By Jeffrey P. Snider

Before embarking on the great unknown of Q4 2015, it makes sense to try to gain a little more clarity about Q3 2015. Specifically, the “dollar” run that blasted through China and opened the prospects for both an end to Fed/Yellen faithfulness and increasing uncertainty about the true nature of economy and finance globally began around July 6; a day (or thereabouts) that shows up in an awful lot of “dollar”-related activity. That date is noteworthy for several reasons, including the midst of the Chinese stock crash and being within that bottleneck “window” of the first few weeks after quarter-end. It was also the day after the Greek vote on creditor terms.

By all surface considerations, Greece just should not matter. It is a tiny country with a small economy (even comparative outside of Europe) and a truly shriveled banking network. The financial foibles have been well-documented for more than half a decade now, so surely “contagion” and exposure no longer exist.

The population of Greece is slightly less than the state of Ohio’s, while its gross domestic product is just a little bigger than the economies of Kazakhstan, Algeria and Qatar.

Instead of focusing on Athens, investors should be much more worried about what’s going on in China. You know, that country with about 1.4 billion people and the world’s second largest GDP?

It is difficult to disagree with that sentiment at any point, including and especially the relative scale of the Chinese meltdown by comparison. However, there does not exist, particularly in the “dollar” world, such certain mutual exclusivity. Clearly, in the “dollar” context, any connection would be made via eurodollar bank operations (to be clear, I am not claiming that the affairs of Greece, even any “dollar” spillover, caused China’s stock crash, only suggesting that the “dollar” run that would follow was a self-reinforcing and compatible circumstance).

ABOOK Sept 2015 Asian Dollar EurodollarABOOK Sept 2015 Asian Dollar 5s10s Swap SpreadsABOOK Sept 2015 Asian Dollar 30s Swap SpreadsABOOK Sept 2015 Asian Dollar Inflation BreakevensABOOK Sept 2015 July 6 WTi

The Monday after the Greek vote (which was held on that Sunday), oil prices crashed almost 10% in one of the biggest selloffs this year. Media commentary, as usual, scrambled to find a culprit and came up with three:

Oil prices suffered their biggest selloff in five months on Monday, falling as much as 8 percent as Greece’s rejection of debt bailout terms and China’s stock market woes set off a deepening spiral of losses.

Adding to the pressure on oil, Iran and global powers were trying to meet a July 7 deadline on a nuclear deal, which could bring more supply to the market if sanctions on Tehran are eased. The self-imposed deadline could be extended again, officials at the negotiations said.

China and Iran make some sense in the context of crude oil (demand and supply), though, ultimately, I am sure they had nothing to do with the events of that day or those that followed, but Greece? The most relevant aspect of Greece as it relates to energy prices is “jitters.” That may not be a specific pathology, but it really doesn’t take much to find that channel again through the “dollar.”

It wasn’t much noticed, but a month before the Greek vote S&P downgraded Deutsche Bank, Barclays, RBS and several other smaller European banks. This was just a few days after Deutsche’s co-CEO’s “resigned” but the more sweeping and broader action by S&P made it plain that the bank’s ratings adjustment was unrelated to the intended restructuring signaled by the change in leadership. If anything, the new strategy was enthusiastically embraced by S&P, as that firm would detail in a later ratings justification. In mid-August, S&P affirmed its “stable” intention for Deutsche Bank highlighting particularly:

Among the financial targets that Deutsche Bank announced as part of Strategy 2020, the stand-out for us was its intention to raise the CRD IV fully loaded leverage ratio to 5% or higher. Its actual ratio at June 30, 2015 was 3.6%. If it achieves its objective, Deutsche Bank would move from the longstanding laggard to a leader among European peers on this metric. It would still lag U.S. banks, partly due to structural differences between these markets such as residential mortgage financing. The deconsolidation of Postbank’s mortgages and deleveraging of CB&S’ [Corporate Banking & Securities] derivative and securities portfolios are key to the achievement of the 5% target, as well as the continued run-off of non-core assets. [emphasis added]

As that affirmation goes on to specify, S&P was suggesting one of the biggest risks to Deutsche Bank moving forward is a potential inability to carry out those intentions for scaling back and “conserving capital.” The ratings agency even goes so far as to describe the issue, which is a familiar banking trend to anyone observing the state of derivatives these past few years:

Reposition the Corporate Banking & Securities (CB&S) division by shrinking large, low-yielding asset portfolios such as long-dated, uncleared derivatives and repos, and exiting unprofitable client relationships. Since 2013, CB&S has already exited some businesses (such as commodities and most single name credit derivatives) and deleveraged others. However, we consider it was slower than some European peers to downsize fixed income activity, partly because it hoped to gain market share as rivals retrenched. Net of selective reinvestments in products such as equities, origination, and advisory, Deutsche Bank’s objective under Strategy 2020 was to cut CB&S’ leverage exposure by €130 billion-€150 billion, or about 15%. [emphasis added]

Like Credit Suisse, Deutsche had held on to its derivatives portfolio (for what we can find, the bank provides little information outside updates included in the notes of its annual report) whereas its eurodollar peers had already made significant progress in repositioning for the “dollar” we know of now. The ratings action of early June, however, must have been another stark kick in that direction, putting to the math what everyone else was seeing all along (except for Deutsche’s former co-CEO’s, obviously). In deciding on June’s downgrade to that BBB+ rating, S&P also made it clear where that downgrade was coming from, especially as it related to the bank’s “anchor” rate of A-.

ABOOK Sept 2015 July 6 DBank S&P Ratings

The bank takes its one-notch adjustment from its “risk position” which includes (really there isn’t much else) the CB&S derivatives book (the only -1 on the ratings score above). Once zeroing in on that emphasis, S&P’s overriding impetus for the banking downgrade on June 9 (beyond just Deutsche Bank) starts to fill out the puzzle:

Deutsche Bank, Barclays Bank and the Royal Bank of Scotland were among a handful of European banks downgraded on Tuesday by Standard & Poor’s, amid concern that state support in a crisis is now ‘uncertain’.

Analysts with the rating agency warned that it was unclear what support even systematically important financial institutions in the UK and Germany would receive, following the recent implementation of the European Union’s Bank Recovery and Resolution Directive.

S&P lowered the counterparty credit rating of Barclays Bank one notch to ‘A-‘, with Deutsche Bank and RBS cut to ‘BBB+’ from ‘A’ and ‘A-‘, respectively. [emphasis added]

The S&P downgrade note itself was just that explicit:

While we do not rule out the possibility that systemic banks in these countries might receive extraordinary government support, we see the predictability of such support as having materially reduced to the point that we regard it as being “uncertain”.

Nothing so much offends the math that defines statistical attempts at managing risk like putting the terms “predictability” and “uncertain” together, especially in the context of one of the pillars supporting perceptions about the general state of risk in banking globally. In plain terms, S&P zeroes in on Deutsche’s derivatives and wholesale book while explicitly stating that, overall in banking, “state” support for it is no longer as assured to the point of being “uncertain.”

Then, on July 5, the Greeks vote against the preferred creditor option which only added to that same directional “uncertainty.” In rejecting the bailout terms, Greece was provoking further political wariness not just about the specifics of Greece but “bailouts” in general. What would you do as Deutsche Bank on the day after the vote? S&P had, less than a month before, knocked you out of the A tiers because of your “risk position” which includes derivatives exposures that have already seeded negative perceptions all the while making it clear that is a problem (for esoteric regulatory concerns like the various and sundry capital ratios) amplified by political, bailout exhaustion. It might make sense to accelerate the intended shift, especially with a new CEO trying to make his mark.

Further, what might counterparties think of all this? The math itself demands that any ratings threshold be treated as an increase in modeled variability, which can and does have very real effects (collateral terms being the most obvious and upfront). Might the Greek vote on July 5 placed an extra emphasis on counterparty calculations remodeling projected volatility, especially toward downside risk with a more “uncertain” nature of “state support?”

ABOOK Sept 2015 Dollar LIBOR

Those questions pertain beyond just Deutsche Bank to the others that were included in the S&P action (and, it should be pointed out here, that Fitch issued a downgrade for the same reasons on May 29), though I think given Deutsche’s massive imprint in “dark leverage” especially how the bank had continued its portfolios long after others were in full-blown cutbacks (thus, marginally, making Deutsche far more important in the past few years as one of the “few” still providing those deeper eurodollar liquidity elements in at least similar scale) the German bank makes for the most logical center of the “dollar” run past July 6. European wholesale operations thus affected will certainly translate into eurodollar behavior; maybe even more so because it is undoubtedly the “dollar” to which Deutsche (and the others) is seeking to shed in order to focus “capital” more locally and less inefficiently sprawling.

There are, obviously, more than a few assumptions and degrees of conjecture on my part. Given that caveat, I do think them quite reasonable particularly in view of the chronology and the nature of the “dollar” outbreak. The wholesale “dollar” is eminently unobservable so we are left to second and third-hand interpretations, but here again I think the explanation offers the greatest fit (admittedly still incomplete) to all possible angles. In this specific case, that means that eurodollar banks are removing themselves in uneven fashion, which has been obvious for some time; thus, the Greek vote may have triggered aspecific intensification and acceleration of that general trend.

In that sense, Greece doesn’t matter as most people stand in wonderment about the affair, but it does matter in the same context as chaos theory applies uncertainty in a complex system – in colloquial understanding of chaos, Greece was the butterfly though not necessarily an unexpected one.