Foreign equities trailed U.S. equities this quarter and the underperformance was not just confined to the drama surrounding Samsung and Deutsche Bank. If you didn’t giggle upon learning that Samsung’s Galaxy Note 7s were catching fire, you had to smile when the U.S. Consumer Product Safety Commission warned that Samsung’s top loading washing machines were exploding. Does unexpected water on the laundry room floor compensate for the unwelcome fire? On a more serious note, Deutsche Bank’s potential inability to shore up their $1.8 trillion balance sheet has begun to shake up the credit markets. With just $60 billion in balance sheet equity to support $1.8 trillion in assets, the thought of the bank losing an additional $14 billion to a U.S. mortgage backed security fine from the Department of Justice has investors, German politicians and trading counterparties highly concerned about the bank’s ability to withstand typical changes in asset volatility. Reminiscent of the Lehman disaster in 2008, supposedly 10 hedge funds cut their counterparty trading exposure to the bank.

Turkeys and Muppets

Speaking of Black Swans, you have to wonder if we as credit and equity investors are not just Turkeys, mindlessly trotting to the food trough after the farmer rings the bell, oblivious to the fact that tomorrow is Thanksgiving. Deutsche Bank’s highly leveraged balance sheet scares me as much as the Bank of Japan’s Governor Kuroda’s comments that there is “No limit to monetary policy” – i.e. he can purchase Japanese Government Bonds in unlimited quantities. It’s worth noting that the highly indebted/leveraged often pay their loans by taking on more debt until such point that they can’t. Thus, it’s all good…until it isn’t. While, I do not know when either Deutsch Bank or Japan will stop being able to repay their loans, I do know that the initial signs of credit concerns have surfaced. This conflicts with Austrian Finance Minister Schelling’s conclusion that the Deutsch Bank situation is not Europe’s Lehman moment due to additional measures put into place by EU bank regulator’s Basel lll to stabilize financial markets.

Don’t Be So Negative

Negative rates and low growth are not only hurting Deutsche Bank, but other German financials as well – underscoring the weakness in the European banking model in which approximately one third of Italy’s loans are in trouble. Commerzbank suspended their dividend and announced job cuts of 25% and Nord/LB is expected to report a loss due to heavy shipping loan exposure. Confronted with this loss and a Moody’s downgrade, Nord/LB, in turn, abandoned plans to sell seven-year euro-denominated notes, citing “market conditions.” While the European Central Bank’s Draghi and the Bank of Japan’s Kuroda defend their negative interest rate policy by claiming it rescued them from deflation, I believe these policies reinforce the pessimism based in the belief that current levels of high debt equate to low growth going forward. Instead of inspiring businesses to borrow, negative rates can harm lenders by narrowing net interest margins, while providing little help on improving balance sheet asset values deep in the economic recovery.

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