By Frances Coppola
Deutsche Bank is in deep trouble. In the last few days, its share price has dropped like a stone and is now at an all-time low. In parallel, yields on its CoCo bonds – a form of debt that acts as an additional capital cushion – are spiking on worries that the bank will not be able to pay the coupons, or worse, that the bonds may be bailed in.
To be sure, Deutsche Bank’s share price taking a beating is nothing new. The bank never really recovered from its losses in 2008: it remains weak, undercapitalized and potentially facing damaging regulatory fines, litigation costs and civil money penalties for a range of alleged offenses including money laundering in its Russian operation, price manipulation in foreign exchange and precious metals trading, and mis-selling of American mortgage-backed securities. The share price has been trending downwards since 2009. But this year, the sell-off has intensified.
In January this year, there was a run on Deutsche Bank shares and CoCo bonds on concerns about the bank’s capital position. The bank fended off market worries at the time, but the underlying issues of poor profitability, inadequate capital, high costs and lack of a coherent strategy remained. It was only a matter of time until another disaster set off a further round of heavy selling.
The proximate cause of the latest panic is the US Department of Justice’s proposed $14bn fine for mis-selling American MBS prior to the 2008 financial crisis. Deutsche Bank insists that it has “no intention” of paying anything like $14bn, and points out that other proposed penalties imposed by the DoJ have been substantially negotiated down. For example, the penalty eventually agreed with Goldman Sachs for MBS mis-selling was $5.06bn: the FT reports thatDeutsche Bank expected a penalty of about half as much. However, the Bank of America and JP Morgan both paid much higher penalties, at $13bn and $16.6bn respectively. If the DoJ can impose such harsh penalties on American banks, it is not clear why the giant German bank should expect leniency.
For a bank whose market capitalization was only $18bn even before the latest sell-off, and which posted a $7.7bn full-year loss for 2015, followed by a 20% year-on-year fall in revenues in Q2 2016, such a large penalty looks disastrous. Deutsche Bank has nowhere near enough provisions, and although a $14bn hit to core Tier1 equity would not force it to cease trading, it would leave its capital levels dangerously low. Indeed, any penalty much above say $4bn would probably force it to raise capital.
So the question the DoJ is now grappling with is how big a penalty to impose. It wants to deliver a punishing blow, but not a mortal one. $14bn is clearly too much, since it has seriously roiled markets, but Deutsche Bank’s expected $2.4bn is equally clearly too little. The final figure will be somewhere between the two.
The German Chancellor, Angela Merkel, has already ruled out state aid for the bank. Ostensibly this is to confirm that Germany will abide by EU rules about bank bailout, but her early intervention suggests a subtler reason. I suspect this is an attempt to bring down the penalty by making it clear that the bank is on its own. The message to the DoJ is that German taxpayers are not going to pay the US government one cent in redress for Deutsche Bank’s behaviour.
This is unfortunately not a credible threat. It is reminiscent of the Greek government’s cliff edge game last year. The German government cannot possibly take the risk that a US criminal penalty could result in the disorderly failure of the bank. So if push came to shove, the German government would have to rescue it. What form that rescue might take is a matter for some conjecture.
A 2008-style bailout would be political dynamite, given the hard line Germany has taken with regard to Italy’s attempts to recapitalize its zombie banks. If Deutsche Bank were bailed out in this manner, the European Bank Resolution and Recovery Directive (EBRRD) would be dead in the water.
An EBBRD-style bail-in is much more likely, and it is this that shareholders and bondholders fear. Shares would be wiped, along with CoCo bonds and other subordinated debt. If all of those proved insufficient, then senior bonds could be bailed in and there could be a haircut on large deposits.
Alternatively, there could be a private sector solution. A merger with Germany’s other large private sector bank, Commerzbank, has been mooted, though this might struggle to get past European competition regulators. It might perhaps get a nod from the head of the ECB, Mario Draghi, who has warned that Europe is “overbanked” and is clearly in favour of some consolidation. I’m not sure a merger between Germany’s two biggest banks would be quite what he had in mind, though: I suspect his target was the thousands of inefficient and unprofitable small banks in Germany and Italy. Nonetheless, a merger between the two troubled behemoths, with some heavy asset stripping and a hatchet job on costs, might possibly create a single commercially-viable entity. But I keep thinking of Bankia, the Spanish bank bailed out only a couple of years after its creation from several failing caja banks: and Lloyds, the British bank that had to be rescued by the UK government after swallowing the toxic HBOS. Mergers between troubled banks rarely end well.
However, it is perhaps premature to talk of rescue. We do not yet know what penalty the DoJ will impose, and we have no idea what the result of other investigations will be. Nor do we know how loyal the bank’s customers will be. Though if large numbers of them take their business elsewhere, Deutsche Bank may struggle to survive even if the DoJ reduces its penalty significantly.
Despite denials from the bank’s management, it is already a racing certainty that the bank will have to raise more capital. This was likely even before the DoJ fired its warning shot. But shareholders are understandably unenthusiastic about a rights issue. Their shareholding is diluted enough already: the bank’s return on equity is dismal and recovery seems a very long way off. CoCo bonds, too, are looking increasingly expensive. The opportunities for capital raising from the market are diminishing fast.
Replenishing capital by means of asset sales is also not looking promising. Deutsche Bank has failed to find a viable buyer for PostBank, and is about to sell its British insurance business Abbey Life for not much more than it paid for it. Delays to the sale of its stake in HuaXia Bank are adding to the uncertainty. There have been suggestions that the bank might sell its asset management arm, but this is one of its core businesses and therefore amounts to selling the family silver. Understandably, it has been rejected by the CEO.
But he may be left with little choice. The vultures are already gathering. The FT reports that hedge funds Marshall Wace, Highfields Capital Management and Discovery have built up large short positions, betting against the bank in the expectation that the share price will fall further. Vultures know a dying bank when they see one. Slowly but surely, Deutsche Bank is going down.
Of course, no-one seriously believes that there would be a disorderly failure. The world learned its lesson with Lehman Brothers. Never again will a systemically-important bank be allowed to collapse. Deutsche Bank is much larger than Lehman, and far more interconnected: in July, the IMF named it as the world’s most systemically important bank.
Nonetheless, whether Deutsche Bank survives – and if it does, in what form – is ultimately a political decision. If the flagship is too important to lose, the German government will no doubt facilitate a rescue. But the political imperative may be to prove to the world that no bank is too big to fail. If so, then Deutsche Bank will sink gently into oblivion, and the vultures will pick its bones clean.