Deutsche Bank’s “American Twin” Is Stockpiling Derivatives. Here’s How to Profit

If you’ve been following our DB trade, you’ve made 277% or more – and you still have a chance to profit. I think the embattled, derivative-ridden monster is headed down to $5, and you can get my latest put recommendations here.

Deutsche Bank stock is now trading at a 30-year low, and was recently called the world’s riskiest financial institution by the International Monetary Fund (better late than never!). In a last-ditch effort to save itself, DB is trying to dump a bucketload of credit derivatives (the murky, risky financial instruments that triggered the 2008 financial crisis).

You would think no one would buy these weapons of financial mass destruction…but you’d be wrong.

There is always an idiot in the bunch.

In a staggeringly stupid move, this American bank has gone on a derivatives shopping spree, eagerly taking credit default swaps off the hands of failing Eurozone banks like DB and Credit Suisse.

That means, of course, another outsize short opportunity for us…

Citigroup Apparently Didn’t Learn Its Lesson In 2008…

Citigroup Inc. (NYSE:C) already nearly destroyed itself with derivatives during the 2008 crisis, requiring the biggest taxpayer bailout in history in order to stay afloat. Strangely, it didn’t learn its lesson the first time its stock fell below $1. As rival banks see the writing on the wall and scramble to get rid of their derivatives, Citi is now cheerfully snapping up billions of dollars’ worth. Several weeks ago, Credit Suisse prudently sold $380 billion of derivatives to Citi, thereby reducing its own leverage exposure by $5 billion. Last year, Deutsche Bank palmed off $250 billion of credit default swaps on (guess who?) Citi, and is in talks to get rid of even more.

The result is that Citi now holds the most derivatives of any of its U.S. rivals (a staggering total exposure of nearly $56 trillion, according to the OCC’s latest report).

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Bizarrely, this is a strategy that Citi has been pursuing for some time. Three years ago, the bank separated its derivatives and cash traders and created dedicated derivatives teams – including a “risk optimization” team led by Vikram Prasad, who explains, “You can’t have every trader obsessing over every capital measure. By giving that responsibility to a dedicated team, we’re using our resources in a more efficient way.” Right.  While acknowledging derivatives are so risky as to require a large stable of dedicated handlers, Citi continues amassing and championing them. “We consider single-name CDSs to be an integral part of our overall credit business,” says Brian Archer, Citi’s New York head of global credit trading. “A large number of our biggest clients still want to trade the product and use it to move risk. We have the appropriate resources in place to service that demand.”

In other words, they’re playing with explosives and they’re proud of it.

Never, Never Play with The Derivatives Monster

There are numerous reasons why Citigroup’s derivatives stockpile is likely to blow up in their faces. I’ve detailed many of them here and here.

A derivative is a contract involving two parties that agree to make certain payments to each other. But if one party is unable or unwilling to live up to its agreement and make those payments, the other party is left holding the bag (and nursing a big loss). That’s what happened in 2008.

In 2008, AIG almost blew up because it wrote too many derivatives contracts on collateralized bond obligations that held billions of dollars of subprime mortgages. AIG couldn’t meet its obligations, leaving thousands of counterparties around the world at risk of loss. This is why the U.S. government had to step in and bail out AIG (and Citigroup, which seems to have forgotten this part of its history) – to save those other counterparties from massive losses that would have destroyed the financial system.

Our current $650 trillion derivatives market is a nightmare scenario waiting to happen.

First problem: the size. It’s 36 times the size of the U.S. GDP and over eight times larger than the world GDP (the entire global output of the entire world in a year). While credit default swaps (the type of derivative that played a huge role in the financial crisis) shrank significantly in size since the financial crisis, they remain large enough to constitute a potential time bomb inside the financial system that could blow up any time.

Second problem: the interconnectedness. Every derivative contract involves two parties. In a crisis, one of these counterparties may be unable and/or unwilling to meet his obligations, leaving a volume of broken contracts that will overwhelm these institutions and render them instantly insolvent.

This level of derivatives in an increasingly unstable and volatile financial system isn’t sustainable.

Derivatives are opaque, difficult‐to‐price instruments from which Wall Street earns large profits. Wall Street is not a public utility – it is a profit-seeking engine whose primary purpose is to generate money for itself. The more complex and opaque the instrument, the easier it is for Wall Street to fool investors (even supposedly smart money investors like hedge funds and large institutions) and mark up these instruments to earn outsized profits from selling and trading them.

We created a complex monster that we don’t understand…and we can’t control it for much longer.

Citigroup certainly won’t be able to.

How to Profit When Citigroup Goes Bust

The global financial system remains grotesquely overleveraged and unprepared for another crisis. Banks like DB and Citigroup are at the epicenter of this weakness. When the next market dislocation arrives, as it inevitably will, these derivatives will again earn their reputation as “weapons of mass financial destruction.” If counterparties are unwilling or unable to perform, all bets will be off.

The definition of insanity is doing the same thing over and over and expecting a different result. The first time Citigroup tangled with the derivatives monster during the 2008 crisis, its stock plunged to a low of 97 cents. It’s expecting a different result this time around, but we shouldn’t.

In order to profit when (not if) this stock collapses, I recommend some long-dated puts: C January 2018 $20 puts (C180119P00020000), currently trading at about $0.48.

Sincerely,

Michael

28 Responses to “Deutsche Bank’s “American Twin” Is Stockpiling Derivatives. Here’s How to Profit”

  1. What is chance of Lehman Brothers scenario happening with any of European Banks such as DB, Credit Suisse, or Italian banks going bankrupt? If a bankruptcy is in the cards, than is this crisis going to be equal or larger than 2008 financial crisis?

  2. I have to wonder why it is that our leading banks pass the ” stress tests ” they are subjected to with such a high percentage of their assets in CDs. Are these of a different sort than those involved in the 2007 collapse?

  3. You keep talking about the great profits of DB and I am loosing on the puts you recommended. What am I missing here. Jan 2017 $10 put down 50% and Oct 2016 $11 put down 55% which is a far cry from your reported 276% profit.

  4. All those at the top are at risk, but Citi is the most exposed cf. total assets, except for the Vampire Squid. But Citi is going to buy more and will leave Goldman in second place.

    Why is Citi being so reckless? It is expecting to be bailed out just like the last time. IN the mean time, it’s having a grand old party.

  5. Folks, most long options expire worthless. Trying to hit a homerun. Swing big, score big. Mostly you will strikeout using long options. Allocate your assets accordingly. Michael is recommending these, it’s up to individual investor to assess risk to your portfolio.

  6. I AM FAR FROM BEING THE SHARPEST KNIFE IN THE DRAWER, BUT LET ME TAKE A STAB AT CLEARING UP A MYSTERY FOR SOME OF YOU. AT SOME TIME BEFORE THE EXPIRATION DATE, THE DETERIORATION OF DB STOCK PRICE WILL CROSS PATH WITH THE TIME DECAY IN THE VALUE OF THE LONG PUTS. THEN THE VALUE OF THE PUTS WILL BEGIN TO INCREASE AS THE DB STOCK PRICE FALLS. AND THEN JUST BEFORE THE EXPIRATION DATE IN JANUARY YOU WILL BE ABLE TO BUY DB STOCK LESS THAN $5 AND PUT IT TO ANOTHER HAPLESS INDIVIDUAL, OR YOU CAN SELL THE PUTS FOR FAR MORE THAN YOU PAID FOR THEM I THINK I WILL BE SATISFIED TO SELL THE PUTS AND NOT EVER OWN AN INTEREST IN DB, UNLESS OF COURSE DB IS SELLING FOR A BUCK A SHARE IN THAT CASE I WILL EXECUTE A DOUBLE TRADE AND BUY DB FOR THE PURPOSE OF SHOVING IT INTO SOMEONE ELSE’S PORTFOLIO AT $5, GIVING ME A 400% PROFIT ON ALL SHARES FOR WHICH I HOLD PUTS ONE THING! IF YOU CANNOT REASON THIS FAR AHEAD, PERHAPS YOU DO NOT BELONG IN OPTIONS AT ALL

  7. Gaming the month or even the year of 2007 Collapse II is going to be just as difficult as it was 9 years ago. Several foresaw the stupidity 3-4 years early on, but the economy kept on rising. The few who made out were lucky enough to make their shots in the last 1-3 months before all hell broke loose. Plan on having enough shorts capital to see you through 1-5 annual renewals before some finally screams the emperor us stark naked again and his private stuff looks pretty disgusting, because that’s what it takes to turn guessing when the dam will finally burst into a viable investment.

  8. Sound of the Suburbs

    “Done at the direction of the Fed as it tries to save the world….with promises of backstops?”

    I think you’ve got it nailed.

    If all the crap is the US system the FED can bail it out and thereby stop the whole system imploding outside the US.

    The FED can keep this shit-show on the road till next time.

  9. And we Americans will be left to pay the bill for saving the world for many generations to come. What kills me is that we are never told what is going on or even given a choice in the matter. They treat us like mushrooms and we sit back and accept it. The only recourse I see is to take profits from the situation. I’d love to be laughing all the way to the bank when the dust clears.

  10. How many of you complaining about losses on long-dated puts actually made sure you understood the concept behind put options before you bought them? I don’t fully understand these concepts, which is why I’m not going near puts (or calls) without a good deal more self-education. Unfortunately, some of you appear to be learning via the School of Hard Knocks. You have fallen victim to time decay. If the share price of the stock on which you’ve purchased the put is going up and the put is waaaaaay out of the money, then of course you’re going to take big paper losses on your positions. Doesn’t mean the options will expire worthless (if at any point the shareprice of the underlying stock ends up comfortably in the money, you’ll be laughing all the way to whichever bank is still left standing). At the end of the day, the market is not currently pricing in a share price as low as the one it would take for your puts to be in the money. Doesn’t mean it won’t in the future though…

  11. At some point, the NWO will have to change currency to a “new money.” We can’t keep going like this. Banks can now confiscate our deposits and give us an IOU. All hell will break loose some day but that will do us savers no good. I don’t see any other way to get back to order. I don’t know what else can end the madness. I wish I did. I do the research but no one has an answer. Am I crazy? Only time will tell. The Federal Reserve that has caused this will be in charge and they don’t know what the hell to do either. No one talks the end game. We’re in a hole that no one seems to know the exit to.

  12. This is what a Citi insider had to say about your report. Thought you might be interested:
    You should first note that all the major banks have Derivatives with Citi holding only slightly more than Chase, Goldman and BofA. So to suggest that Citi is reckless is reckless journalism.

    If you now re-read the article understanding that the author is sensationalizing for the purpose of throwing a specific bank under the bus you may arrive at a clearer picture.

    Next you need to understand what derivatives are before you accept the comparison to explosives. As I understand them, they are a method of packaging various debt assets (car loans, mortgage loans, commercial paper, Corp Bonds, Govt Bonds, etc) in such a way that you establish a reasonable risk portfolio. It’s not unlike health insurers that can afford to insure a few cancer patients if they have enough healthy participants paying premiums without catastrophic illness.

    As long as you understand what’s in your portfolio, have properly assessed and monetized the risk, it’s a good way to spread the risk of bad debt among good debt.

    What went wrong in the financial crisis is that the mortgage debt incorrectly assessed the default risk because it was assumed the current mortgage risk equaled the historical norms. However, because lots of bad mortgage loans were made, mortgage debt was much riskier than assumed/priced. Everyone got lazy and greedy and kept pricing their derivatives as if the music would never end and crossed their fingers that because they were lumped in with other good debt, it wouldn’t matter. Derivatives failed because they initially masked the growing risk of bad mortgage loans.

    So back to the point, if you properly measure your risk and price accordingly derivatives are a viable risk management tool. The fact that Citi has a focused team to me says they are doing that just that.

    Believe me, Banks and Govt regulators learned their lesson from the last crisis. The question is whether we’ll see the risk around the corner that hasn’t been understood and properly priced yet.

  13. Mr. T. DRUG, I MEAN “DRUG”
    MUST BE AN IDIOT ON METH & COCAINE TO BELIEVE THAT BANKERS LEARN FROM THE PAST. BANKERS’ WIN-WIN GAME:
    1. PROFIT = THEIRS
    2. EXPLODED, WE POORS BAIL BANKERS OUT + “IN”
    BANKERS SEE NO RISK, U + WE SHOULD SEE SKY FILLED W/ BLACK SWANS(NO WHITE!)
    SINCERELY YOURS

  14. Ronald E. Baker

    Recently the FED Stress Tests of US Deutsche Bank came up with “failing” grades for the second quarter in a row. Stress Tests are an obscure yardstick that few can interpret, fewer understand. There is a current madness in the stock markets which is partly fueled by excess cash creation and liquidity with cheap money in USA and abroad. Too much money sloshing around all markets tends to flow into safer USA securities and equities only throwing fuel on the fire. That is why the US markets for shares and homes are climbing ever higher as corporate profits top-out, and interest rates creep ever lower. The criterion for action, alas, rests upon timing when this party shall end. The horn blows at midnight, but nobody can tell us what time it is!! Dance on, drink the cool-aid and be merry; this show could last well into 2017; nobody knows. Unlike predictable old faithful at Yellowstone, nobody knows when she’ll blow; yet we can be certain she will: Like Noah, we must all plan for the deluge and wait on the Lord of Truth to show up. Hedge like George Soros: buy (some) gold and silver.

  15. Ronald E. Baker

    DB recently failed the FED’s stress tests for the second time in a row. This party cannot go on forever, but the fire rages as cheap money sloshes, like kerosene, onto the scene.. Like Old Faithful at Yellowstone we know she’ll blow; only snag is nobody knows when. Our timing is all fouled up as huge flows of excess bank fiat liquidity (cash) pours across the globe into USA equities and real estate, while interest rates creep lower. The party’s great, dance on, drink the cool-aid; it could last until 2018. Smarter, cooler, heads, like George Soros are buying gold and/or silver as a hedge. Sounds like a good bet for 10% to 20% of one’s resources/savings right now.

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