis can’t happen again – Deutsche Bank won’t fail and can’t pull down the system.

Brace yourselves. Sooner or later, history repeats itself, and the banks will fail again.

Peter Morici is a professor at the University of Maryland’s Robert H. Smith School of Business. He served as chief economist of the U.S. International Trade Commission from 1993-1995. He tweets @pmorici1.
© 2016, Washington Times