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Deutsche Bank: The “DEUTSCHE BROS”

Deutsche Bank: The “DEUTSCHE BROS” by Simon Jacques

Something is wrong in Deutschland, namely Deutsche Bank¸AG. In 2015, DB has received fines for the manipulation of the Libor, money laundering and for the inadequacy of its information and compliance systems.

Regulators squarely blamed DB senior staff for misleading them, failing to be open and cooperative, and prolonging the investigation.

It is no coincidence that the procedures in all cases were brought by the U.S and UK authorities, and not the EU regulators, which were drawn into the investigation in retrospect.

Now what to do with John Cryan, CEO of DB, shakily telling its staff to spread the message that the bank is “rock solid” and assuring that the Bank has liquidity and capital adequacy?

Even the assurances of the mighty German Finance Minister Wolfgang Schauble are not enough to reassure the financial markets.

The financials of Deutsche Brothers are enough to convince anyone that the situation is not looking good: what remains to be ascertained is how bad it could get.

Deutsche Bank is in the red and will continue to generate losses for several years as heavy fines and hyper-leveraged assets are booked to fair value, leading the bank to the necessity of a recapitalization.

DEUTSCHE BROS

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It is worth noting in the context of Basel III, DB’s risk-weighted assets form only 0.4-to- 1 of the assets side of the balance sheet, while the average for the US banking sector is 0.8-to-1.

This means that the financial institution will leverage its available liquidity twice as much as the other banks while increasing its actual level of risk.

At least we can say that over the last three years, DB’s balance sheet has been hiding unpleasant surprises. The constant assurances of the officials and the bank itself are causing serious doubts about their credibility.

Regulatory arbitrage

The German bank for years managed to “hide” from its balance sheet loans worth €395.5 billion, or the equivalent of one fifth of its portfolio, through agreements with other banks. With these agreements, the Deutsche Bros have managed to avoid recording substantial risks in their portfolio, thus showing better picture of its capital adequacy in the face of the financial regulators, evading billions of capital requirements, increasing their leverage and showing a better picture on an equity adjusted-basis.

Deutsche Bank: The "DEUTSCHE BROS"

At the same time, the bank has created leveraged products, building a gross notional exposure of €60 Trillion, a figure sixteen times greater than the German gross domestic product in 2014.

Also the Deutsche Bros have been involved in the offshore tax-haven operations scandal.

The recent public announcements reassuring the stability and adequacy have just convinced us that something is wrong with the Bank.

The Bank said Monday that its economic situation will allow paying all of its financial obligations for 2016 and for 2017.  However, something is off because DB’s liquidity hinges on the financial demand for high-yield instruments.

Overall, the past four years have seen a supportive dynamism in the primary activity across the major convertible bond markets.

Deutsche’s “CoCos”

These instruments carry a distinct accounting advantage as unlike other kinds of convertible bonds, CoCos do not have to be included in a company’s diluted earnings per share until the bonds are eligible for conversion.

Deutsche’s “CoCos”, the so-called contingent convertible bond prices have plunged to a record low. The liquidity river for capturing the convex potential in the convertible bond of DB has now dried-up.

DEUTSCHE BROS – 6% CoCo Deutsche Bank AG

DEUTSCHE BROS

After 2011, these bonds were engineered to transfer the risks away from Banks and away from the German government by paying a hefty coupon to investors.

It certainly should not be ignored that for the third quarter of 2015 the German bank announced net loss – a record €6 billion, while it was stated that the institution has “put aside” €4.8 billion for future litigations costs.  This amount has just increased by another €1 billion in the while the bank announced that it will proceed to cut a total of 35,000 jobs and will cease operating in ten countries.

The above information is the main reason why Germany, in a theatrical way, knew that a recapitalization was a certainty for the bros. Everything has been done by the German authorities to ensure no domino effects on European Banks. But rest assured: the markets listen.

In addition, we believe that DB’s complexity and book visibility is limited, heightened downside risks to our base-line expectation may increase as the global credit downturn looks to be prolonged rather than based on an overreacting market.

In this light, how can we assume that the bros will manage to roll their liabilities and to overcome any danger?

Simply, we can’t.

Simon Jacques is the author behind “Navigating the Commodity Markets with Freight and Spreads». He is highly knowledgeable about Commodity Finance as it relates to counterparties and counterparty risk. Simon is a member of the Global Association of Risk Professionals (GARP) and he has considerable mastery of the market risk, derivatives and regulation subject matters.