September 27, 2016
All eyes this morning are on Hillary Clinton's supposed victory. Our focus over the last 24 hours has been the astonishing events surrounding Deutsche Bank. Hardly a day passes by when somebody is not asking us what will happen to it. Will the German government bail it out? What would be the consequences? What would be the implications for the rest of Europe, especially on the Italians, who have been observing EU rules fastidiously.
Deutsche Bank yesterday took a new hit in the financial markets: share price down over 7%, CoCos down 3%, CDS spread over 250bp. Deutsche bank's CDS have been elevated since the start of the year, and the recent stock price movements fit an 18-month trend where the share has lost two thirds of its value. What's different this time is the external circumstances. Monday's movements are likely the reaction to reports - denied by both parties - that the bank sought help from the German government in relation with an impending US Department of Justice fine over the mis-selling of subprime mortgage-backed securities. The German government would neither provide diplomatic help, nor consider a bail-out. The problem is not the fine itself, but its size, which according to leaks could reach $14bn. This is well above the €5.5bn that the bank said earlier this year that it had provisioned for legal costs. As long as there is uncertainty over the possibility that the fine exceeds Deutsche Bank's legal provisions, markets can be expected to be nervous.
About half of DB's legal provision is reportedly earmarked for the mortgage case. Frankfurter Allgemeine suggests that the leak of the larger DoJ figure may have been in reaction to the bank disclosing that it expected to be fined up to $2.5bn in the case. In a comment on Frankfurter Allgemeine, Franz Nestler blames DB's CEO John Cryan for this, which is strange given that he cannot be blamed for the original malfeasance as he's only been in charge for some 15 months. Nestler also criticises Cryan for not having a plan to raise capital.
The question is, then, will the DoJ fine exceed DB's ability to pay it, and how would that be resolved? Compared to DB's €1.8 trillion balance sheet, €14bn is a relatively small amount. In its Q2 financial statement, the bank reported under €21bn in retained earnings and €62bn in shareholders' equity, though its market capitalisation has dropped to under €15bn. The bank has over €160bn in long-term debt, €8bn of which subordinated. In its annual report it listed €12bn in hybrid Tier 1 and €8bn in Tier 2 capital instruments. And a fine does not impair its assets. So, it does not look like government help would be necessary. The problem is not Deutsche Bank, but the knock-on effects of, say, a bail-in of subordinated debt. We don't know who holds DB's subordinated debt - could there be German pension funds caught in there?
The German government needs to worry about the systemic implications. While Deutsche Bank's activities are mostly outside Germany these days, the bank remains central to German interbank liquidity and foreign clearing operations. The bank is clearly too large to fail, which is why the German government's principled denial of a readiness to help recapitalise the bank lack credibility. They don't want to be drawn into a recapitalisation debate ahead of the elections. And they certainly don't want to trigger any bail-in procedures, or break EU state aid rules.
We also have stories on Italy’s constitutional referendum in December; on the apparent lack of of a Brexit effect; on Pedro Sánchez challenged by his party; on Syriza’s different battle fronts; on Emmanuel Macron leading the polls on the left; and on Portugal still on track to reach the deficit target against all odds.