Editor's Note: MarketMinder does NOT recommend individual securities; companies referenced herein are merely cited as examples of a broader theme we wish to highlight.
Few things in markets are predictable, but here is a near-certitude: Investors always fight the last war. Since the Global Financial Crisis, people have looked for signs of a repeat around every corner: Dubai. Greece. Spain. Ireland. Student loans. Subprime auto loans. Community banks in the oil patch. Chinese shadow banking. Brexit. And this year, eight years and a day after Lehman Brothers declared bankruptcy, another potential “Lehman moment” stole headlines and hasn’t left them since. Investors worry the Justice Department is about to fine Deutsche Bank out of existence to settle old claims of mis-selling mortgage-backed securities, potentially stoking a run on the bank and panic across the financial system. As with all the other 2008-redux ghost stories we’ve seen in recent years, however, Deutsche Bank’s woes shouldn’t spark a new crisis. This fear misunderstands how to measure a bank’s health—Deutsche’s problems center around return on capital, not return of capital.
It’s fair to say Deutsche Bank isn’t having a good year. Investors have feared its relatively weaker capital position since January, when the bank announced a record loss for Q4 2015. In June, its US unit failed the Fed’s stress test and, while the ECB didn’t grade banks in July’s stress test, Deutsche’s capital scores were toward the bottom of the pack. Its stock price has fallen by almost half since the start of the year, its contingent convertible (coco) bond yields are up and some hedge funds (10 of 800) are reportedly pulling transaction-clearing business (and capital). And now, the fine, which a widely cited leak said could hit $14 billion. Rumors swirled last week that the German government is prepping a bailout package. Chancellor Angela Merkel denied them, but the chatter persists.
It may seem weird that these fears are rooted in a $14 billion fine. While this is a big number, it’s tiny compared to Deutsche’s €1.7 trillion balance sheet. But the day the number was leaked, Deutsche Bank’s market cap was—wait for it—$14 billion. Many assumed, wrongly, that paying the fine would wipe out the entire company, conflating market valuation with capital and assets. This, however, is not how banks work (nor any other company). When a bank pays a fine, it doesn’t pay out of its market cap. That is not a reserve, just the market’s rough estimate of what the firm is worth on any given day. Most firms set aside reserves for legal penalties and settlements. Deutsche has such a reserve. It’s only €5.5 billion (~$6 billion), but that is far from the end of the bank’s liquidity. It had €220 billion (~$250 billion) of liquid reserves as of Q2. It also had roughly €1.7 trillion (~$1.9 trillion) worth of assets, and surely management could carve out roughly $8 billion worth to sell if need be. Being a German bank, it also has access to a lender of last resort named the ECB if it really needs cash in a pinch. Not that Mario Draghi would lend Deutsche Bank money to pay a fine, but if it paid the fine and then eventually got into a jam, it has options. Paying will obviously hit earnings, but it won’t drive the bank out of business.
Plus, Deutsche may not even have to cough up $14 billion anyway. Lost in most coverage is the fact that the DoJ didn’t actually send Deutsche a bill for $14 billion. Rather, that number is supposedly the starting point for negotiations. We say “supposedly” because there was no official announcement. That’s normal for these situations, where negotiations happen behind closed doors. After the DoJ makes its opening pitch, the bank gets to submit its counterproposal. Then they haggle for a while, maybe leak some more numbers, play a few rounds of Rock Paper Scissors, and finally settle on something, presumably something lower. Already there are reports that they cut a deal to drop the penalty to $5.4 billion, just under what they already have set aside. There is precedent for this. In 2014, the DoJ demanded $12 billion from Citigroup, also over alleged wrongdoing regarding mortgage-backed securities, ultimately settling for $7 billion. Goldman Sachs, Bank of America, JP Morgan Chase and others went through similar negotiations over crisis-related settlements. Even if $14 billion ends up being the final headline number, judging from past settlements, that likely doesn’t mean the bank would cough up that much instantaneously. When JPMorgan had to “pay” $13 billion to settle WaMu’s alleged misdeeds, a good chunk of that $13 billion was actually mortgage relief for borrowers, allocated over a number of years.
Some people concede that the fine alone probably won’t break the bank, pointing instead to its plunging share price, spiking coco yields and those fleeing hedge fund clients, worrying this is the beginning of a long and very bloody run on the bank. But bank runs are when depositors ask for their money back—money the bank doesn’t have because it’s tied up in long-term loans banks can’t just call in. This is completely separate from what investors think Deutsche is worth, which is based on its expected future profitability. Rising coco yields also don’t point to a looming run on Deutsche. These bonds are inherently riskier than traditional bonds because they may be used to “bail in” Deutsche in the event it’s undercapitalized. Given paying the full fine would knock the bank’s capital, it seems fairly reasonable to presume they’ll have to raise some. Bailing in coco bondholders would be one way to do it. As for those fleeing hedge funds, we’re talking about 1.25% of the bank’s hedge fund clients deciding to clear derivatives transactions somewhere else. This isn’t a repeat of investors fleeing Bear Stearns’ hedge funds in 2007, widely seen as the shot heard round the world.[i] Fact of the matter is, these aren’t even a viable funding source for a bank, as hedge funds are virtually constantly moving the money around. Actual deposits are staying put, as they have throughout the bank’s tumultuous year.
The recent story isn’t terribly unlike the fears that swirled earlier this year over Deutsche. Then and now, people conflated return on capital—whether Deutsche would be profitable—with return of capital, or whether investors would get their money back. In February, Deutsche’s coco bonds plummeted after the bank announced that record loss, causing investors to fear the bank was undercapitalized. Investors feared it may stop making interest payments and might have to “bail in” bondholders by converting the debt to equity. But these fears were overstated. Deutsche never missed coco bond payments and it ended up buying back other bonds at a discount—booking a profit—to show investors it had ample liquidity. By mid-March, these bonds had recovered the bulk of the decline they experienced in January and early February. This time around, markets seem to be presuming the bank will have to issue new stock to raise capital, diluting shareholders. Fair enough. But again, that’s an issue of return on investment, not return of investment.
Deutsche isn’t the only bank where people have feared a 2008 repeat brewing. Bankia—a Spanish bank formed in 2010 from smaller, regional banks—was partially nationalized by Spain in 2012 to avoid its collapse. In 2014, Portugal’s central bank took control of Banco Espirito Santo, the country’s biggest lender, after it teetered on collapse due to mounting bad loans. More recently, Italian bank Monte dei Paschi di Siena has been the focus of fears Italy’s troubled banking system, weighed by non-performing loans, may spark another financial crisis. Each time, people feared dominoes would fall. They didn’t. Fears over the potential fallout from these troubled banks are an indicator of sentiment, not fundamental problems in the banking universe, and all they show is that people continue to misunderstand what happened in 2008. Lehman’s collapse didn’t cause the crisis. Neither did Bear Stearns’, for that matter. Their failures were symptoms of much deeper problems. Banks began writing down hundreds of billions on their balance sheets almost a year before Lehman failed, and stocks were already in a bear market. Lehman’s collapse certainly stoked more panic, but it is different than today in the sense global stocks are up broadly, even with Deutsche doing poorly, and presently there is no accounting rule forcing trillions in unnecessary and exaggerated writedowns on illiquid assets. In other words, even if Deutsche were to fail, there would be no reason for markets to go looking for the next victim, or for other banks to experience a run.
None of this is to say Deutsche is in great shape. It clearly has problems, including ultralow rates and flatter yield curves. It has, like many big investment banks, multiple ongoing lawsuits against it. It is undergoing a broad-based restructuring. But it is a stretch to presume problems primarily involving future profitability are analogous to a looming crisis.