Looming Banking Crisis? Understanding Deutsche Bank with Historical Context October 2016
- Peter A. Johnson, Chief Executive Officer and Portfolio Manager
Why We Think Deutsche Bank Can Avoid a “Lehman Moment”
Financial news headlines have recently profiled Deutsche Bank AG (DB) as a potential rerun of Lehman Brothers in 2008, where the failure of a major investment bank precipitates a near collapse of the global financial system. The story received international attention in September, when the public learned that the U.S. Department of Justice was seeking to fine Germany’s largest bank $14 billion (€12.72 billion) for falsely stating the risks of mortgage backed securities sold before the Global Financial Crisis. The price of DB stock has dropped by half during 2016, and news of the fine brought about speculation that the institution might imminently fail.
Deutsche Bank AG is at the center of the European financial system and a counter party to nearly every other European Bank, so a failure could severely destabilize an already fragile European financial system, and perhaps carry global implications. Ashfield Capital clients are not directly invested in DB, nor do we have any meaningful exposure to the European financial sector. However, any level of crisis that impacts the global financial sector would impact global stocks. As such, it is important to closely weigh whether the Deutsche Bank fine could represent a “Lehman moment.”
Examining Deutsche Bank’s Liquidity Position
At the time the public was made aware of the potential $14 billion fine, Deutsche Bank’s (DB) market capitalization was also around $14 billion. This coincidence led many to the false conclusion that the fine was capable of wiping out the bank. Such a comparison confuses market capitalization with capital position—DB has a €1.7 trillion balance sheet with about €220 billion in liquid reserves (as of the end of Q2), with high quality liquid assets totaling €196 billion. That is compared to the €65 billion it had in 2007, which shows that Deutsche survived the worst financial crisis with less and has also increased its liquidity reserve 3.4x from pre-crisis levels.
Bank failures generally tend to stem from a liquidity event, not a solvency one. At the time the Federal Reserve forced its bankruptcy, Lehman’s assets exceeded its liabilities. Solvency was not the issue. Liquidity became the issue with the passage of the accounting rule FAS 157 in November 2007, which forced it—and other banks—into massive mark-to-market write-downs on mortgage-backed securities. This was Lehman and other bank’s liquidity event. Where banks had been counting mortgage-backed securities as long-term assets on their balance sheets, the accounting rule forced them to re-value the securities in terms of what they could be sold for immediately. At that time, this meant making many of those assets worthless, even though they largely were not—there was just no market for them at that time. It forced banks from a position of ‘highly leveraged’ to ‘severely leveraged.’
The mark-to-market write-downs severely impacted Lehman’s capital position and essentially destroyed its loan collateral, making it near impossible to secure overnight funding to cover its daily obligations. Every bank relies on overnight/short-term loans for everyday operations, and their balance sheets serve as collateral to secure those loans. With a destroyed balance sheet, a bank will be shut out. Lehman could not sell off other assets on its balance sheet quickly enough to shore up its capital position, and as a pure investment bank it could not tap the Federal Reserve’s discount window for emergency funding. No other bank wanted to risk stepping-in to help, and the collapse ensued.
Deutsche Bank’s situation is different in just about every way. It not only has ample liquidity on its balance sheet, it also has €5.5 billion in reserves set aside for litigation costs. Deutsche could also sell new stock in the amount of about €5 billion without requiring shareholder approval, which taken together would already be close to enough cash needed to cover the DOJ’s suggested fine. Being a German bank, Deutsche also has access to a lender of last resort in the European Central Bank, which Lehman did not have.
At this point DB is posturing for the worst and has been cutting costs and exploring options to raise capital from additional share sales, asset disposals, or both. It has currently secured backing from its largest investor and is seeking advice from other banks. We would not expect a capital raise until the actual fine is known, since the market will likely not be receptive to new shares without knowing the full impact on DB’s capital position. But the interest in new shares has already been established, as some of Germany's top industrial companies have revived a decades-old network to discuss taking a direct stake in the bank; in addition, Qatari investors (who own the largest stake in the bank ~10%) have indicated they do not plan to sell their shares and would consider buying more.
The Bottom Line
It still remains to be seen what the actual Department of Justice fine will amount to. In 2014, the DOJ sought $12 billion from Citigroup for the same allegations, but Citi ultimately knocked that number down to $7 billion. Additionally, some of the fines levied will be for consumer relief, which will mean forgiving loans or changing terms of loans for lower monthly payments. In essence, that means DB would not have to fork over that cash, they would just have to forego receiving it in the future.
The risk we’re watching most closely is how Deutsche’s hedge fund/prime brokerage customers respond on a going forward basis. So far, DB has only lost about 1.25% of their clients (10 of 800), so it is far from a Bear Sterns-level mass exodus. These clients, however, account for €71 billion of the €220 in liquid reserve on Deutsche’s balance sheet, so losing all of those clients would change the narrative completely. While it does not appear to be a pressing risk right now, in our view it is the key variable to watch closely.
U.S. banks remain well-capitalized.
If you have any questions about this commentary, our current market outlook, or your portfolio strategy, please do not hesitate to reach out to us. Thank you for your continued confidence.
The opinions expressed herein are strictly those of Ashfield Capital Partners, LLC and are subject to change without notice. The information provided is for illustrative purposes only and is not intended to be investment advice or securities recommendations.