Deutsche Bank: A Full Review

| About: Deutsche Bank (DB)

Summary

Deutsche Bank's balance sheet looks solid.

Fears about its derivatives exposure are exaggerated.

Profitability must be a major concern for investors.

Deutsche Bank (NYSE:DB) has attracted much attention after the Brexit vote. Sharp stock price decline (it has plunged by 42.6% year-to-date) has bolstered speculations about the stability and soundness of the largest financial institution in Germany, and one of largest banks (measured by assets) in the world. Some blame the firm's low profitability (2014 was the last year when its net income was positive, where ROA was 0.099%, while the average ROA of European banks in 2014 was 0.139%, according to ECB, and in 2015 Deutsche Bank recorded losses of almost €6.8 billion), while others, like Italian Prime Minister Renzi, cite its huge derivatives exposure. IMF has added its share into these discussions, naming Deutsche Bank the biggest global systemic risk contributor. A closer look into the institution makes understanding the associated risks clearer. The data is provided by Deutsche Bank 2016 Annual Report unless stated otherwise.

Here are the principal components of the Deutsche Bank balance sheet as of December 31, 2015. Most of its assets (€1.63 trillion) are comprised by Financial Assets at fair value (€820.1 bln), Loans (€427.8 bln), Other Assets (€118.1 bln), Cash and Central banks reserves (€96.9 bln) and Financial Assets available for sale (€73.6 bln). Liabilities (€1.56 trillion) consist of Financial Liabilities at fair value (€599.7 bln), Deposits (€567 bln), Other Liabilities (€175 bln) and Long-Term Debt (€160 bln). Total shareholders' equity is €67.6 bln. To understand the risks associated with the balance sheet, one needs to review these particular assets. The most sensitive to risks are financial assets and loans.

Loans. Almost half of the total loans portfolio of Deutsche Bank are household loans (€200.8 billion), according to its annual report. Below is a diagram showing a full breakdown of the bank loans portfolio on a sector basis.

Deutsche Bank loans portfolio breakdown on a sector and area basis

Mortgages comprise 78% (about €155 bln) of the household loans, €129 bln of which are held in Germany. The remaining portfolio is predominantly consumer finance related, according to the Deutsche Bank annual report. The main regions of the loans provided are Germany (€203.3 bln) and Western Europe (€100.4 bln) (See Figure above). Deutsche Bank is often compared to Lehman Brothers since its hypothetical bankruptcy has the potential to cause severe financial distress. Well, they are similar in terms of exposure to a single mortgage market: Lehman mortgage-backed securities exposure was $54 bln during the end of 2006, or about 8.4% of its assets, and this figure increased to 17.3% during 2007. Deutsche Bank's Germany mortgages portfolio accounts for about 7.4% of its assets if derivatives are considered, and 10.7% if derivatives are regarded off balance sheet. However, the rest is principally different. Most of its mortgages are fixed-rate traditional loans, according to the Deutsche Bank annual report. Most of these mortgages (68%) have less than 50% Loan-to-Value ratio, while 16% have a LTV ratio between 50% and 70%. Lower LTV ratio provides a margin of safety from significant house prices drop for mortgages portfolio.

(click to enlarge) LTV ratio of the Deutsche Bank mortgages portfolio Click to enlarge

In 2014, Germany's household debt was 94% of its net income; that is well below the figures of 105% in France, 113% in the US, 173% in Sweden, and 277% in Netherlands, according to OECD data. Moreover, it has decreased from 116.5% in 2000. At the same time, household net worth was about 450% of the net income in 2015. These considerations make Deutsche Bank's mortgages portfolio look solid.

As for other consumer loans, the main risk is an economic shock that may trigger an NPL rise. The German economy has grown by 1.45% in 2015, according to IMF, and is expected to grow at the same pace in 2016. Consumer credit exposure outside Germany is about €38.7 bln, €25.4 of which are mortgages. (See Figure below).

(click to enlarge) Deutsche Bank Consumer Credit Exposure Click to enlarge

Currently, according to Reuters, Deutsche Bank's NPL ratio stands at 5%, while the Euro area average in 2015 was 5.7%, according to World Bank data. The figure has been declining since 2013. Net Deutsche Bank credit exposure (including instruments other than loans) to European peripheral countries (Greece, Ireland, Portugal, Italy, Spain) is €26.1 bln or 38% of its shareholders' equity.

A corporate loans portfolio breakdown with respect to Deutsche Bank internal credit rating methodology is below.

Deutsche Bank corporate credit portfolio

Financial Assets. The bulk of Deutsche Bank's financial assets are in derivatives. Their total market value is €515.6 bln. The institution's huge derivatives exposure has been discussed extensively in the media, however, statements like "Deutsche Bank has €52 trillion derivatives exposure" tells us nothing because of the nature of the derivatives market. These astronomical sums are attributed to the notional amounts of the derivatives, which are the values of the underlying assets. For example, the bulk of Deutsche Bank's derivatives are interest rate related instruments (€346.3 bln); normally they are interest-rate swaps and forward-rate agreements. Banks use them to hedge interest-rate risks. Interest-rate swap is the agreement in which one counterparty agrees to pay fixed-rate payments on the principal amount, while the other agrees to pay floating-rate payments. However, counterparties do not exchange principal amounts, since it does not make sense. This also makes credit risk of such agreements minimal compared to the negotiated principal. The latter is a swap's exact notional amount.

The positive market value of derivatives (assets side of the Deutsche Bank balance sheet) is discounted payments receivable on it less payments to be made. If the difference is below zero, then a derivative has negative market value (liabilities side of the balance sheet). However, due to so-called Master Netting Agreements, most parts of these derivatives' assets and liabilities could be net out. Master Netting Agreements between counterparties allow both sides to turn multiple transactions on different instruments into single net payments by a net debtor. These agreements allow transactions to be made easier and a reduction in credit risk. For example, consider two parties are engaged in two swap transactions. One of them is defaulting. For the non-defaulting party, Transaction 1 has a negative value of $1 mln, while Transaction 2 has a positive value of $0.8 mln. Thus, the non-defaulting party is a net debtor to the defaulting party. It has the net obligation to pay $0.2 mln. However, without netting, the non-defaulting party would be obligated to pay $1 mln, and wait, possibly for a rather long time, for whatever fraction of the $0.8 mln gross amount it recovers in bankruptcy. These considerations are summarized in the chart below.

(click to enlarge) Example of the bilateral swap transactions Click to enlarge

According to the Deutsche Bank annual report, 92% (or €474.1 billion) of total derivatives are bilateral agreements. At the same time, 79% (€407.1 bln) of its derivatives assets are under Master Netting Agreements, while 13.4% (€69.1 bln) could be net out by cash and financial instruments collateral. Liabilities derivatives could be net out by Master Netting Agreements and collateral by 95% (Deutsche Bank 2015 Annual Report, page 311). Thus, if Deutsche Bank derivatives positions are net out, its net derivatives assets are about €22 bln, or about 1.9% of its total assets and net derivatives liabilities are €23.1 bln, or about 2.1% of its total liabilities. Netting by collateral and Master Netting Agreements is normal practice in use by US banks, and that's why their derivatives positions could look much lower compared to their European peers. This inconsistency stems from the differences between IFRS and GAAP accounting standards.

Netting could explain why derivatives assets and liabilities tend to move in the same direction and almost by the same amount. For example, during 2015, the positive market value of the bank's derivatives decreased by €114.4 bln that was offset by a negative market value decrease of €116.1 bln. These considerations undermine fears about Deutsche Bank's derivatives exposure.

Another big part of Deutsche Bank's financial assets is trading assets and purely financial assets. Their total market value is about €305 bln. Debt securities comprise 70.5% of this amount, and the rest is equity instruments. Below is the breakdown of the debt securities on an internal credit rating basis.

(click to enlarge) Deutsche Bank Debt Securities Assets Click to enlarge

Deutsche Bank assets are not risk-free, as is the case with any banking institution. However, it does not look weak. Consumer loan portfolios consist primarily of mortgages; loans were originated and held by Deutsche Bank itself; 87% of the corporate loan portfolios have a default probability of less than 2.27%. NPL ratio is below the European average, while financial assets are primarily debt instruments with a high credit quality; 92% of its derivatives positions are bilateral, meaning they are bearing no or very low credit risk.

Solid assets are the main reason why one should not expect sudden bankruptcy of one of the largest banks in the world. However, there are some other risks that could gradually erode Deutsche Bank's capital and make its financial position weak. The key risk Deutsche Bank faces is low or negative profitability. Given its high leverage ratio (see chart below), prolonged period of low profitability and losses can cause a significant decrease in capital. That is exactly what scares investors who are selling off Deutsche Bank stocks and bonds (see chart below). Losses can create difficulties in servicing bank's debts. Investors respond to it as Deutsche Bank CDS spreads are rising.

Deutsche Bank Leverage Ratio (Source: Bloomberg)

(click to enlarge) Deutsche Bank Stock Price (Source: Yahoo Finance) Click to enlarge

(click to enlarge) Deutsche Bank CoCo price (Source: Financial Times) Click to enlarge

(click to enlarge) Deutsche Bank CDS spreads (Source: Financial Times) Click to enlarge

One major challenge for all European banks' profitability is ultra-soft monetary policy. Net interest income accounts for 51% of the total bank profits in Europe, according to ECB data. Lowering interest rates across the all maturity spectrum squeezes banks' net interest margins. The ECB QE program makes the Euro area yield curve flatter (see chart below).

Euro Area yield curve (Source: ECB)

Given banks' traditional role of maturity transformation - that is, bank liabilities generally have shorter maturity than assets - QE lowering the spread between long-term and short-term rates is also cutting banks' interest rates margins. In the short term, however, QE may increase interest rate margins, as earlier originated loans have higher interest rates than newly accepted deposits. As these loans mature, however, and new loans with lower interest rates are originated, interest rate margins decline. That is exactly what has happened with US banks (see chart below).

(click to enlarge) US banks Net Interest Margin (Source: St.Louis FRED) Click to enlarge

Another concern for European banks' profitability is negative interest rate policy (NIRP). It is unclear how it will affect banks' interest income. As ECB rates are slightly below zero, NIRP acts as a traditional rate cut - retail deposit rates are declining, but they are still positive. However, it is expected that banks will be reluctant to lower retail deposit rates for its customers below zero if ECB rates come to a deeper negative territory. Brexit vote increased the probability of additional stimulus from both BOE and ECB, which can extend the period of squeezed banks' interest margins; investors reacted with the selloff.

Another major concern for Deutsche Bank investors is legal troubles. One of the major contributor of expenses rising in 2015 was litigation costs - the company increased general and administrative expenses by almost 27% (See Deutsche Bank income statement). Deutsche Bank has put aside €5.2 billion for looming lawsuits against the bank. Currently, according to Bloomberg, Deutsche Bank is under scrutiny by the US Department of Justice and UK Financial Conduct Authority on mirror trades in its Moscow office. The Justice Department is also examining currency manipulations cases. In May 2016, the SEC started an investigation regarding pricing and reporting of certain mortgage-backed securities. Another mortgage losses lawsuit against Deutsche Bank accounts for $3.1 billion. Payments to settle these probes are extremely unpredictable and may be well above the 2015 litigation provision of €5.2 bln.

Deutsche Bank operates in a very tense environment. It has to deal with elevated legal risks during the year ahead and prolonged period of contracting interest rate margins. Moreover, it has to compete with its peers and deal with mounting regulatory pressure. The latter was behind the bank's massive assets write-offs in the third quarter 2015, which, along with litigation provisions, was responsible for Deutsche Bank's annual losses of €6.8 bln. These risks could be manageable if bank executives succeed in eliminating new legal risks, restructuring the bank's assets to avoid new write-offs, and in increasing the bank's efficiency in the face of low profitability. Deutsche Bank management has already addressed these issues in its new Strategy 2020. However, the road to changes could be bumpy. New assets write-offs and losses could erode the bank's capital, and that will require new capital injection by investors or maybe by taxpayers. The bank's solid balance sheet may be a form of guarantee that the bank is able to generate profits if the restructuring succeeds.

P.S. When IMF says that Deutsche Bank is the largest systemic risk contributor, it does not mean the riskiest bank. It means that Deutsche Bank is a highly interconnected institution, failure of which can create a chain reaction among other global banks and cause global financial turbulence by spillover effects.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.