Article / 09 October 2015 at 10:33 GMT

Is Deutsche Bank Europe’s Lehman Brothers moment?

Managing Partner / Spotlight Group
United Kingdom
  • Deutsche Bank is under pressure and may suspend dividend
  • Bank looks to axe up to a quarter of its staff and suspend the bonus pool
  • Urgently needs new capital; faces massive fines for financial misconduct
  • Its substantial derivatives book is worth 50% more than what Lehman's had

Deutsche
Extract from today's Financial Times detailing Deutsche Bank's predicament. Image: ft.com 


By Stephen Pope

Could it be that the premier bank of Germany and maybe Europe will take us all by surprise and prove to be European banking’s Lehman Brothers moment? After the Volkswagen scandal, what a hammer blow that would be to Teutonic pride and discipline.

On Wednesday evening the new chief executive office of Deutsche Bank, John Cryan (in the post since July) revealed a looming record loss: it expects to post a Q3 deficit of €6.2 billion ($7bn). That is the largest quarterly splash of red ink in a decade and is the direct result of balance sheet adjustments and mounting legal costs.

The bank will also  eliminate or reduce its dividend. This would be the first time in 60 years that the once sacrosanct dividend payment has not been made.

The mighty DB now faces an urgent need to raise additional capital and faces further investigative fines. When coupled with ever increasing regulatory hurdles it is clear that profits generated by the commercial and investment banking units are rapidly diverted to satisfy increased compliance and regulatory costs.

Jobs in jeopardy

Cryan has let it be known that approximately 25% of the jobs at DB are set to go and that there will be a hit on the bonus pool; it may even vanish altogether.

However, that kind of statement is released into the public domain simply to satisfy political and public demand. The word around the City and Finanzplatz is that in an attempt to retain as many of the highly skilled and legally profitable dealers with the capital markets unit (DBCM) the bank has hiked salaries by more than bonuses have been reduced. This is just another way to circumvent the new draconian rules in Europe. That said, there is also talk that within DBCM the level of staff morale is rock bottom and CVs are being updated.

Frankfurt
 Frankfurt's financial district isn't this glittering any more. Photo: iStock

Admission of rate rigging 

Michael Curtler, a now ex-senior trader at DB admitted to conspiring to manipulate benchmark interest rates as the US investigation into the rigging of the London Interbank Offered Rate (LIBOR) widens is scale and scope. The US Department of Justice and others have already secured a $2.5bn settlement with DB over the LIBOR manipulation and the DoJ is now seeking to hold individual bankers accountable.

Mr Curtler, (aged 43 and British), worked on DB’s USD cash desk and he yesterday pleaded guilty in the Manhattan Federal Court to a charge of conspiring to commit wire and bank fraud in connection with the LIBOR rigging scheme. He is scheduled to be sentenced on 19 January 2016 and his likely tariff will be a prison term of 30 years. He is the 13th person charged in the US and the first from DB.

Impacting the value of bank paper

The effect on DB paper over the next few weeks/months is going to be fascinating, and there are potential contagion risks.

One has to ask exactly what DB’s decision to stop equity dividends will mean for non-cumulative debt holders. The general rule is that while DB has available distributable item facilities under German accounting rules it could and should continue to make debt payments.

However, if DB is forced to set aside even further huge capital sums as a contingency what happens if the non-cumulative debt holders have their assets impaired? Surely DB would not risk the markets wrath if it didn’t pay out bond holders.

Hmm…do not be so sure as in this matter DB actually has form. The bank is on record as not making an expected call on subordinated debt in 2008. Then it was the first bank to stun bond holders as its inaction on the call option plunged the entire bank subordinated debt and Tier 1 (T1) capital market into chaos.

This is not a time to be caught out as there is a raft of new European regulation that is upending the subordination market and really putting a squeeze on bondholders. Such actions one would generally make investors be wary, after all, every bank sold its subordinated debt to the yield hungry clients on the virtual guarantee that the bank would always exercise the call option. The structure was such that it made logical sense to evaluate the assets on the attractive yield to call as against the less attractive yield to maturity.

Of course, as has been seen in all manner of instruments, the yield hungry or greedy investors always return and let’s face it…if DB is fighting to stay afloat, it will not be caring too much about its short to medium-term reputation. Long-term survival …in fact, just plain old survival would all that mattered at such a point.

Not my cup of “CoCo”

Contingent convertibles, also known as CoCo bonds, Cocos or contingent convertible notes, are different to regular convertible bonds in that the likelihood of the bonds converting to equity is "contingent" on a specified event.

The market is relatively thinly capitalised and DB’s CoCo Additional Tier 1(AT1) bonds fell by a 4 point correction at Thursday’s open trade. Of course some banks are calling clients and suggesting that this will blow over and that these bonds are cheap if one takes the view that there’s no chance DB will breach their capital ratios and trigger a “bail-in”.

Of course fortune favours the brave, but I would sooner repeat to myself the mantra that says “only fools rush in”. Let another investor be the hero, there really is no sense in getting killed out there when we do not have clarity as to where this will stop.

One has got to be extremely cautious right now and any buying at the moment is not only premature it is based on an entirely inappropriate, highly skewed risk-reward scenario. Right now DB is dire need of more capital.

How will the capital be raised?

How is DB going to raise that necessary new capital from the AT1 market when switched on investors will be deeply suspicious of all outstanding DB debt and capital levels.
The structure of contingent convertible securities, of which AT1 capital instruments are the major component, is:

 “… shaped by their primary purpose as a readily available source of bank capital in times of crisis ...”

Specifically, they aim to provide a private-sector alternative for recapitalising financial institutions, aside from the issuance of new equity – which can at times be less appealing due to dilution effects.

Of course DB can line up for offer as much T1 debt as it wishes…but the value of something is only what someone will pay for it. Right now investors may find that they cannot actually determine what fair value is. After all and forgive me being provocative, how close is DB to a point of non-viability?

The point of non-viability (PONV) is the point where the relevant authority determines that the institution meets the conditions for resolution or the authority decides that the institution ceases to be viable if capital instruments are not written down. Resolution authorities will take resolution action only if all of the following conditions are met:

• It has been determined that the institution is failing or likely to fail.

• There are no other private sector measures, including early intervention measures or the write down or conversion of capital instruments that would prevent the failure of the institution in a reasonable timeframe, and resolution action is necessary for the public interest.

Cryan will be setting out the positives in investment meetings and no doubt assuring them of the bank’s plans to cope with the ongoing regulatory and capital contradictions.

Banks generally don’t become bankrupt over a lack of capital. Rather it's more commonly the lack of access to liquidity that is the tipping point. Whilst I am not comparing DB to the Greek banks, their needs over the spring and early summer illustrates how difficult life can be for any bank without liquidity. 

So we accept that DB is not as weak as the Greek banks were, however, right now DB is facing a tricky time as regulatory capital charges will force it to sell assets.

That process has already started as DB is selling a credit-default-swaps (CDS) trading portfolio of more than $250bn , with JPMorgan Chase & Co. among several banks in talks. DB said in 2014 it would exit trading in CDS positions tied to individual issuers.

It struck a similar deal with Citigroup Inc. to sell a portfolio of nearly $250bn in single-name swaps. These transactions will help DB meet a target to reduce leverage by $225bn . DB has accumulated a substantial derivatives book, worth over €52 trillion in notional value. This is over 50% higher than Lehman Brothers had at the time of its bankruptcy.

Derivatives, the dark arts and voodoo vehicles

Financial instruments are as we know tradeable assets of any kind, such as cash, equities, and bonds. They represent either an asset, a claim on an asset or a contractual right to an asset.
Step away from the plain vanilla world of cash, fixed income or a cash equity and one crosses the threshold into the world of derivatives. 

These instruments derive their value from the performance of an underlying asset. The price of such an investment vehicle can fluctuate based on the price of the underlying asset and time. One key feature is that they can be leveraged and so they can potentially vary in value substantially, producing outsized gains and losses.

At the time of the financial crisis it was hoped that investors and of course the banks had learned their lesson with respect to risk. If something carried a large yield or spread, one should be suspicious. However, quantitative easing snapped up sovereign assets so yields fell. As the zero interest rate bound became the norm so other assets priced off sovereigns also saw their yields collapse. This drove yield hungry investors further down the credit spectrum or deeper into derivative and structured products to gain a yield enhancement.

The bonus structure of the market meant that there became increased incentive to try and cheat or rig the system. Now we can see that the German powerhouse that once led the league tables for new issue bond underwriting and was a global titan as a “universal bank” has failed to learn the lesson about avoiding potentially toxic assets and not monitoring closely the malpractice of its staff.

Just as with Volkswagen the question was who else has fiddled its test results, one will see investors look at DB and question what will be the next banking shoe to drop.

lawyers
 Deutsche Bank is facing an enormous legal bill but the size of its
derivatives book is even more worrying. Photo: iStock

– Edited by Clare MacCarthy

 

Stephen Pope is managing partner at Spotlight Ideas

3y
fxtime fxtime
Excellent overview but I also wonder how well French Banks will report....they seemed to have missed the sub prime lending silliness and I just keep wondering how they really compare to stress tests and new pending ECB directives....they just seem too silent for my liking.
3y
fxtime fxtime
Capital adequacy is too opaque in its interpretation of accounting standards whether as an ED or SSAP as the inputs used are gamed by banks much as VW gamed the emissions tests. Banks can interpret source and application of funds flow data and immediate assets available for security and/or sale which make the data of capital control etc questionable imho.
3y
fxtime fxtime
I am sure that if Greek Banks are effectively bailed out so far that the ECB will fudge something to maintain DB. As to if I would invest in DB with this view....NO I would not. My mantra is wait for evidence before committing hard earned funds. Only the Lender of last resort will commit to DB. A staff culling of the magnitude you mention would be politically unpalatable in Germany. Hopefully DB doesn't have a workers union that is as strong as VW's so that it can pursue a swift rationalisation of its Banking basis.
2y
SvsG SvsG
Not much changed after one year, situation even got worse
2y
Stephen Pope Stephen Pope
A result of light weight stress testing and a refusal to be transparent.

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