Just last week, Jeff Gundlach - in his latest DoubleLine investor call - cracked jokes that Deutsche Bank's imploding stock, which has been hitting fresh all time lows virtually every day, has a major support area at €0.
Once again, he was on to something because now, just a few days later, the FT reports that the bank which was this close to nationalization in 2016, and failed to consummate a merger with that "other" German bank, Commerzbank, is preparing to roll out Plan Z: amid a deep overhaul of its trading operations (read: mass terminations), the biggest German lender is set to roll out a "bad bank" holding some €50 billion in toxic assets, in a plan that was quite popular in the depths of the global financial crisis.
Meanwhile, as part of CEO Christian Sewing's ongoing restructuring of DB away from investment bank, "the bank's equity and rates trading businesses oustide continental Europe will be severely shrunk or closed entirely as part of the revamp", while managers are also set to unveil a new focus on transaction banking and private wealth management.
... will stuff its "bad bank", known internally also as "the non-core asset unit", with - drumroll - long-dated derivatives.
According to the FT, the CEO will likely to announce the changes with the bank’s half-year results in late-July.
While the final scale of the bad bank has not been decided and the number “continues to oscillate”, executives are reportedly discussing at least €30bn of risk-weighted assets with an eventual size of €40bn to €50bn most likely, at the high end almost exactly 4 times greater than DB's current market cap, and accounting for 14% of Deutsche’s balance sheet.
"The cuts need to be radical,” one senior banker told the FT. “It makes sense for us to put all these long-term, nil-revenue assets in a non-core unit.” The person added: “We now have the capital and liquidity freedom to do what needs to be done; we couldn’t have acted decisively much sooner because we needed to have built up those buffers.”
"Nil-revenue" but far more than nil expenses.
Recall that last April, IFRE reported that then CEO John Cryan "came clean" about a €60 billion portfolio of years-old trades that were costing the German lender about €500 million a year. Never previously disclosed, the revelation stunned analysts. Deutsche had done several clean-ups since the crisis – including one by Cryan just 17 months earlier – but had never mentioned the trades, some of which were over a decade old.
It got worse: although a relatively small piece of its balance sheet, which at the time stood at €1.6 trillion, the positions were consuming between €4bn and €5bn of equity – equivalent to 10% of the bank’s entire core equity Tier 1 capital base, and more than half the amount shareholders were being asked to cough up.
Worse still, Cryan admitted that some of the positions wouldn’t run off until after 2030, more than two decades after some were initially booked. Christian Sewing, who was running Deutsche’s private and commercial bank and oversaw the failed efforts to spin off its Postbank subsidiary, said at the time: “We just want to create the transparency that these are things we are going to work out.”
Unfortunately, as of last April, and shortly after raising €8bn in a critical rights offering which Deutsche at the same said is all the funds it would need, the bank had not updated investors on the portfolio, other than to say late last year that it “continues to roll-off as planned”.
It now appears we know the fate of this €60 billion toxic derivative portfolio: it will be rolled up and into the "bad bank" of a bank many already call "bad" (so bad bank squared perhaps). While the derivatives destined for the non-core unit still provide some cash flow, all the profit on the deals — and therefore the associated bonuses for those who arranged them — were booked up-front.
Now that the bank is sitting on €260bn of cash and similarly liquid securities, it no longer relies on these assets for cashflow and can attempt to run them down or sell them to other banks with lower funding costs and capital pressures, or to private equity investors eager to scoop them up at a discount, one of the people said.
In response to the FT article, DB said in a statement: “Deutsche Bank is working on measures to accelerate its transformation so as to improve its sustainable profitability. We will update all stakeholders if and when required.”
Of course, DB's derivative woes are just a small - if costly - part of the equation: once a Wall Street gem, Deutsche’s investment bank has weighed on earnings in recent years, and made losses in the past two quarters. Along with a series of fines for misconduct scandals, the poor performance of its core business has driven down the bank’s share price to the lowest in its 149-year history. Sentiment darkened in April when a long-rumoured merger with Commerzbank collapsed.
The lender is targeting a return on tangible equity — a measure of profitability — of at least 4 per cent this year, below most rivals. But it generated only a 1.3 per cent return in the first quarter. None of the analysts that cover the group forecast it can achieve its goal without major structural changes.
So why now? Deutsche Bank believes it can divest the assets without taking large hits to its profit or capital "because the long-dated interest rate derivatives are not toxic and have a predefined run-off plan", an FT source said.
Of course, it is debatable whether a €60 billion derivative portfolio which is bleeding half a billion each year and will continue doing so for decades is "not toxic", but we'll leave that discussion for the semantic purists... and whoever is Germany's Chancellor in a few months when the nationalization of Deutsche Bank is once again sprung upon the German government.
Additionally, a reason the bank has waited so long to make the changes was a fear it would close down large parts of the equities and rates businesses at the bottom of the cycle, people briefed on the plan said.
In another amusing tangent, sources said the new non-core unit "comprises mainly non-strategic assets and would be different to its prior bad bank, which contained far more loss-making and toxic assets. From 2012 to 2016, Deutsche ran down a non-core unit with about €125bn in risk-weighted assets — including a $4.3bn Las Vegas casino it took over when the developer defaulted — resulting in a cumulative pre-tax loss of €14.6bn over the period. When Deutsche dissolved the bad bank, the roughly €10bn of assets left were reintegrated into the core businesses."
All we know, is that if Deutsche Bank is the "good" bank, it's becoming impossible to track its "bad banks."
Meanwhile, the bank will retain its better-performing bond trading business — which is ranked in the global top-five by industry monitor Coalition — and its currency-trading operation, which reclaimed the second spot in the Euromoney FX survey last year.
Will that help DB become viable? Probably not: JPMorgan recently estimated that Deutsche’s US operation was losing 25 cents for every dollar of business it does and its global equities business alone loses about €600m annually.
There is one final problem: in the summer of 2016, just a month before fears about the viability of DB sent its stock careening lower and prompting Angela Merkel to discuss whether or not DB will be nationalized, the IMF found that Deutsche Bank is "the bank that poses the greatest risk to the global financial system":
Network analysis suggests a higher degree of outward spillovers from the German banking sector than inward spillovers. In particular, Germany, France, the U.K. and the U.S. have the highest degree of outward spillovers as measured by the average percentage of capital loss of other banking systems due to banking sector shock in the source country.
Here is the IMF's chart showing the key linkages of the world's riskiest bank:
Since then, the gross notional value of derivatives on DB's balance sheet has indeed shrunk, but so has its equity market cap... which has never been lower and the buffer to absorb losses is virtually nil - DB's market cap is now just €12.5 billion, the same as Friday's IPO star, Chewy. Which makes sense: one creates dog shit, the other is collateralized by it.
So should things turn bad, it is virtually certain that Germany's taxpayers will once again be on the hook for the most important bank bailout in European history.
But the biggest irony of all, is that Deutsche Bank may actually have a chance of survival, if the ECB were to ever hike rates. As it stands now, however, with the ECB set to cut rates in the near future and possibly resume QE, the Frankfurt banking giant is as good as nationalized.