Monday , October 22 2018

Deutsche Bank’s future is more Fannie than Lehman

It’s hard to recall the last time there was good news out of Deutsche Bank AG. Record fines and criminal charges. Restructuring plans with layoffs and write-offs, that don’t seem to work. Losses. Senior management infighting. Credit-rating downgrades and new lows for the stock price. Added to a US list of troubled lenders. Only three of the 33 equity analysts following the German lender are positive on the stock, according to data compiled by Bloomberg.
It’s no wonder that there’s a heightened fear that some bad event will completely destroy faith in Deutsche Bank, leading to its collapse and a 2008-style financial crisis, just as Lehman Brothers Holdings Inc.’s bankruptcy ignited a global financial conflagration.
But Deutsche Bank is no Lehman. Lehman’s core problems were bad long-term investments and insecure funding. The recent downgrades of Deutsche Bank’s credit rating weren’t due to asset impairment, but because it’s losing money and has no clear path to profitability. Unlike Lehman, Deutsche Bank has a stable and diversified funding base. Any asset shock that threatened Deutsche Bank solvency would take down most other major banks before the firm. The cost to insure Lehman’s debt was 580 basis points six months before it defaulted. Its only 150 basis points for Deutsche Bank.
Deutsche Bank’s role in the next financial crisis could be more like Fannie Mae or Freddie Mac. In July 2008, a few months before Lehman fell, the US began the process that would eventually result in a takeover of the two government-sponsored enterprises. The companies, which guaranteed mortgages, suffered losses as mortgage default rates rose and recovery rates fell. The losses caused their stock prices to fall, leading investors to distrust the GSE guarantees. This made it harder to write mortgages, which meant house prices fell, which made everything worse. The government took over the GSEs to restore faith in their guarantees. It was almost three years from the emergence of serious problems at the GSEs to their bailouts.
Like the GSEs, any Deutsche Bank collapse will likely be in slow motion. It holds 124 billion euros ($145 billion) of “total loss absorbing capital,” or TLAC, which is basically stock and bond securities that the firm has the right to convert to equity in a crisis. The amount is about 50 percent above the regulatory minimum. But the market value of these securities is far lower, and probably somewhat below the regulatory minimum. That’s not an immediate problem since regulatory minimum isn’t based on market value.
But over time, losses will erode the TLAC, as will maturing debt. Regulatory minimums are scheduled to increase. As Deutsche Bank’s TLAC gets closer to its regulatory limit, the market value of TLAC securities falls, because converting the debt to equity would likely wipe out the equity and severely impair the value of the debt. Deutsche Bank can try to escape by issuing new equity and TLAC debt, but it will have trouble finding buyers. It can start generating profits, but it seems to be having trouble doing that. Or, it could sell assets, but the more troubled it gets, the lower the fire-sale prices it will get for those assets, and losses on asset sales erode capital.
The German government has denied that it would bail out Deutsche Bank, but I don’t know anyone who believes that. The lender is probably more important to the German economy than the GSEs were to the US. Moreover, it would be an irresistible financial deal. After wiping out the TLAC investors and using the cash on the Deutsche Bank’s balance sheet, the government would acquire the lender’s businesses and long-term assets at a small fraction of their book value. Without the investor fears of a holding company collapse and the heavy burden of bank regulation, those assets could likely be sold for a profit of several hundred million euros.
German government credit would not be strained by a bailout of Deutsche Bank, but it would make it difficult to prevent other euro zone countries from bailing out their banks, or for Germany to extend the support the European Central Bank would need to prevent euro zone sovereign debt defaults. And if the German government did let Deutsche Bank fail, the repercussions could be even more severe.
Deutsche Bank will not be the spark that turns the next financial downturn into a full-blown crisis, but unless it can start delivering more good news than bad to investors, it’s a very big pile of deadwood to add to a conflagration started elsewhere.

—Bloomberg

Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management

He is the author of “The Poker Face of Wall Street.” He may have a stake in the areas he writes about

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