Deutsche Bank’s (DB) troubles have caught our eye. The German bank has dominated markets in the weeks since the US Department of Justice (DoJ) announced that it was pursuing a USD14bn fine in relation to its pre-crisis US mortgage activities. With DB under huge pressure, our contrarian instincts have led us to question whether the shares offer deep value or are simply uninvestable? If it’s the latter, could DB’s woes be the trigger for another banking crisis?
Market fears have been calmed for now. DB is not the next Lehman Brothers. Before its collapse, Lehman argued that it was solvent. That was until its liquidity dried up. DB, on the other hand, is awash with liquidity but is it solvent? An enormous and complex balance sheet with more than a trillion euros of assets, a multi-billion dollar DoJ fine (with other litigation to follow) and high leverage mean that it almost certainly will need to raise fresh capital. This could be in excess of EUR5bn by some estimates. Raising that amount of money compared with a market capitalisation of EUR17bn and shares trading on 0.3x tangible book value will be hugely dilutive to shareholders. Furthermore, would investors be willing to stump up that much more capital? Management will need to deliver a credible plan involving asset disposals and severe cost cuts. DB’s issue is that it has no core business to pivot to. UBS and Credit Suisse have their wealth management franchises and Barclays has its retail banking and cards businesses. DB has a large and high quality asset management business, but this could eventually have to be sold or IPO’d to raise funds – a measure the CEO, John Cryan, is reluctant to pursue. Shareholders may also want to see staff bonuses frozen, cut or even clawed back to ease the capital strain. After all, they have stumped up EUR13.5bn in new equity since Q4 2009 over which time bonuses have totalled EUR19bn. Such drastic measures on bonuses would only serve to further erode staff morale, potentially hastening more departures. DB’s predicament is beginning to look like a vicious cycle, and the longer it goes unresolved the worse the permanent damage will be for the franchise.
Unfortunately it is becoming clear that European investment banking, and FICC (fixed income, currencies and commodities) in particular, is in structural decline. Deleveraging, slowing money velocity and a shift towards derivatives clearing are weighing on revenues. US investment banks (IBs) have stolen a march on the European banks by taking 7ppt of revenue market share in 6 years. The depth and concentration of US capital markets relative to Europe puts US IBs in a much more dominant position and they will continue to take market share.
The bull case for DB is that it raises capital, successfully restructures its business and revenues rebound in a cyclical upswing. These seem a long shot to us. DB is certainly cheap but could well be a value trap. For now we prefer to play any cyclical upswing in trading activity via the exchanges and other market infrastructure stocks like Flow Traders. These offer cyclical upside but also structural growth via exposure to derivatives clearing and ETFs. Financials stocks continue to be battered by numerous headwinds. In this tough environment, we continue to hunt for high quality businesses to add to the portfolio. These are good illustrative examples of how we implement our contrarian approach in practice.
Michael Clements is head of European equities at Syz Asset Management.