Recent discussion of possible European bank bailouts has focused on Italy. Saddled with €360bn of souring loans and enfeebled by a stagnant, over-regulated economy, a number of Italian lenders face a very real risk of insolvency.
In July, the country’s third largest, Monte dei Paschi di Siena, failed a stress test set by the European Central Bank (ECB). In the same test, Deutsche Bank just managed to scrape through. But a potential fine by the US Department of Justice (DoJ) looks to be testing the resistance of Germany’s largest bank for real.
Earlier this month, the DoJ announced that it is seeking $14bn to settle claims that Deutsche mis-sold mortgage-backed securities before the financial crisis, causing the share price to plummet. That sum is not far from the bank's total market capitalisation of $18bn.
Yesterday, a further 7 per cent was wiped off after comments by unidentified government officials to a German magazine, Focus, claiming that Chancellor Angela Merkel would not be offering any state assistance to the bank to pay the US authorities in the short term, or before next year’s election.
The bank has downplayed the idea that it will need assistance, but investors have endured a torrid year and its share price is now languishing at a level last seen in 1992.
Europe’s lenders are suffering from a toxic cocktail of poor economic growth on the continent and higher capital requirements. And the pressure has intensified since the ECB began imposing negative interest rates late last year, essentially charging banks on their cash deposits.
Wary of passing negative rates onto their customers, and forced to keep enough cash and liquid assets on hand to sell quickly in the event of another crisis, their potential to make profits has been reduced. Deutsche Bank, however, faces a host of other problems as well.
Deutsche has a low capitalisation, the largest derivatives portfolio in the world, and many of the bank’s businesses are low on returns. Chief executive John Cryan has been cutting risky assets, and has removed around 9,000 staff and suspended dividend payments. Deutsche is trying to sell off assets, such as the 20 per cent stake it has in Hua Xia Bank, but this has yet to go through. “The restructuring hasn’t gone well,” says Spread Co’s David Morrison. “And there has been talk that there may need to be a rights issue.”
Deutsche is confident its settlement with the DoJ will be far less than $14bn, though Bank of America ended up paying it $16.7bn. At the end of June, the German lender had set aside litigation provisions of $6.2bn. Though its shares are cheap relative to its assets, “there are still downside risks,” says Morrison, and many believe its stock has further to fall.
Is a bailout feasible?
Speculation that Deutsche will be left to go the way of Lehman Brothers, which was allowed to collapse in 2008, may be exaggerated. “If this continues, it’s likely to be similar to the Royal Bank of Scotland (RBS) situation,” says Bill Blain, head of capital markets and alternative assets at Mint Partners. In 2008, RBS called on investors to buy new shares in a £12bn rights issue before receiving a bailout from the UK Treasury.
“No matter what Merkel has said, some kind of bailout will be arranged. It’s nailed on,” he says. “[Deutsche] is too important to the German economy – that’s a view supported by Allianz and some of the bigger German financial institutions.”
But even if there is a rescue, things will be worse for Deutsche’s bondholders than they were for the creditors of banks bailed out during the financial crisis.
No matter what Merkel has said, some kind of bailout will be arranged. It’s nailed on.
As part of a new European directive which came into force this year, bondholders may find their debt converted to equity if Deutsche’s capital falls below a certain level. Designed to “bail in” bondholders before any taxpayer-funded bailout occurs, coupon payments could be missed and even senior creditors may find themselves on the hook.
“Our central scenario is that they won’t switch off coupons [on tier 1 bonds], but it can’t be ruled out,” says Carlo Mareels, credit analyst at MUFG Securities. “We still see risk as significant and that needs to be priced in. However, if the DoJ’s fine is in the area of $6bn or higher, our view is that a capital raise may be necessary.” In July, Cryan ruled out the need for a capital raise.
But the panic around Deutsche has spread to other banks, and all lenders in the Stoxx 600 were brought down in yesterday’s trading. Barclays, UBS, HSBC and others may also be targeted by the DoJ, but are better positioned to deal with potential fines.
Bondholders may find their debt converted to equity if Deutsche’s capital falls below a certain level.
Given the pressure it placed on Greece as a condition of its rescue, bailing out Deutsche would be very difficult politically for the German government. And while €200bn of Italian bank bonds are owned by Italian retail investors, Deutsche is largely owned by institutional investors, for which the taxpayer will have less sympathy.
As her popularity dwindles, there is little wonder Merkel is reluctant to wade in.