DB - Deutsche Bank Is Not Credit Suisse But It's Certainly Not 'Safe'

2023-04-26 21:20:03 ET

Summary

• Deutsche Bank's credit default cost has soared to multi-year highs over the past two months following Credit Suisse's downfall.
• The bank's proactive move to consolidate its business and sell legacy services over recent years proved wise as it avoided losses in its financial services segment last year.
• Deutsche Bank's leverage is significant but has declined over the past decade as it shifts away from riskier asset and loan exposures.
• The bank's massive derivatives and trading book is a significant uncertainty risk factor, but other European and UK banks are likely riskier today.
• I believe DB is significantly discounted to its peer group, but it still may be best avoided due to the need for higher interest rates in Europe due to its high inflation rate.

Last November, I published " Credit Suisse: Bank Failure Is Not Off The Table ," which detailed my bearish outlook for Credit Suisse ( CS ) and my view that the bank could fail in 2023. Understandably, that article met some controversy, as, at the time, the possibility of such a large bank failing seemed too extreme. Today, the stock is roughly 75% lower as the bank crumbles, with UBS ( UBS ) buying the remainder of its business at an incredibly steep discount .

If I were to make a theme for 2023, it would be to "expect the unexpected." Considering the immense extent of off-balance sheet losses in many US and European banks, investors would be wise to brace for a sustained increase in volatility and uncertainty. As detailed in " KRE: The Banking Crisis Has Slowed, But It Cannot Be Stopped " regarding the regional bank ETF ( KRE ), many US banks have a net asset value near zero today if we account for the ~$2.2T in unrealized losses on securities positions. As banks face deposit outflows (due to low savings rates, rising living costs compared to wages, and a falling money supply from QT), they're forced to sell these assets at significant losses. The US Fed's encouragement of the "Discount Window" and the ECB's similar moves have temporarily aided the liquidity shortage; however, the critical issue of excess total public and private debt, combined with increased interest costs on that debt, cannot be resolved so quickly.

The fact that inflation is persistently high in both the US and Europe makes it difficult for governments to provide the necessary stimulus, as doing so could jeopardize the already weakening position of Western currencies (compared to BRICS). Accordingly, the Fed, ECB, and their respective governments are walking on a fragile tightrope between supporting a (predominately) "zombified" financial system (which has been dependent on government support since 2008) and potentially causing the end of the US and Euro's dominance as international currencies. While allowing banks to fail could cause significant issues for the financial system, the same can be said for enabling currencies to inflate excessively - particularly given the US and Europe import dependency. Admittedly, there is no easy solution to this situation as the long-held effort to "kick the (debt) can down the road" will no longer suffice.

Investors may want to focus less on the regional banks and more on the large systemic banks, including those of Europe. The knock-on effects of Credit Suisse's "failure" have been limited through significant government intervention, also requiring questionable legal actions that completely disregarded investors' rights . The Swiss government quickly disregarded the usual due process in this situation to mitigate the crisis. Of course, if this occurs again, for example, in Deutsche Bank ( DB ), investors should probably not expect to exercise their shareholder rights. Of course, DB's situation is different than Credit Suisse's, so the company may manage to avoid this scenario.

Will Deutsche Bank Follow Suit?

DB and CS traded in lock-step for most of the years following the European Financial Crisis of ~2011. Both banks were found to have immense non-performing loans and significant risks within their derivatives portfolios. However, since 2019, the tide has shifted as Deutsche Bank closed many legacy businesses and dramatically reduced sales & trading and investment banking businesses. This change has provided DB with a fair amount of isolation from the current crisis, as the sharp slowdown in IB and S&T activity last year was the initial primary culprit in CS's rapid downfall. See their comparative performance below:

Deutsche Bank is a benefactor of Credit Suisse's collapse as it seeks to absorb its fleeing clients and has had an eye on some of its assets . Of course, the general increase in anxiety in European and US financial markets does not bode well for the company due to its poor historical track record. The cost of insuring DB against default (credit default swap) has risen dramatically this year and is the highest since 2016 . While DB and CS are now very different businesses, the market is concerned that the ECB and SNB will not contain the contagion factor.

Interestingly, Deutsche Bank ranks around the middle of the pack in terms of overall debt leverage and returns on assets compared to the other largest European banks. See below:

Notably, the French banks BNP Paribas ( OTCQX:BNPQF ) and Credit Agricole ( OTCPK:CRARF ) rank the worst due to their high debt leverage levels and lower asset returns. High leverage is not necessarily an issue, but when ROA levels are low, and deposit borrowing costs are rising, it can lead to significant losses. Still, those two banks have generally stable income levels, while Deutsche Bank's ROA volatility is the highest after Credit Suisse. DB's income has been particularly volatile over recent years as it shifted its focus away from financial services and closed legacy businesses.

Deutsche Bank has fared well despite strains in many of its peers. The bank's investment banking profit remained normal last year at ~E3.5B while its corporate and private profits grew. Its asset management profits declined by 27% last year, but that could reverse as it obtains some of Credit Suisse's clients. DB's CET1 ratio was 13.4%, lower than Credit Suisse's at 14.1%; however, CS's failure is mainly attributable to a loss of confidence and losses on financial services, not insolvency (as in SIVB and others in the US). DB's CET1 ratio is a bit higher than most US banks; however, as seen in SIVB, CET1 ratios are deceiving since they don't account for most sovereign debt (which was subject to substantial unrealized losses last year).

At the end of 2022, DB reported having €1.32T in assets and €1.26T in liabilities, with €72B in net equity. The bank is enormous, but it is not entirely clear what fixed-income securities exposure it holds today. Its last annual report ( Pg. 180 ) showed €491B in total financial assets (excluding loans); of those, €299B comprised derivatives positions, while around €100B were fixed-income trading assets. This data indicates that the bank's exposure to unrealized losses on bond assets is likely lower as a percentage of equity than we see in most US banks today. Comparatively, European and UK pension funds are likely carrying more significant sovereign debt loss exposures.

Still, we should not write off the possibility of DB suffering significant losses due to a sharp rise in risk. Germany's 10-year bond has not risen as much as US bonds and is currently at 2.37% today, up from -60 bps in 2020. Since Germany's yields remain so low, its inflation has been higher at 7-9% year-over-year over recent months, indicating German and European bond yields and interest rates may need to climb much more. The ECB is raising interest rates, but that figure is still around 1.25% below the dollar's .

Because Europe has lower interest rates and higher inflation today, I believe it will need to see a sharper rise in both long-term and short-term rates to tame its inflation. Since interest rates on German fixed-rate debt were so low in 2020 (generally negative), the "duration impact" from a rise in interest rates will be much more significant on European debt than US debt, particularly if interest rates continue to rise in Europe.

The Bottom Line

Overall, Deutsche Bank is not Credit Suisse. The bank's financial services business performed much better than its Swiss peers did last year due to the company's proactive move to consolidate operations in 2019. The overall situation creates some "loss of confidence" risk for Deutsche Bank; however, this is limited because investors and clients have fewer places to go today, and there are essentially no "very safe" European or US banks to switch toward.

While the bank's default risk has grown significantly, it is still lower than in 2016 and much lower during the European debt crisis. Unlike Credit Suisse, the bank does not appear to be facing a large wave in asset and client outflows that could bring it under; in fact, it may benefit from the flows from Credit Suisse. Further, due to its poor historical track record, DB continues to trade at a significant discount to its peer group, at a staggeringly low "price-to-book" of just 0.28X, compared to a sector median of 1.01X. Most of its other valuation metrics are between 33% and 66% below the sector median, indicating DB is trading at a considerable discount today compared to peers.

Given the increase in quality and stability of DB's business and its vast discount, an extended outlook on the stock would be justifiable. That said, I am neutral about the stock and am not bullish on DB. While the bank has many positive attributes, I believe the overall systemic risk in the European financial system is very high today, stemming from the continent's colossal inflation level (due to its exposures to Russia-Ukraine) and the need for a sharper rise in EU interest rates. Banks with large derivative books, like DB, can carry opaque directions to such a significant and sharp rise in rates, particularly considering EU rates were negative just ~18 months ago.

If the European bank crisis continues to grow, I doubt DB will be the next to go. I believe DB will rank better than most in this regard since investors and analysts underestimate the company and may overestimate other EU and UK banks, such as NatWest Group ( NWG ). Of course, given any European, UK, and likely US bank that is "systemically important" begins to face strains, I do not believe Deutsche Bank will have sufficient solvency to avoid taking a hit. Thus, I would not personally buy DB stock today, particularly considering the uncertainties regarding its massive derivatives and trading book.

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