So a “mini” bet on Deutsche Bank has burned 30 billion from the European stock exchanges – Corriere.it

Financial market regulators spotted a trade in some derivatives linked to Deutsche Bank that may have triggered the German bank’s stock market crash on Friday. This was reported by the financial information agency Bloomberg. It would be one bearish bet on credit default swaps (cds) linked to the subordinated bonds of Deutsche Bank: small in itself but, in a market shaken by the instability of Silicon Valley Bank and Credit Suisse, capable of destroying market value for tens of billions of euros.

What are credit default swaps

What is it about? Credit default swaps are derivatives issued by financial institutions and function like insurance policies against a company’s default. In the event of non-repayment of the debt, whoever sold the CDs must repay those who hold those derivatives the full value of the defaulted bonds. It is therefore obvious that the price of CDS rises if a debtor is considered more at risk, exactly as the premium of a life policy rises for a less healthy person.

Difference from traditional policies

However, there is a crucial difference between credit default swaps and traditional policies: while it is not possible to insure the life of another person, it is instead permitted to buy CDS to cover the debt of a financial institution that one does not own. Therefore, whoever owns the CDS, without being directly exposed to the debt of a company, benefits directly if that company is considered by the market to be more fragile: the value of its derivatives in fact rises. This also derives from the use of credit default swaps as tools with which a bearish operation on a security is triggered and accompanied, as happened last Thursday and Friday against Deutsche Bank. The advantage of using CDS is (also) in the possibility of obtaining large shifts in value by mobilizing relatively limited financial resources: the purchase of a few derivatives raises the price considerably, giving the market the impression of weakness of a company which, in turn, it causes its stock to collapse on the stock market.

Speculative funds

Thus, according to what he writes Bloomberg, a bet worth just five million euros on Deutsche Bank’s subordinated debt CDS wiped out more than 30 billion in European banks’ share values. And the hedge funds that triggered the movement benefited a lot, while risking very little. In essence, as told by the Courier on Friday itself, it was an operation of the few, for the few, to the detriment of the many. But allowed by the distraction and omissions of the authorities, because in this the lesson of the collapse of Lehman Brothers passed without a trace. The 2008 crisis, in particular, has not taught us that it is dangerous allowing those who do not have direct exposure to a bank to hold CDS instead: it is like being insured on the life of another, with all the perverse incentives that this implies.

Deutsche Pfandbriefbank and Aareal Bank

After all, last Thursday and Friday the situation was ideal for such an attack. The zeroing of Credit Suisse’s subordinated and convertible bonds, the previous weekend, had increased the yields to be offered to investors for all European banks to be able to issue new ones. Soon the market focused on who should do it soon: two fragile German local banks, Deutsche Pfandbriefbank and Aareal Bank, had their bonds due. Since the two would still have had to refinance themselves by issuing other securities of the same type (the so-called “coco”), some American hedge funds have predicted that Pfandbriefbank and Aareal Bank would have taken another route: instead of repaying the holders, they would have turned the bonds into perpetual bonds (it was still legal, according to the contracts). And that’s what the two did because the cost to them was still less than issuing new bonds.

American hedge funds

It wasn’t the first time those two relatively small banks had done this. But, with Credit Suisse’s bond wound still raw, some US hedge funds predicted the move by the two institutes would scare the market. For this they have targeted Deutsche Bank, predicting that the tension would be unloaded on its stocks. For this Thursday hedge funds have built bearish positions on the first German bank, to earn by selling its shares without owning them. Also on Thursday evening, they began buying credit default swaps on Deutsche’s own subordinated debt, the price of which therefore soared.

The collapse of the action

When the jitters about German bank coco spread, the jackpot hit for hedge funds. They gained from the rise in the price of Deutsche’s default insurance derivatives (in part caused by them). Then they also gained from the collapse of the share of the large German bank, when the market thought it understood from rising quotation of the CDS that someone feared the bankruptcy of Deutsche itself. We will now see if the European regulators will decide to prohibit the purchase of CDS on debt that is not owned: perhaps the Deutsche Bank case will make clear the lesson that, after Lehman, they wanted to forget. Perhaps because too many market interests at stake also cause memory to falter.