- The Oracle of Delphi
The Monte dei Paschi rehearsal
Monte dei Paschi (OTCPK:BMDPY) (BMDPD), the globe's oldest - and therefore worst managed, weakest - bank, is answering a question I first asked myself almost ten months ago. How will Deutsche Bank (NYSE:DB) escape default on its contingent collateral (COCO) bonds? In this earlier article, I argued that DB credit default swaps were too expensive, overstating the risk of default, since Germany would not permit an event of default at DB. But without Germany's implied backing, DB would have been history long ago.
The short answer to "How will DB escape default?" is the obvious one - with an implied government bailout. As we are learning in Italy, an actual bailout is both unattractive and unnecessary.
And, since the European governments have been forbidden from bailing out their banks (and German Chancellor Angela Merkel has sworn not to do so) and since the European Union regulators have also resolved not to bail out eurozone commercial banks, major machinations are necessary, yet possible, to do what the United States will soon also be doing - bailing out a Too Big to Fail (TBTF) bank but finding a way to call this bailout something else.
Following the Italian upward revision of Monte dei Pashci's internal estimate of its capital needs, and the European Central Bank's further upward revision to a total of 8.8 billion Euros, a plan has been formed on the Continent.
The Monte dei Paschi plan
A government loan is out of the question. Here's the alternative:
- A precautionary recapitalization by the Italian government, about 6 billion euros.
- Another 2.3 billion euros will come from the conversion into shares of existing subordinated debt. But why would these debt-holders voluntarily relinquish their position in bankruptcy? Because these retail investors will then be able to swap their equity for senior debt of equal value. Also not a bailout. Plainly.
What is a precautionary recapitalization? According to Reuters, a precautionary recapitalization is:
a type of state intervention in a struggling bank that is still solvent. It means only a modest bail-in of investors though the government can buy shares or bonds only on market terms endorsed by EU state aid officials in Brussels.
Not a bailout. Why not? Because Monti dei Paschi is still solvent. Why is the bank still solvent? Because of the precautionary recapitalization plan. The Italian government will own 70% of Monti dei Paschi following the precautionary recapitalization. No bailout to see here folks.
Monte dei Paschi plans to use 20% of these capital funds to refinance failing loans. My confidence in this plan knows no bounds.
DB's legal reprieve from the United States
Deutsche Bank, in September, had been threatened with a fine for its miscues in the mortgage-backed market. The threatened amount, $14 billion, exceeded the value of Deutsche Bank's market equity at the time, increasing the value to DB's debt-holders of Germany's implicit protection. DB's market equity was only worth about $12 billion.
The combination of a post-election stock market rally for financial institution shares generally, and for Deutsche Bank particularly, has resulted in a 45% increase in DB's market equity valuation since the election, reducing the risk that the fine would blow up the bank. In addition, on December 23, DB settled with federal prosecutors for an amount much smaller than $14 billion - an estimated total of slightly more than $3 billion up front. The combination of these two auspicious developments makes for a Merry Christmas for DB.
Why are Deutsche Bank's problems endemic?
DB will not do what I believe it ought to do - exit from the competition for global trading revenues; keep Deutsche Post; return to being a European financial institution in the Continental tradition. On the Continent, it is still possible to turn a profit making corporate loans and taking consumer deposits. Or at least, this way of banking will become profitable after rising dollar interest rates permit euro-based rates to return to higher, more normal, levels.
DB has never performed well in the investment banking business. It has been slow to combine Bankers Trust operations and those of other acquisitions into a coherent unit; DB costs have been excessive, execution poor.
During the 80s and 90s, DB's culture allowed itself to split into Anglo-Saxon and German components. In part, this was due to the lay of the land. European finance is loan-driven, not commercial paper-driven as in the United States. Hence, trading is finance in the US, not so in Europe.
While the London and New York operations made the bank look good during the roughly fifteen years from 1993 to 2008, the managers of these operations were quintessential hired guns. They paid little attention to operations costs, less to customer service.
Continental European banks generally are in no position to compete with American financial institutions today. The Continental banks generally refused to take their medicine following the Financial Crisis. Now the opportunity has passed - in part because of the departure of Britain from the EU, partly because of the Continent's (excluding the Swiss) failure to understand the ingredients that generate financial market success.
What will happen to DB?
DB's belief that it should reduce the scale of its operations, rather than exit the investment banking business, further smacks of misunderstanding. The fundamental question DB, or any business, should ask itself, "Why will DB be more productive than its competitors?" is not being asked.
As US regulators put clamps on the US operations of DB, fully aware that DB's US operations have been poorly managed since the Bankers Trust acquisition, a capable US investment banker must ask herself, "Why, other than high compensation, should I work for this bank?" Management formed from people so motivated cannot succeed.
I believe current DB management plans change by half-measures - not a clean break with the past. Instead of selling its investment banking operations, DB plans to shrink them. And the bank seems not to plan expansion of some other, more auspicious, component of the bank. This will perhaps mollify the bank's largely German shareholders. Guided by eurozone-think, these shareholders want austerity and efficiency. Audacity is not part of eurozone-think.
This is one more reason why Continental European banks will prosper in Continental Europe, but should reconsider activities in the wild, wild, West. Audacity is essential in the wild, wild, West.
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.