Deutsche Bank Distractions
27 September 2016 by
There are a number of themes building in markets but what is lacking at the moment is a clear directional driver. We have had the Fed, we have had profit taking, we now have US elections and reforms in Italy. The oil price had a go last week at driving the market, and now it is Deutsche Bank again. Bottom up themes don’t tend to be lasting drivers unless they bring down a whole sector, but when it comes to banking stories they do tend to be the transmission mechanism of risk, so we have been discussing Deutsche Bank’s woes quite a lot since the scale of their US mortgage litigation was announced to the market.
I would like to start by saying that I like DB, not as a credit risk, but as a firm; they are a highly respected counterparty that has built a terrific reputation as one of the best risk takers in capital markets. They were the pre-eminent investment bank in Europe for perhaps a decade, so it is sad to see them at the forefront of such negative newsflow.
The share price is just above €10 now, its lowest since the 80s, and this represents a price to book value of 23%. The Additional Tier 1 bonds that its CEO John Cryan said he would pay the coupons on in February, are now 13.5% yield to call. Over the summer they positively surprised markets with a good outcome from the ECB stress tests, but as soon as the US Department of Justice leaked the number of their initial fine proposal for DB’s misdemeanours in the US RMBS market at $14bn, the negative spotlight was straight back on them.
The reality is that the $14bn is just an opening gambit and in all likelihood a settlement around $5bn would be more consistent with previous fines. This number would be close to what DB has already provisioned for, and consequentially manageable. However markets know that DB can’t afford $14bn, so the fine may as well have been propped as $50bn. Consequently markets are once again questioning DB’s solvency. This is the same issue that we had back in February, which led to a sudden sharp fall in financials.
So will this be the case again now? Well markets were already beaten up pretty badly in February and there was nervousness from the potential contagion from the oil price decline. Markets feel in better shape now, and they did recover very quickly from February lows. This is also very much an idiosyncratic story, although RBS are next in line to receive their punishment from the DoJ. This one we fear could be even worse.
However back to DB, while their plan is to settle with the DoJ at a far lower amount, they will also need a Plan B and it is this that we think is probably causing DB damage at the moment. The drag on senior management time must be enormous and reaching into all areas as the bank seeks to bolster capital and reduce risk. Is reducing risk even further really what DB needs? Are they making good risk decisions while this top down distraction is going on? They employ terrific people who have had a great habit of being profitable, are these people focused right now, or are they distracted? After all, potential minus interference equals performance.
The best case for DB is probably a fine of about a third of what has been leaked, plus some additional losses/provisions that they incur working on their Plan B. The best case is probably also the base case, so no real need to upset markets. However, should the worst case scenario play-out then it could send further shockwaves through the financial system again, so it’s one to watch closely, but hopefully this story goes away quite quickly without too much contagion.
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