In what started off as a good day with a couple of great earnings reports from Accenture (ACN) and Pepsico (PEP) and another very low weekly unemployment claims print, things just weren't meant to be as Deutsche Bank (DB) ended up taking the whole market down.
Unfortunately, we now find ourselves in a market similar to what we had early in the year where oil prices dictated the action in equities, except now it's DB dictating things. The DB news that came across the wires just after noon on Thursday was that several hedge funds had decided to transfer assets away from the DB prime brokerage unit to other banks in fear that DB may go bankrupt.
Prime brokerage is a service that large banks offer to clients in which the bank holds the client's assets and supports the trading that the client does with the prime broker and other banks all over the street. In this case, should DB go bankrupt, clients could have their assets tied up in a lengthy bankruptcy proceeding that could severely impact their own business. For example, in the case of the MF Global bankruptcy back in 2011, it took years for some clients to get their money back.
Because market participants are now talking about a potential bankruptcy (which I do not believe will happen), this is where proper capital structure analysis and the belief in efficient markets will allow investors to make money. Capital structure refers to the mix of debt and equity that a company has used to fund its operations, while efficient markets describe a financial theory in which all public and private information is reflected in the price of a security.
In the event of bankruptcy, all the people who own the debt and equity of the bankrupt company stand in line to claim whatever is recoverable of the company. Capital structure also dictates where people stand in that line, with debt holders being in the front and equity holders in the back. Typically, by the end of a bankruptcy proceeding, there is nothing left for the equity holders, and their investment is wiped out. In the case of DB, we have a very complex capital structure made up of many different layers of debt and equity instruments.
This is where efficient markets come in.
All across Wall Street, there are portfolio managers and analysts who are spending their entire day analyzing the capital structure of DB and figuring out who will recover the most in the event of a bankruptcy. Conversely, people are also figuring what securities are the most undervalued because they have determined that DB can withstand its existing problems.
Because we believe in efficient markets and people's desire to make money, the trading in DB securities will tell us what we need to know. Should we see DB bonds start to trade down aggressively, then we know bankruptcy has become a real problem. DB equity could still see another downturn without bankruptcy being a legitimate outcome.
We can see DB bond activity here on the FINRA-TRACE trade reporting site. Trades done in most corporate bonds have to be reported to a regulator so that the public is aware of the activity. You can see a couple DB bonds listed in the most actives section, where you also can see historical prices.
Right now, DB bonds and equity are saying that things are bad, but not over. So keep in mind that DB got to this point because of a potential government fine, not actual trading losses.
Granted, DB stock has been in decline for some time, which really reflects a poorly run company, not a bankruptcy situation. Ultimately, I believe there is value to be found in DB -- we just haven't gotten there yet. So let's keep an eye on how DB securities are trading and remember, we still have a healthy economy, so once DB stabilizes, the bulls will be back in charge.