Speed Read
Banks are shaped by their environment, and Deutsche Bank is the product of an environment designed to extend credit with little to no capital buffers.
The credit extension created a credit bubble. Much of the trillions in credit extended could not be financed through EBITDA.
As credit extension went into reverse, banks and regulators have been forced to recapitalize and re-regulate very complex institutions. Any time massive derivative books are unwound, massive losses are the result.
Deutsche bank is very under-capitalized per its leverage ratio. Without capital, bad loans can’t be written off.
Management focus on persistent cost-cutting ultimately impairs asset productivity, and league tables indicate it lags its peers.
There’s no easy way to figure the necessary capital raise, much less raise it. CDS spreads have been marching wider since January 2018, now about 100 basis points cheap to European peers.
There is no value play here: In 2015, level III assets equal 96% of its book value. This means its book value is way over-stated.
Expect some flavor of stealth nationalization with a bail-in that imposes pain on the maximum number of creditors.
The Back-Drop
Deutsche bank equity has been moving with 10Y bunds like a champ.
Second, Euro area inflation is rolling over, now at the lowest level since October 2016. With central bank policy stance shifting, even tentatively so, another 20 basis point decline before support is a high percentage shot. Never good for bank balance sheet health.
Finally, the increasing financial stress on the European banking system is embodied in the BTP/BUND spread. The ECB lowering bond repurchases combined with an upcoming rating agencies' decision on Italian sovereign debt has this spread trading in the 260 -280 basis point range (really big moves in the last two days). If there is the expected ratings downgrade on BTPs, don’t be surprised to see spread levels around 400 bps.
If correlations hold up given a move like this, it will put Deutsche bank in jeopardy because it is very, very under-capitalized. Without capital you can't write off bad debt. In what follows, we discuss why these correlations will hold. Then we perform some balance sheet analysis on DB to clarify the danger this name is in.
Once upon a time, on a planet about a decade ago, there lived a globalized financial system.
It was a high-performance, leverage-generating ecosystem. It book-ran trillions in dodgy bonds to state-owned enterprises in BRIC countries with to no rigorously verified financials. It bought up trillions in fixed rate long-term loans to household bear massive interest risk and metrics far beyond a families’ ability to service them out of income. Trillions in corporate loan much of which made at least some economic sense. It was as lean as a cheetah: fast, aggressive, and completely specialized for the environment it lived. As a predator it was far too specialized to survive even a modest change of environment.
How did it get so lean? Instead of capital buffers, it built big hedge books of contra-revenue and contra-liability assets that mitigated credit, currency, and interest rate risks very well, but introduced large and mostly unhedged counterparty risks on those hedge books. This risk was so unappreciated that loss-absorbing reserves—cash—was considered as unhealthy as a bucket of lard.
Some perspective: Bank reserve buffers globally were about 30% of assets in the 1960s. Leading up to 2008, reserve buffers had eroded to nearly nothing relative to wholesale repo and unsecured Eurodollar markets.
Lo, debt was everywhere. There were three types of borrowers a la Minsky:
Hedge borrowers: names that could pay interest and principal at all times.
Speculative borrowers: names that could pay interest out of cash-flow but need refinancing of principal to avoid default when loans come due.
Ponzi borrowers: names only able to pay interest and principal if they could refinance on the basis of rising asset prices on book.
Here’s an example to illustrate the difference between a hedge borrowers (safe) and speculative and Ponzi (toxic) borrowers. Assume a name is leveraged 5x(Debt/EBITDA), has capital expenditures 30% of EBITDA, and other cash outflows at 20% of EBITDA. If a given interest rate is 6.5%, then interest cost out of EBITDA is 32.5%. Cash interest cover is 50% of EBITDA. This means said name can pay 17.5% of EBITDA to debt principal. This is a hedge borrower where a measure of debt deleveraging is possible. Now… raise that leverage from 5x to 8x. A borrower then crosses over to speculative and Ponzi borrowing. At this leverage, the interest costs (52% of EBITDA) exceed the cash cover (50% of EBITDA). Thus, the name can’t even make interest payments.
It is not possible to differentiate speculative/Ponzi borrowers in terms of EBITDA. EBITDA is not decisive when an entity cannot pay both interest and principal. The issue becomes whether the combined net present value of future cash-flows and book value of the name exceeds its debt. The key different between these two types of borrowers is that Ponzi borrowers need rising book asset prices just to remain solvent.
Then book asset prices stopped rising. This is exactly the kind of modest environment change that started killing off banks in the financial ecosystem. The deaths lead to a vicious cycle where asset prices didn’t just stop rising. They collapsed. Prices always collapse at the worst possible time, while those liabilities and debt service remained mercilessly the same. More and more speculative borrowers became Ponzi borrowers in a vicious downward cycle.
This impacted creditors as much borrowers, precisely because bank are borrowers too. They borrow short-term funding rates and lend at long term rates. The economy and financial system were both dead in the water. The only real medicine was a default cycle to clear out the excesses through judicial due process. Low rates can make the sheer volume of defaults more manageable at the expense of asset productivity and lower rate of return. But ultimately debt write-offs and resolution are a very messy, complicated, bargaining process accomplished through courts or mediation.
The Choices
Everybody was culpable in making the mess. Borrowers shouldn’t have borrowed more than they could handle. Creditors shouldn’t have thrown credit around like cheap wine. Politicians and regulators that turned blind eye shouldn’t have turned a blind eye.
The choices available to the guys in charge were to allow market forces to clear the rot and in exchange lose control. Lose more TBTF banks, suffer systemic collapse, and imploding bond, forex, and commodity prices. Losing control to a politician is a no-go. The other alternative was to monetize debt, slowly resolve garbage banks, hold down interest rates, support real estate, prop up remaining US industry and equities, and flood the financial system with money. Control will be maintained somewhat, but the dollar will continue falling, zombie companies will lock up capital that could be used better elsewhere, and productivity will fall year after year. This was the price of control, the price of deflating a balloon without a sudden pop.
After all, this is why the Federal Reserve exists. It must pilot as best as it can a directed crash. Governments chose the latter, as did the ECB, the BOJ, and pretty much everyone else.
The Lessons
There is no limit to what countries will do to ensure banking system solvency, but a few ugly ducklings are free to die from time to time.
Central banks are no longer just the lenders of last resort in a currency. They are also the dealers of last resort to their corner of the financial system, willing to take toxic financial goop on its balance sheet when no one else will.
FDIC-style receivership of bail-in resolution for a TBTF bank is too complicated to do, central banks aren’t equipped to do it, and it can’t be done over the weekend in any case.
It is always the wrong time to unwind a derivatives book, so a regulator will go to great lengths to keep the entity intact.
Concealed nationalization is a better approach to money center bank resolution.
The Fed’s standing swap lines with other central banks make it the global liquidity source.
The Fed inherently more sensitive to global financial conditions, more sensitive to global growth, and inherently more dovish.
Bond liquidity will never be the same as it was before 2008 because Basel III limits matched repo bookrunning, the former source of market liquidity.
At ZIRP and NIRP interest rates gold is just another money market instrument. Either choice, you earn no interest.
Note that one of the lessons learned is that “[t]here is no limit to what countries will do to ensure banking system solvency, but a few ugly ducklings are free to die from time to time.”
Deutsche Bank is the ugly duckling in this bedtime story.
Any story about a bank starts and ends with its balance sheet. With a twist.
A bank balance sheet consists of assets, liabilities, equity… and management. It takes management to steer the composition of assets on book and management skill to extract returns from the book. Risk management. Liquidity management. One could argue this is the case for all businesses but it is especially true in the case of banks. The greatest banking analyst of all time, Walter Bagehot, write in 1873: “A well-run bank needs no capital. No amount of capital will rescue a badly run bank.”
Deutsche Bank doesn’t have stellar management. The Board has replaced CEOs like they are playing whack-a-mole. You never hear about high profile traders leaving Goldman Sachs or Morgan Stanley for Deutsche Bank. Most telling is that high-margin advisory activities where capital isn’t key and skill commands a premium, their 2016 league table rankings for fees are lackluster. In equities market share they ranked 6th out of 10, in debt 8th out of 10, and didn’t even rank in M&A. In 2016, their asset management AUM ranking stood at 19th out of 25. Wealth Management was decent, ranking 10th out of 25.
Poor management shows up directly in the balance sheet. Deutsche Bank CEOs have implemented a turnaround plan of cost cutting and staff reductions that impact liabilities, but it misses the core problem they have been incapable of addressing. DB carries too much leverage.
The leverage ratio of a bank is defined as Equity / (Securities + Loans). In 2014 it stood at 33.45% for Deutsche Bank compared to European peers averaging around 25%. A capital shortfall is a big problem because it locks a bank into holding toxic assets, as opposed to writing them off. Since 2014, DB equity has continued to fall off a cliff. Raising capital is only going to be harder in 2019 as central banks turn the credit cycle. A leverage ratio of 33.25% is also an extremely conservative estimate due to the composition of asset on balance sheet.
In 2015, Level III assets equate to 96% of tangible book value. Level I assets are liquid and mark-to-market assets. Level II assets are less liquid but can be marked with market inputs and discounting. Level III assets are illiquid and a market has to be made for Level III assets based on modeling assumptions of value. This tells you the book value of DB cannot be determined in any meaningful way, so no use in it for valuation purposes.
Datagrapple shows that since 2015, the CDS market has been pricing in more uncertainty (https://www.datagrapple.com). It is worth noting the DB credit spreads are wide to most of its European peers by ~100 bps.
Some misunderstand how the story will end. They think of our duckling as a value story, a swan in disguise because of its deeply discounted price to book value. In this view, one fine day, DB will meet some investors that think it is beautiful and flock to it with feathers and birdseed.
The story ends with the ugly duckling finding out he is the lone turkey among vultures. And in this story Thanksgiving is coming soon. A bunch of vultures tearing into Deutsche Bank is politically unseemly and damaging to incumbents. It is always the wrong time to unwind a derivatives book. Expect regulators to go to great lengths to keep the bird entity intact through concealed nationalization or some short-gun merger that bails-in the maximum number of creditors in the process.