Deutsche totters on the brink once again
CEO John Cryan had hoped to remove uncertainty overhanging Deutsche Bank’s stock by speeding up the resolution of litigation, but the Department of Justice’s opening claim for $14 billion over RMBS refocuses attention on the bank’s weak capital.
Deutsche Bank CEO John Cryan
In banking, always be careful what you wish for.
Cryan has been telling investors in Deutsche, ever since the panic around its capacity to service AT1 coupons cratered the share price in February, that 2016 will be a peak restructuring year for the bank.
As part of that, Cryan wants to speed up settlement of the biggest pending litigation cases and regulatory investigations still hanging over the bank, inviting enforcement agencies around the world to bring what they have on Deutsche to the table and negotiate.
Every senior banker Euromoney has ever met backs himself as a poker player. And Cryan is no exception.
At the end of April, the CEO presumably wanted to sound bullish after the bank had come through its mini-crisis in February by the clever expedient of spending some of its abundant free liquidity on buying back senior debt. He told investors that ending litigation uncertainties for the bank early could come at a high short-term price, but one that would be well worth paying.
“We’d like to settle as many cases as we can and there’s a possibility that that could cost us additional amounts, where we choose to settle at amounts over and above whatever reserve we might have, just to clear it away and remove the uncertainty,” he said.
Now sadly, doubts gather over whether Deutsche has the means to afford it.
If there is more pressure coming from the litigation side as in higher cost, then we need to manage RWA further down - Marcus Schenck, Deutsche
When news broke in mid-September that the US Department of Justice’s (DoJ) opening gambit over Deutsche’s issuance of pre-crisis subprime residential mortgage-backed securities (RMBS) was to demand $14 billion in settlement, the bank was keen to portray this as the first bluff in a big game. Deutsche said it has no intent of settling anywhere near that amount and that it expects to end up paying, like other banks, a materially lower number.
It might well be right, but there are at least three problems here.
First, while Deutsche senior management might have the nerve for bluff and counter bluff, the bank’s shareholders are already wounded and ready to flee. The final size of the settlement now becomes yet another pressing uncertainty overhanging the stock of a company whose entire business model is in question. That makes it almost impossible to raise external capital when Deutsche is generating none through retained earnings.
Second, if the eventual RMBS settlement should soon overwhelm Deutsche’s litigation reserves, that raises the troubling question of how it will pay other settlements, notably over mirror trades in Russia, which Cryan also wants to settle quickly.
Third, while all this grabs the headlines, it distracts attention from the bank’s biggest problem that its core business generates a return on equity far below the implied cost, with little clarity over how this will improve, even if the bank can manage hefty restructuring costs including to overhaul its redundant IT infrastructure.
Recent discussion of aborted merger talks with Commerzbank hint at the anxiety among the board.
When Deutsche announced in June last year that Cryan would replace Anshu Jain as CEO, the share price rallied in relief to €32 at the end of July 2015. But it has been falling since.
It sank to €15.30 in February amid the overblown panic about whether Deutsche had sufficient capacity to pay AT1 coupons, before bouncing to €18.30. Management might have clearly signalled poor first- and second-quarter results for this peak restructuring year but those results still took the share price down to €13.10 before news of the DoJ’s $14 billion demand broke.
One week later the price had fallen to €11.26, so down another 14%. This bank has lost almost two thirds of its market value since the start of August 2015 and with a market capitalization of just €15.5 billion in late September 2016, the outcome of negotiations with the DoJ now becomes existential.
In January, Goldman Sachs paid a $5 billion settlement over RMBS, below the DoJ’s opening bid for sure, but higher than the market had expected.
Through the big sell-off in its AT1s in February, equity investors were already concerned that with Deutsche carrying $5.5 billion of litigation reserves and maybe $2.5 billion to $3 billion of that earmarked from RMBS, any larger settlement could leave it with nothing to pay other fines coming due.
Oddly, back then investors were more worried about the potential pay out for the Russian mirror trades, in case this strayed into the area of dealing with embargoed individuals.
Now, analysts at Credit Suisse are modelling a €4 billion ($4.5 billion) settlement for RMBS. Other analysts suggests that $5 billion is the pivotal figure. A settlement much higher than that would spell big trouble for Deutsche.
While it could possibly absorb such a sum, with the eventual price for the Russian mirror trades still unknown, the prospect of new equity supply, something Cryan has been holding out against throughout his term as CEO, once again delays recovery in an already battered stock.
While Deutsche might receive some credit for self-reporting these suspicious mirror trades, for shuttering its business in Russia, ending client relationships and co-operating with authorities, investors see no reliable guide as to where the bill will come in. The fear is anything like the $8.9 billion BNP Paribas was hit with in 2014.
That would be as good as game over for Deutsche. Even if the final bill is a mere €1.5 billion, that would leave little remaining cover for settlement of sundry other pending investigations and civil class action suits, for example into alleged manipulation of FX and precious metals markets as well as various ibors.
Brief outlines of these individual proceedings and provisions cover 10 closely typed pages of the bank’s second-quarter earnings report.
In the second quarter of 2016, Deutsche’s fully loaded common equity tier 1 ratio of 10.8% was only marginally ahead of its SREP requirement for 2016. It will get a 40 to 50 basis point boost this year from the sale of its stake in China’s Hua Xia Bank, but Deutsche is already worrying analysts with its aim of running a 12.5% fully loaded CET1 ratio by 2019, a modest buffer of just 25bp above the regulatory requirement of 12.25%, after adding the G-Sifi add-on. (Remember, over the summer, the IMF assessed that among global systemically important banks, due to its interconnectedness and no doubt its famously large derivatives book, “Deutsche Bank appears to be the most important net contributor to systemic risks”.)
Credit Suisse analysts say the market will demand a minimum 13% full-loaded CET1 at least and that leaves the bank with a capital hole of around €7 billion, or almost 45% of its present market cap.
Low expected ROTE of c5% in 2018 pins the valuation at under 0.4x current TBV
Source: Credit Suisse
Beneath the surface calm with which Deutsche greeted the DoJ’s $14 billion demand, signs of alarm are evident, not just in the disclosure of aborted merger talks with Commerzbank but also continuing qualifications about the timing of a sale of Postbank, given the low valuations to tangible book that equity markets now apply to German retail banks.
In late September, capital markets bankers were reporting Deutsche scrambling to reduce risk-weighted assets (RWAs) through a large synthetic securitization of corporate loans, the kind of fallback plan it had hinted at deploying on its second-quarter earnings call, when CFO Marcus Schenck acknowledged: “If there is more pressure coming from the litigation side as in higher cost, then we need to manage RWA further down.”
One can understand and applaud Cryan’s urgency to get on with addressing the many problems he inherited at Deutsche. Unfortunately, as CreditSights points out, five months on from that fighting talk about speedy resolution, “with negotiations [with the DoJ over RMBS] only just beginning, a final settlement looks much further away than anticipated”.
Cryan must play his hand very well from here.