When I woke up this morning and checked the headlines, markets were jittery with S&P futures looking down about 1%. The news driving the weakness was that Deutsche Bank’s credit default swaps (essentially insurance nervous bondholders can buy) were moving sharply higher. Immediately, you see this and the inescapable knee jerk thought is, OMG this is contagion from Credit Suisse and this is the GFC all over again taking place in Europe. But by the end of the day, Deutsche Bank’s US listed shares were down only 3% and US equity markets finished slightly higher.

So what happened? Well, there has been some contagion from the Credit Suisse collapse. But, the contagion has come as a result of the resolution. The Swiss National Bank, in their effort to quickly foist CS upon UBS, had to make some hard decisions and concessions. I have no opinion as to right or wrong, but in order to get UBS to pay all of $3B for the equity, they would wipe out more than $10B of the AT1 (Alternative Tier 1) Contingent Convertible Bonds (CoCo’s). These are bonds that supposed to, at some level of distress, convert to equity. That obviously didn’t happen. What happens from here between the SNB, UBS and the creditors will only be good for the lawyers. The issue this inelegant concession created was to scare the hell out of every investor long European bank CoCo’s, which are a meaningful slice of these bank’s capital structures. So these investors start buying Credit Default Swaps to hedge their exposure driving the price higher in an illiquid market. Therefore, DB’s CDS blowing out isn’t really a sign of distress at DB but a sign of junior debt holders who are understandably worried about how they might get treated with this precedent that has been set.

Ultimately, I don’t know what will happen with DB, but by most accounts and to the best of my understanding (I worked there for 5 years fwiw) the bank has plenty of capital. The issue is the lack of growth and profitability.

We have plenty of things to worry about in the US economy with the cost of debt going up and its availability going down, but European bank CoCo’s probably isn’t one of them.

As my Dad says, “Don’t borrow trouble”. Have a great weekend.

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