Three awful announcements of new losses from Bank of America, Royal Bank of Scotland and Deutsche Bank cratered bank share prices in the US, UK and continental Europe in January. The sheer scale of the loss at RBS plus the talk of looming full nationalization and the unseemliness of the circumstances at Merrill Lynch diverted attention from Deutsche Bank. But its losses are perhaps the most disheartening of the three.
By the low standards of a humbled industry, Deutsche Bank had had a good credit crunch until its January update on the fourth quarter of 2008. It had spotted the sub-prime mortgage crisis early in 2007, avoided the worst itself and even won plaudits for advising clients of the dangers. True, it had stored up problems in leveraged loans but had been working through these, riding its luck as some acquisitions whose finance it had underwritten were cancelled.
Chief executive Josef Ackermann had spoken thoughtfully of a new approach to compensation, of mechanisms for portions of this to be withheld pending longer-term outcomes for bank shareholders. And he had rightly implied that anyone at Deutsche unhappy at this might pause to consider that the lower scale of redundancies at the bank might be a bonus in its own right.
Then came the announcement of 4.8 billion of losses at the end of last year, including at least 1.2 billion on credit trading where Ackermann complained that exceptional market conditions had caused the relationship between positions and their hedges to break down.
It is an explanation that should have owners of the banks stock banging their heads on their desks in frustration.These bankers, shareholders must conclude, still dont get it. To describe market conditions of dramatically increased correlation and high market volatility as somehow exceptional is to miss the point by a country mile. These conditions stopped being exceptional about 18 months ago. Market conditions must now be characterized as permanently treacherous until proven otherwise. Old trading relationships, including those between bonds and credit default swaps, will inevitably break down. Basis risk will, at times, be huge. Ackermann and Deutsches traders should surely have known this. Indeed they did know it.
Why, then, the big trading losses? One must conclude that the old mentality is hard to stifle. Presumably Deutsche traders spotted glaring inconsistencies between spreads on bonds and spreads on the same issuers CDS, which raised the prospect of easy, risk-free profit. And so they filled their boots, convincing their superiors that to do otherwise would be an abrogation of their duty to capture profit for shareholders arising out of the markets dislocations.
They had been smart once, avoiding the losses. Now they could be smart twice and reap some profits oh and, of course, boost the bonus pool as well.
This is worse than a mistaken judgment, worse than a flawed but perhaps understandable application of old-market trading mentality to the prevailing conditions. It is a complete misreading of what banks must now be and how they must operate. Deutsche invites criticism not because the trades went wrong but for doing them at all.
Such trading strategies might be underpinned by a valid rationale and might, in other circumstances, have paid off. That is a risk, however, that cannot be accepted at any bank sustained by the explicit or implicit support of taxpayers. The Deutsche traders are not suddenly bad people. It is simply that they take gambles that are legitimate only for hedge fund managers and those who place their money with them.
Capital is scarce. Banks have a core role as intermediators of credit, hence their privileged status. Risking large amounts of it in big proprietary trades, no matter how logical those trades appear, has no place in markets where experience teaches that anything that can go wrong will go wrong... and probably more besides.