Quantitative Factors
At some $1.5 trillion in total assets, Deutsche Bank AG (NYSE:DB) ranks 17th in the world by assets -- if you include the state-owned banks in communist China on the list of global depositories. At the end of 2019, DB closed below $8 per share, equating to 0.2x book value with a projected earnings growth (5 years) of negative 5%.
DB is a bank that increasingly has no clear reason to exist. It has been shrinking its assets and off-balance sheet swap exposures as management attempts to rationalize the bank’s business model, but most recently management has backtracked and begun to again expand these activities.
Like Citigroup (NYSE:C) and Goldman Sachs Group (NYSE:GS), DB’s business is heavily focused on capital markets and derivatives trading, and equally light on traditional banking business and core deposits. In the Appendix to this report, we feature an interview with Achim Dübel, who discussed the origins and defects in the business model of DB and other German institutions.
Only 30% of the bank’s revenue and funding come from operations in Germany, thus the future of DB as a going concern is largely based upon its foreign non-bank securities operations. Less than one third of DB’s balance sheet is funded with deposits with the remainder supported by borrowings in the capital markets. The table below shows the rough allocation of the assets and pre-tax revenue different business lines of DB:
Source: Deutsche Bank
The Corporate Bank has displayed relative stability in terms of revenue, but has slipped into loss periodically. The Investment Bank, DB’s largest and most variable business line, has been under pressure in recent quarters. In the nine months ended Q3 2019, the investment bank generated only €537 million in pre-profits or less than half the previous level.
One of the difficulties of performing a financial analysis of DB is illustrated by the table above. The presentation of DB financials is opaque to put it mildly. Note that when you add up the total assets of the different business units in the DB Q3 2019 financials, the total is €400 billion less than the €1.501 trillion in “total assets” included in the Q3 financials. The difference is allocated to what DB management calls the “Capital Release Unit,” which is essentially the repository for the bad assets and non-core businesses accumulated over the past decade. There is little or no visibility into the contents of this business unit.
One of the most important points to make about DB is that the bank is critically under-capitalized. The €1.5 trillion in total assets is supported by €58 billion in total shareholder equity for a “fully loaded” leverage ratio of less than 4% as of September 30, 2019. Tangible equity is just $51 billion and has been falling for several years.
Virtually all of the intangible assets within DB, some $8.9 billion as of 9/30/19, is carried on the books of its top-tier US unit, DB USA Corporation (RSSD:2816906), a $120 billion asset bank holding company that ranks 37th by assets among US banks. The holding company has dozens of US and foreign affiliates, including Deutsche Bank Securities and Deutsche Bank Trust Company.
When you subtract the intangibles from the reported total equity capital of DB USA Corporation of $13.5 billion, the common equity of the BHC is essentially wiped out. What’s left is a bit more than $4 billion in perpetual preferred stock. The US unit of DB includes several important business lines that provide administration and custody services to the US capital markets. The chart below shows the results of DB USA Corp as reported to the Federal Reserve Board.
Source: FFIEC
The management of DB generally does not talk very much about the capital shortfall in its investor presentations, preferring instead to focus on the fantasy view of “risk weighted assets” (RWA) afforded by the Basel framework. DB’s RWA is €344 billion, allowing the bank to report to investors and regulators a ratio of Common Equity Tier 1 (CET1) capital to RWA of 13%. But the reality is very different and raises basic questions as to how DB continues to do business in the US market, at least as a bank holding company subject to regulation by the Federal Reserve Board.
Most European banks, like DB, largely play the game of referring to RWA in their financial disclosure to investors. EU bank regulators are entirely complicit in this charade. Indeed, since the end of 2017 DB’s total capital has actually fallen every quarter. The bank has sought for years to raise new common equity, but with the bank’s stock trading at 20% of book value, there is no real possibility of completing an offering of new common shares. The purchase of DB shares by HNA of China using substantial leverage was a ridiculous episode that provided no new common equity to the bank. HNA has largely sold its position in DB as the company has sought to reduce debt.
When DB CEO Christian Sewing says that DB’s capital is “at the high end of our international peer group,” he is correct when the focus is only European banks. In comparison with its US peers, however, DB ranks toward the bottom of the list in terms of capital, efficiency and profitability. This is one of the key reasons that we include DB in the IRA Bank Dead Pool.
Banks that are members of the IRA Dead Pool have poor financial performance, inferior equity market valuations and no apparent plan to correct these deficiencies. As this IRA Bank Profile was finalized, US financials were at the highest equity market valuations in a decade, but the four institutions in the IRA Dead Pool – DB, GS, C and HSBC Holdings (HSBC) – all trade at or below book value. DB has the lowest multiple of equity price to book value of any major bank.
One area where DB has been hurt in Europe is the negative interest rates maintained by the European Central Bank. That said, however, it is important to note that the bank has a higher cost of funds than many of its peers. The chart below shows the cost of funds of DB USA Corporation vs some of the largest US banks and the 128 largest banks in Peer Group 1. At the end of Q3 2019, the cost of funds for DB USA Corporation was 250% of the average for Peer Group 1.
Source: FFIEC
DB has been mostly focused in recent quarters on decreasing leverage and releasing capital to placate frustrated investors, something that is a positive trend in credit terms but is unlikely to increase profitability in the near term unless accompanies by further cuts in overhead expenses. The transfer of the bank’s Prime Finance and Electronic Equities business to BNP Paribas (BNP) is a key part of this strategy, according to DB management.
Qualitative Factors
The fundamental issue when it comes to the qualitative analysis of DB is the business model and the bank’s execution of that strategy. Both the management team and the board of DB are culpable in this regard but frankly have few easy choices when it comes to repositioning the bank.
Market Strategy
First on the list of concerns is market strategy. In terms of management and corporate governance, DB has struggled for years to find a business approach to deliver consistent profitability, the key measure of stability for any bank. The supervising board of DB has likewise been unable or unwilling to make positive changes to the direction of the bank.
For the full year 2017, the bank lost €735 million. In 2018, DB delivered a profit of just €341 million. In the first nine months of 2019, DB lost €832 million. As yet, the management team has been unable to articulate a coherent plan to move forward to avoid such poor results. Most recently, CEO Sewing has indicated that the bank wants to grow in private banking, a highly competitive area that is unlikely to yield quick results in terms of business volumes or profits.
Of note, in the middle of 2019, DB announced that it was re-entering the market for credit default swaps (“CDS”) as a dealer, illustrating the bank’s desperate need for revenue and, again, raising questions as to the long-term business model of the bank. As noted above, DB shut down CDS trading in 2014 in an effort to de-risk the bank and focus on other areas of banking.
“[The] return to CDS trading stands in contrast to the group’s ongoing disposals of assets as it retreats from parts of investment banking, Bloomberg News reported in September of 2019. “Sewing has marked the entire equities trading division and large parts of interest-rate trading for wind down.” While the bank is cutting back in some unprofitable areas such as equities trading, it continues to embrace high risk, highly leveraged activities such as investment banking and derivatives trading as a key part of its business.
Risk Management
The second factor to consider is risk management. The quantity and quality of DB’s earnings is inferior to that of other large banks operating in the global capital markets. From underwriting sub-prime mortgage loans to money laundering to inferior quality investment banking clients, DB has been willing to accept business from dubious sources in a desperate effort to boost earnings – creating oversize operational and reputation risks for the bank in the process. More, the bank has refused to make adequate disclosure of these risks to investors.
One example of DB’s poor management and disclosure of risk is in the US market for subprime mortgages. In 2017, the US Justice Department, along with federal partners, announced a $7.2 billion settlement resolving federal civil claims that DB misled investors in the packaging, securitization, marketing, sale and issuance of residential mortgage-backed securities (RMBS) between 2006 and 2007.
The poor quality of DB’s subprime mortgage lending and securitization activity is legendary among institutional investors. The $7.2 billion agreement represented the largest ever RMBS resolution for the conduct of a single entity and included a $3.1 billion cash payment and $4 billion in assistance to relief to underwater homeowners, distressed borrowers and affected communities.
Consider another example. In February 2019, for example, the Wall Street Journal reported that DB had lost approximately $1.6 billion over a decade in a bond strategy gone awry, but failed to disclose the loss to investors in a timely fashion.
“The loss, which hasn’t previously been reported, represents one of Deutsche Bank’s largest ever from a single wager—roughly quadruple its entire 2018 profit—and ranks as one of the banking industry’s biggest soured bets in the last decade,” Jenny Strasburg and Gretchen Morgenson of the Journal reported.
The tendency of DB and other EU banks to fail to perform adequate risk management when it comes to market, operational and other hazards is a serious qualitative deficiency. In a prominent example, the role of DB in laundering billions of dollars for Russian criminals with links to the Kremlin, the old KGB and its main successor, the FSB, badly damaged the bank’s credibility. Last year, DB conceded that the “Global Laundromat” scandal hurt its “global brand” and is likely to cause “client attrition,” loss of investor confidence and a decline in its market value.
DB is known on Wall Street as a bottom feeder that supports shoddy deals and is not afraid to use bribery and other questionable means to obtain business. As The New York Times reported in October 2019:
“[T]he German lender used gifts and political maneuvers over 15 years to become a major player in China. More than 100 relatives of high-level Communist Party members were hired for jobs at the bank without meeting qualifications, and millions of dollars were paid to Chinese consultants with access to politicians.”
Needless to say, there is in DB an appearance of a culture of corruption which carries with it enormous operational and reputation risk for the bank. In an interview with The Financial Times in July last year, CEO Sewing described DB as a business where “we lost our compass in the last two decades.” He accused his predecessors of a “culture of poor capital allocation” and chasing revenue, without concern for sustainable profits. Yet he has never mentioned the poor management and weak corporate governance that allowed these events to occur in the first instance.
But perhaps more important than even seeking stable profits is the need to avoid investment banking business that threatens the bank’s reputation and ability to continue as a going concern. It is significant that even as Sewing has focused on reducing risk and leverage, DB has begun to rebuild its investment bank. At the end of 2019, in a change of tone that surprised many analysts, CEO Sewing revised upwards the 2022 financial guidance targets, signaling that the investment bank will again become DB’s fastest-growing business.
Liquidity
The third qualitative factor, namely liquidity, has been addressed above from a quantitative perspective, but is also a reflection of management and the bank’s reputation. The fact that DB has been willing to follow business strategies that hurt the bank’s reputation and standing with global regulators makes it difficult to convince counterparties to support the bank with either deposits or capital.
The bank’s possible role in a vast money-laundering scandal at the Danish lender Danske Bank, for example, marks another instance where DB management and supervisory board failed to adequately oversee the bank’s operations and enforce anti-money laundering laws. These lapses, in turn, have damaged the bank’s reputation, which impacts the ability of DB to fund its operations.
Given the clear quantitative evidence in the bank’s US disclosure that the cost of funds for DB is significantly higher than that of its peers, it is difficult not to conclude that poor management is the key contributing factor to this inferior market position. The failure to supervise the bank’s operations and, more important, the choices of business strategy have contributed not only to a sharp drop in the bank’s equity market valuations, but a related increased in the bank’s cost of funds.
When an issuer has a deeply depressed stock price, this factor tends to affect debt spreads and credit derivatives markets such as CDS. Early in 2019, DB’s CDS was trading 200bp over the Treasury yield curve because of investor concerns about an imminent default. Since, the middle of 2019, however, the market expectations regarding a default by DB moderated and CDS prices have fallen dramatically. This welcome improvement, however, did not translate into a stronger price for the bank’s common stock. The fact of central bank action to drive down benchmark interest rates and credit spreads must also be factored into the analysis of DB’s improving pricing in CDS.
Operating Environment
Finally, the global market for universal banks is more competitive now than at any time since 2008. The fact of negative interest rates in Europe, combined with the competition from larger, better capitalized and managed institutions in the US, creates a very difficult operating environment for DB and other European banks. The fact that DB under current leadership thinks that it can grow in areas such as investment banking and CDS dealing suggests that the bank’s management is badly out of touch with reality.
In 2019, EU commercial and investment banks across the board saw a significant decline in such areas as equity trading, prime brokerage and investment banking. This is one reason that DB made a decision to sell business units in these areas. In order to replace the lost revenue from these areas, DB decided to move back into CDS trading, albeit limited to cleared swap contracts that have lower capital and margin requirements.
As the requirements of Basel III for posting initial margin for many derivatives contracts come into full effect in 2020, however, it remains to be seen whether DB will have the capital to grow or even maintain this business. More, the embedded risk in CDS contracts, which is ultimately tied to credit spreads on individual corporate exposures, creates the potential for future surprises that could put the stability of DB at risk. The huge number of sub-investment grade issuers such as SoftBank, which have traditionally been the sweet spot for DB’s investment banking clients, creates the potential for a negative credit event that could adversely impact the bank.
Caught between regulatory requirements, much needed infrastructure investments and cost reduction initiatives, all of the major universal banks in Europe are being squeezed in terms of profitability and are being forced to downsize. Eurogroup Consulting noted in a 2019 report:
“US CIBs have strengthened their position outside their home borders notably as a result of a strong domestic market with a more favourable regulatory landscape. European CIBs have been crippled by stringent regulation and scarce resources, whilst attempting to implement cost reductions programmes to address their cost base European CIBs must now consider drastic structural changes and address the fundamental constraints the industry is currently facing: cost inelasticity and revenue decline. They should focus on Asset Industrialisation and Structured Finance opportunities.”
Translated into plain terms, DB and other EU banks need to shed high-risk business such as trading and traditional investment banking, and instead become asset managers and originators of structured finance transactions. Models such as UBS Group (NYSE:UBS), Credit Suisse Group (NYSE:CS) and Morgan Stanley (NYSE:MS) come to mind, but DB simply seems to lack the tools and the vision to make this type of dramatic change. We view the prospect of DB doubling down in markets such as investment banking and CDS trading with alarm and wonder whether prudential regulators in the EU and the US fully understand the implications of the latest strategy pronouncements by DB’s leadership.
Assessment
After considering the quantitative and qualitative factors affecting DB, its is relatively easy to reach an overall assessment for the bank which is negative. But perhaps the most significant and disturbing factor facing DB is the feebleness of the bank’s management and corporate governance. DB exhibits a striking weakness in terms of business model selection and internal systems and controls, yet the bank seems unable or unwilling to change.
Putting scarce capital into growing market share in investment banking, OTC derivatives, leveraged loans and collateralized loan obligations (CLOs), for example, strikes us a distinctly unattractive at the present times. But the fact is that for the past decade or more, DB has made a living of sorts by advising inferior banking clients and underwriting equally suspect assets that other global banks will not touch. The legal and reputational risk from these activities have been enormously costly to the bank and its shareholders.
Despite this and other examples of the toxic nature of the DB business, the management of DB, along with the supervisory board as well as senior German politicians up to the highest-level, refuse to accept that the bank has fundament problems. CEO Sewing told investors last year: “[w]e are seen as one of the better banks in this business and, therefore, we see increasing volume.” The vision of DB inside the executive suite as well as in German business circles seems to be taken from a parallel universe where bad intentions and equally bad actions are somehow seen in a positive light.
We assign a negative outlook to DB and have little expectation that the situation will change in the near term. In our view, the most promising way to resolve what is an increasingly precarious situation would be for DB to sell its US operations in their entirety and wind up the remaining bank operations. Since Germany political leaders refuse to consider such a possibility, we expect that DB will stagger along, depleting capital and creating outsized risks, until such time as the bank’s poor management makes a mistake of sufficient magnitude to cause the bank to fail.
Appendix: Interview with Achim Dübel
Achim Dübel on Deutsche Bank AG
The Institutional Risk Analyst
May 6, 2019
New York | In this issue of The Institutional Risk Analyst, we talk to our friend Hans-Joachim (Achim) Dübel of FINPOLCONSULT in Berlin to provide some context for the latest troubles affecting Deutsche Bank AG (DB) and the German banking system more broadly. Dübel is one of those rare independent analysts of the banking sector in the EU and has worked on a number of internal and external debt restructurings.
In our conversation, Dübel reminds us of the obvious, namely that the largest “bank” in Germany is not really a bank at all when compared with US institutions. Even the $2 trillion asset JPMorgan Chase (JPM) is still more than half core deposit funded and boasts a significant loan book focused on small and medium size enterprises (SMEs). A fatal flaw in the business model of Deutsche and many other private German lenders has led to the present juncture. Deutsche seems so toxic due to bad loans and inadequate disclosure that it cannot raise new equity capital or combine with another institution.
“In a nutshell, German (and Japanese) banks are traditionally bond buyers and not lenders, notes Duebel. “All of them, not just Deutsche and Commerzbank AG. Germany doesn’t have a pension system, so much of our surplus has to go through bank deposits and bonds bought by banks.” He notes some of the structural differences between banks in Germany and the US, but cautions that these disparities are not sufficient to explain the decline of German banks.
“Structurally they didn’t build up international retail and SME lending as opposed to, for example, BNP Paribas (BNP). As their corporate client base increasingly became banks themselves, Deutsche thought they could compensate through trading income,” he notes. “Of course the strong cooperative and public banking system made the domestic retail/SME market difficult, but that is no excuse. Consider the international success of BNP or Société General (SG) against strong domestic co-operative bank competition. German banks used to be internationally strong in Latin America, Russia and the Middle East, these markets are history today.”
Once the focus on traditional corporate and SME lending started to fade, Deutsche Bank and others were lured by the big returns of global investment banking, notes Dübel. “Being securities-overweight, they jumped into extremely crowded investment banking, where banking is dominated by the soccer model (most profits end up with staff, not shareholders),” he relates. Dübel notes that Deutsche and other German banks reaped a large share of their profits from taking market as opposed to credit risk, which is extremely curve- and volatility-sensitive. In addition, due to weak regulations, the German banks pushed up risk levels across their portfolio, with disastrous results.
“Where they ventured into credit risk especially,” Dübel notes, “Deutsche focused on the synthetic market where it didn’t have a natural hedge due to the absence of a real credit portfolio. They ran into legal troubles when seeking those opportunities in local governments, retail investors, etc. They were brutally hit by adverse selection in bonds from Anglo investment banks during the crisis. And they contributed to inflating the economy of our neighbors and the U.S. via the bond markets. With ZIRP and only low-yield alternatives in the bond market, Deutsche effectively was bailed out by American and German governments without any consequences.”
Dübel believes that the key issue as first mentioned is the unhealthy structural development, that is, management mistakes at Deutsche. “Achleitner (Allianz, Goldman) fired Cryan because he wanted to correct the investment banking bias. Now he trapped himself into something worse,” says Dübel. “I believe in contrast that the money laundering allegations against Deutsche Bank are mostly politically driven. Look who is talking. Details are very hard to verify.”
Dübel adds: “Also let us not forget that international banking is as brutal as international oil. German banks were strong for example in Russia and Iran – these countries were lost as clients due to political pressure. One serious mistake they made is to leave everything in between Central/Eastern Europe to Italian and Austrian banks. So bizarrely, today Unicredit (CRIN) of Italy is a more serious contender for a Commerzbank takeover today than Deutsche.”
As we’ve noted in The IRA previously, Deutsche has been struggling to make a bad business model work for over a decade. Faced with the fatal structural flaws in the business, the bank has drifted without clear direction from its board of directors and management.
German pride makes it impossible for the government of Chancellor Angela Merkel to admit the obvious, namely that Deutsche Bank needs to be wound down and sold. And the public anger at big banks makes it politically impossible for the German government to take an example from Italy and lead this process. Thus we wait to see a solution to the financial and operations problems at Deutsche Bank as the moral hazard risk facing the markets grows.
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