Submitted by Jeffrey Snider – Alhambra Investment Partners
With China prepared to open again after a week long holiday absence, the breaking news from Deutsche Bank signaling a huge loss expectation for Q3 is not good timing. As noted previously, China’s various wholesale “dollar” fill, in the end, is truly dependent on a good and robust “dollar” environment appearing sometime soon. Deutsche was one of the last global holdouts in terms of maintaining a huge presence in balance sheet sectors that patrol and maintain the various dimensions of eurodollar operations. Not anymore.
The bank has been under considerable pressure for years, as suddenly after the taper summer of 2013 the bank, like its eurodollar peers, lost its prior profitability boost. That was a huge problem because the bank had been inordinately dependent upon internal profitability to restore some semblance of leverage discipline. Instead, everything turned upside down whereby leverage remained high only without anything close to sufficient returns to justify it. Again, this was a similar situation to other eurodollar banks but to an added degree (think Deutsche’s enormous derivatives book, dark leverage, in its CB&S division).
What Deutsche did to restore balance in the wake of 2013’s changed QE profit circumstances was almost unique (Credit Suisse would try something similar). The bank loaded additional capital early last year, under circumstances that remain somewhat unclear, and then plowed ahead into as much risk as it could possibly source. In its press publications displaying those forward intentions in May 2014, the bank (this is somewhat unbelievable in hindsight, far more so than it was then) openly discussed how it expected to drive returns while maintaining leverage from new ventures into US junk and leveraged loans as well as emerging market debt. Given that the price inflection seems to have occurred as the “dollar” turned only a month or so later, Deutsche seems to have placed all its chips right at the top.
Only those banks TBTF can play here. As DB makes plain, there are only “5-6 FIC players left” and there exist exceptional barriers to entry ensuring smaller banks stay smaller. This oligarchical structure is perfect for DB in “attractive products”, such as high yield and leveraged lending (both can fairly be termed the modern incarnation of junk).
To sum up the weekend [May 19, 2014]: DB acknowledges last year’s taper selloff permanently altered its business and capital plans. The bank will shift its focus for primary profits to US junk because that is where the bubble is currently taking place, a frenzy fit for only those TBTF.
Now, in later 2015, you can appreciate the scale of the problem Deutsche’s new CEO finds the bank firmly entrenched within. The leverage still remains (last year’s “capital” issues were supposed to help alleviate that, as well as kickstart the returns in the junk bubble) and now profitability is again hammered by ill-mannered (desperate and, frankly, ridiculous) past decisions.
The loss expectations reported today are not related to any leveraged loan, junk bond or EM debt positions but rather continued leverage pressure weighing on goodwill calculations – thus, a massive writedown in one of the CB&S franchises. The bank is not helping in this matter because they don’t spell out the exact nature and location of the loss generation: they give a total estimate for a €5.8 billion impairment, then account for only €0.6 billion in its partial stake in Hua Xia Bank Co. Ltd. plus litigation provisions of €1.2 billion. I know this is only a preannouncement, but to only divulge these impairments as, “largely driven by the impact of expected higher regulatory capital requirements on the measurement of the value of these segments as well as current expectations regarding the disposal of Postbank” leaves perhaps too much to the imagination.
However, given the enormous pressures all over the bank because of this almost three year post-QE odyssey, it makes sense that there may be far more going on here and thus warranting considerations of a truly drastic step:
As part of the planning for the implementation of Strategy 2020, the Management Board will recommend a reduction or possible elimination of the Deutsche Bank common share dividend for the fiscal year of 2015.
Annual revenues in CB&S were once €21 billion, but only €13 billion last year and who knows how low it might get by the time this year has mercifully ended. But the bank has other problems related to that CB&S book (especially the derivatives portion) leverage aside from the potentially nasty return environment. The way it is structured (heavy “dollar” presence) actually makes a rising dollar work against the leverage ratio and thus offsets some of the downsizing intent as it is taken. As Fitch noted back in January:
In 4Q14, Deutsche Bank reached its stated 3.5% fully-loaded leverage ratio target, largely through a reduction in its derivatives and secured financing transactions, which contributed to a 5% fall in leverage exposure to EUR1,445m during the quarter.This reduction was to some extent offset by the appreciation of the US dollar against the euro, which had a neutral effect on the CET1 ratio and a positive effect on pre-tax profit. [emphasis added]
And so it’s aggressive approach toward traditional money dealing FICC that seemed to be a strength last year now actually begins to potentially reveal so much about this year (beyond just the bank, to the “dollar” and more):
Deutsche Bank remains strongly biased towards fixed income trading, which generated half of CB&S revenues in 2014, highlighting that fluctuations in the segment affect its pre-tax profit more than at peers that are more weighted towards equities trading. Deutsche Bank generated sound trading results in FY14 compared with many of its European peers that have scaled back trading activities, and its 4Q14 results compare favourably with trading revenue at its US peers, which experienced a decline in fixed income trading in the quarter.
The net result of this toxic stew of bastardized banking is a highly negative return (revenue) environment for CB&S in 2015 beyond all scale of 2013, while its efforts to reduce assets (especially risk weighted calculations) continue to fly against its “dollar” activities. The firm managed to take the worst course possible by thinking the shrinking eurodollar system particularly post-May 2013 was an opportunity to replay lost pre-2007 financialism glory. To do that, the bank kept up its leverage and then went after the junk and EM bond bubbles with enthusiasm.
My own interest here is less about Deutsche Bank than it is the continued trajectory of the eurodollar system. I wrote not long ago about my thinking with regard to Deutsche Bank’s central role in the “dollar” run that started July 6 or so; today’s announcement is pretty bad, and likely just the beginning without some miracle turnaround, which adds up to nothing good about the “dollar” moving forward. Whatever negative effect Deutsche may have been having already in eurodollar liquidity, these results will quite likely speed that up.
The problem is, as it has been since 2013, who is going to fill the money dealing gap? This is a persistent topic I have explored, and wondered not long before the events of July and August why it wasn’t appreciated as a huge systemic risk:
I personally find way too much complacency in blindly believing that going from B to C will be only a minor inconvenience. It would be dangerous even under the circumstances where the system shifted from the dealers to the Fed and back to the dealers, with an infinite series of potential dangers even there. But to undertake a total and complete money market reformation from dealers to the Fed to money funds? There are no tests or history with which to suggest this is even doable under current intentions. Poszar and Mehrling’s contributions more than suggest that difficulty, but I think that still understates whether or not we ever get that far.
In the first little while after the taper shift, the answer was Deutsche Bank, Credit Suisse and only a few others. Credit Suisse has learned its lesson and is also scaling back significantly, and now Deutsche takes another huge blow from the bowels of what is essentially the eurodollar itself. Who is left?
The answers seem to lie in mid-August.