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Daily Archives: 10th December 2018

10th December 2018

Brexit farce, markets sink

iTraxx Main

88.1bp, +3bp

iTraxx X-Over

357bp, +14.6bp

🇩🇪 10 Yr Bund

0.24%, -1bp

iBoxx Corp IG

B+176.3bp, +1.3bp

iBoxx Corp HY

B+526.5bp, +7bp

🇺🇸 10 Yr US T-Bond

2.86%, +1bp

🇬🇧 FTSE 100

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🇩🇪 DAX

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🇺🇸 S&P 500

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Under siege amid chaos and confusion…

It was all hands to the pump in a session which effectively resulted in yet another near collapse in markets. The massive uncertainty over the Brexit vote continues even after the UK’s PM May incredibly decided to postpone the Brexit vote which was due on Tuesday! It doesn’t really change much and she remains in an extraordinarily difficult place. Overall though, markets are lacking confidence and with it participants lacking a will to get involved. In credit it means, for example, nothing other than drive-by deals (from quality well-known borrowers) in primary might only be the ones to get done – few will be willing to chance it. So the mood generally remains defensive and weakness prevails through risk markets. We can only think that it will persist, after all, there’s just too much uncertainty about everywhere.

That mood was not helped by having clearer signs of a Chinese economy losing considerable momentum, as figures for export growth for November recorded a slowdown to 5.4% year on year, versus over 15% growth in October. It is being felt by BASF as the company found it necessary to issue a profits warning representing a 15-20% decline in 2018 earnings. They were just the latest to warn, highlighting how Germany Inc. is suffering hard from slowing demand in China and from in the auto sector in particular.

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10th December 2018

What now for DB credit? Bank Capital

Negative headlines keep on coming…

Headline risk continues to overwhelm DB stock and, over the last few weeks, it has been hit by a plethora of negative news including its involvement in the Danske Bank’s money laundering case, ongoing tax raids by German authorities, cum-dividend issues on ADRs etc. The impact of these relentless negative headlines has had a significant impact on the bank’s stock, which is now trading at less than 0.30 times P/TNAV.

This raises the question – Can the bank afford to absorb large sized settlement and litigation costs that may yet arise from the above issues?   Given the very high cost base (cost to income ratio is 90%), the bank generates very poor operating income to absorb unexpected losses and if revenues were to decline further due to a lack of client activity and ongoing risk aversion, it exposes the bank to negative earnings and hence a potential hit to equity.   The unknown factor in terms of future litigation costs is a key driver of investor pessimism.   In addition, if the bank were to undertake a very large business restructuring this would involve significant one-off costs, which again adds to the pressure on profitability and ultimately capital build.

Capital ratios are the not the issue, leverage is

DB reports good regulatory capital ratios, well above minimum thresholds – but a 4% leverage ratio for a bank with EUR 1,305 billion of leverage exposure is just not good enough, especially if underlying earnings momentum is weak or even negative. For example, in a highly hypothetical situation, if the bank had to take, say, an additional EUR 10 billion of provisions/costs for the matters discussed above, it would create an almost EUR 8 billion capital hit (assuming current revenues hold) and that would translate to the Tier1 capital dropping to EUR 44.5 billion and leverage ratio falling to 3.4%.  Add to this the EUR 23 billion of Level 3 assets and one gets the picture.   And that is why equity investors are nervous.

Yes, the bank has good liquidity buffers and can withstand potential short-term counterparty/deposit flight. But the wall of debt that is maturing over the next few years (almost EUR 20 billion every year until 2022) means that the bank is reliant on wholesale markets being open and available.

Can a merger with Commerzbank make a difference

Press reports over the weekend indicate that the German Government may be considering a merger of Deutsche Bank with Commerzbank to create a large German national champion bank. At first glance, this looks an interesting option to combine two underperforming banks with similar attributes in terms of low profitability and limited future visibility but with significant scope for cost reductions and a larger capital pool to absorb losses.

But merely creating a much larger entity does not solve the underlying core issues faced by both banks, more so for DB; The reason being that the bank is too large and too complex to be managed as a standalone entity and any additional merger will only complicate matters and cause further uncertainty.

DB’s issues stem from multiple factors – oversized/overstaffed businesses in FICC land and a strategic failure in the past to redirect capital to the more profitable wealth management and corporate banking businesses.  FICC is a highly cyclical business and one that is undergoing profound structural change. Technology and automation are the key drivers of profitability in that business and DB has been very slow to react and adapt to the new landscape.  What DB needs is a radical restructuring in the FICC business and it needs to get rid of many units that are currently generating very poor returns – and downsize its balance sheet exposures significantly.

Equity looking down the barrel but credit hoping for better times

Equity investors have taken notice of the issues and hence give the poor valuation on its stock. It seems that credit investors especially AT1 and LT2 investors are stuck in no man’s land and unsure of what to do next (yes, the yields are attractive but there are significant tail risks).

In my personal opinion, the bank’s AT1s are still not fully reflecting the substantial downside risks especially in the unlikely event of PONV (point of no viability) being reached or if there is a significant counterparty run. Coupons may not be at risk for now but it is still an overhang given the low profitability and current levels of ADI.

Can CBK save DB credit investors?

CBK as in Central Bank Kindness and not Commerzbank.

Given the systemic nature of the bank in the global financial system, it is likely that some form of government or central bank support (at least in liquidity) would come through but that will be at a price wherein sub-debt holders will be fully bailed in.

To that extent it seems to me that only the preferred senior part of the capital structure is safe for now (though one may yet get spread widening). I fear that credit investors have still not fully factored the potential downside risks.