Two weeks ago I highlighted the weakness in shares of Deutsche Bank (DB) and shrinking spread between the 2 & 10 year U.S. Treasury yields as reason enough to take a dim view on U.S. bank stocks for the summer. My thoughts were likely fairly obvious… as the potential for some sort of Euro Bank contagion to spread to our shores, coupled with lower net income margins resulting from tighter yield curve would weigh on bank stocks (read here), highlights below:
its worth looking at DB’s equity performance and put into context the recent spike in DB’s 5yr CDS which has risen from 64 basis points to 137 basis points since January, but still well below the 265 basis points where it was when the stock was last in a free-fall in 2016 trading near current levels
Looking at the U.S. banking sector, which has been a bit of a mixed bag this year, a year where interest rates have had a very healthy bounce despite a little movement on the yield curve, the spread between the 2-year Treasury yield (most influenced by monetary policy) and the 10-year Treasury yield (when rising viewed as a barometer on U.S. growth and inflation) very near the lowest spread in years at 45 basis points
This spread is important for banks for two reasons, they borrow short term and lend long term and the difference, the net interest margin is a major determinant on their lending profitability, and obviously, U.S. banks are very levered to the health of our economy which should result in greater loan growth and supposedly wider yeild differential.
Since writing that on May 25th, shares of DB have made new all-time intra-day lows, and the XLF under-performed the broad market, which got me looking at what the options market is implying for DB. With the stock at $11 the July 11 straddle (the call premium + the put premium) is offered at $1.24, or about 11%, if you bought that, and thus the implied movement in DB between now and July expiration you would need a rally above $12.24 or a decline below $9.76 to make money. Given the stock’s volatility of late, this seems dollar cheap to me, despite not exactly being a high probability bit.
Looking out to Jan 2019 expiration, the 11 strike straddle is offered at $2.65, much of this is time value, but it highlights that to buy the implied movement 7 months out you would need some extreme movement, approximately 25% in either direction to make money on Jan 2019 expiration. But for a stock that is down 42% on the year, and down 90% from its all-time highs made in May 2007, this implied movement at all time lows seems fair with so much time to expiration.
At the moment, DB’s problems seem contained to DB, and as the Wall Street Journal’s Heard on the Street column suggested on Friday, Deutsche Bank s problems are chronic but not acute:
Despite Friday’s downgrade from credit-ratings firm Standard & Poor’s, Deutsche is stronger and has more stable funding than at any time in the past decade.
Its core problem is slow and intractable revenue losses, stubbornly high costs and an extremely hard operational restructuring program
Deutsche doesn’t have a weak balance sheet: By the simplest measure of total assets versus total shareholders’ equity, its books are far less leveraged than they were in the past. Its problem is a vicious spiral of deteriorating profitability that makes the bank less attractive in the eyes of staff and investors—and ultimately clients, too.
Wow, that seems a tad rosy. To my eye, the Jan 2019 $10 puts offered at 80 cents (vs stock $11) seem dollar cheap for those who think there are lower lows to come in this stock and it could go the way of Bear Stearns a decade ago. I don’t mean to suggest that this is what is going to happen, but to quote a friend of mine who is a savvy options trader who traded bank stocks (and options) very successfully throughout our financial crisis in the latter part of last decade and throughout the Euro Sovereign Debt crisis in the beginning of this decade, when asked about the DB Jan19 $10 puts:
“I’d rather own those than be short the stock, and if I owned the stock, I’d want those as a hedge”
I guess the most important takeaway though is that playing for the “big one” is generally a losing proposition making you feel in hindsight pretty silly and emotional most of the time. Pressing lows is a hard game which is why it makes sense to have a fairly convicted view on a story using multiple inputs. For the moment it appears that investors are fairly complacent about the potential for DB’s internal struggles to have much impact on anything other than DB’s equity and debt.
Sometimes option look dollar cheap for good reason, in this case these Jan19 10 puts might be a great hedge vs a long but a horrible way to express an outright bearish view. We’ll See!