Deutsche Bank AG (NYSE:DB): A Greek Tragedy At A German Institution? by Aswath Damodaran

This may be a stereotype, but the Germans are a precise people and while that precision often gets in the way of more creative pursuits (like cooking and valuation), it lends itself well to engineering and banking. For decades until the introduction of the Euro and the creation of the European Central Bank, there was no central bank in the world that matched the Bundesbank for solidity and reliability. Thus, investors and regulators around the world, I am sure, are looking at the travails of Deutsche Bank in the last few weeksand wondering how the world got turned upside down. I am sure that there are quite a few institutions in Greece, Spain, Portugal and Italy who are secretly enjoying watching a German entity be at the center of a market crisis. Talk about schadenfreude!

Deutsche Bank’s Journey to Banking Hell

There are others who have told the story about how Deutsche Bank got into the troubles it is in, much more creatively and more fully than I will be able to do so. Consequently, I will stick with the numbers and start by tracing Deutsche Bank’s net income over the last 28 years, in conjunction with the return on equity generated each year.

Deutsche Bank

If Deutsche Bank was reluctant to follow more daring competitors into risky businesses for much of the last century, it threw caution to the winds in the early part of the last decade, as it grew its investment banking and trading businesses and was rewarded handsomely with higher earnings from 2000 to 2007. Like almost every other bank on earth, the crisis in 2008 had a devastating impact on earnings at Deutsche, but the bank seemed to be on a recovery path in 2009, before it relapsed. Some of its recent problems reflect Deutsche’s well chronicled pain in investment banking, some come from its exposure to the EU problem zone (Greece, Spain, Portugal) and some from slow growth in the European economy. Whatever the reasons, in 2014 and 2015, Deutsche reported cumulative losses of close to $16 billion, leading to a management change, with a promise that things would turn around under new management. The other dimension where this crisis unfolded was in Deutsche’s regulatory capital, and as that number dropped in 2015, Deutsche Bank’s troubles moved front and center. This is best seen in the graph below of regulatory capital (Tier 1 Capital) from 1998 to 2015, with the ratio of the Tier 1 capital to risk adjusted assets each year super imposed on the graph.

[drizzle]Deutsche Bank

The ratio of regulatory capital to risk adjusted assets at the end of 2015 was 14.65%, lower than it was in 2014, but much higher than capital ratios in the pre-2008 time-period. That said, with the tightening of regulatory capital constraints after the crisis, Deutsche was already viewed as being under-capitalized in late 2015, relative to other large banks early this year. The tipping point for the current crisis came from the decision by the US Department of Justice to levy a $14 billion fine on Deutsche Bank for transgressions related to the pricing of mortgage backed securities a decade ago. As rumors swirled in the last few weeks, Deutsche Bank found itself in the midst of a storm, since the perception that a bank is in trouble often precipitates more trouble, as rumors replace facts and regulators panic. The market has, not surprisingly, reacted to these stories by marking up the default risk in the bank and marking down the stock price, most strikingly over the last two weeks, but also over a much longer period.

Deutsche Bank

At close of trading on October 4, 2016, the stock was trading at $13.33 as share, yielding a market capitalization of $17.99 billion, down more than 80% from its pre-2008 levels and 50% from 2012 levels. Reflecting more immediate fears of default, the Deutsche CDS and CoCo bonds also have dropped in price, and not surprisingly, hedge funds sensing weakness have moved in to short the stock.

Revaluing Deutsche Bank

When a stock is down more than 50% over a year, as Deutsche is, it is often irresistible to many contrarian investors, but knee jerk contrarian investing, i.e., investing in a stock just because it has dropped a lot, is a dangerous strategy. While it is true that Deutsche Banks has lost a large portion of its market capitalization in the last five years, it is also true that the fundamentals for the company have deteriorated, with lower earnings and hits to regulatory capital. To make an assessment of whether Deutsche is now “cheap”, you have to revalue the company with these new realities built in, to see if the market has over reacted, under reacted or reacted correctly to the news. (I will do the entire valuation in US dollars, simply for convenience, and it is straightforward to redo the entire analysis in Euros, if that is your preferred currency).

  • Profitability 

As you can see from the graph of Deutsche’s profits and return on equity, the last twelve months have delivered blow after blow to the company, but that drop has been a long time coming. The bank has had trouble finding a pathway to make sustainable profits, as it is torn between the desire of some at the bank to return to its commercial banking roots and the push by others to explore the more profitable aspects of trading and investment banking. The questions in valuation are not only about whether profits will bounce back but also what they will bounce back to. To make this judgment, I computed the returns on equity of all publicly traded banks globally and the distribution is below:

Deutsche Bank Global Bank Data
I will assume that given the headwinds that Deutsche faces, it will not be able to improve its returns on equity to the industry median or even its own cost of equity in the near term. I will target a return on equity of 5.85%, at the 25th percentile of all banks, as Deutsche’s return on equity in year 5, and assume that the bank will be able to claw back to earning its cost of equity of 9.44% (see risk section below) in year 10. The estimated return on equity, with my estimates of common equity each year (see section of regulatory capital) deliver the following projected net income numbers.

Year Common Equity ROE Expected Net Income
Base $64,609 -13.70% $(8,851)
1 $71,161 -7.18% $(5,111)
2 $72,754 -2.84% $(2,065)
3 $74,372 0.06% $43
4 $76,017 1.99% $1,512
5 $77,688 5.85% $4,545
6 $79,386 6.57% $5,214
7 $81,111 7.29% $5,910
8 $82,864 8.00% $6,632
9 $84,644 8.72% $7,383
10 $86,453 9.44% $8,161
Terminal Year $87,326 9.44% $8,244

I am assuming that the path back to profitability will be rocky, with losses expected for the next two years, before the company is able to turn its operations around. Note also that these expected losses are in addition to the $10 billion fine that I have estimated for the DOJ.

  • Regulatory Capital 

Deutsche Bank’s has seen a drop in it Tier 1 capital ratios over time but it now faces the possibility of being further reduced as Deutsche Bank will have to draw on it to pay the US

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