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Deutsche bank A review

I have been following the turmoil of Deutsche bank closely over the last
few weeks. Through examining market reactions interesting insights into
investor sentiment and behaviour can be made. This year there have been
significant global sell-off of equities. Share prices have recovered some
ground over the last few weeks but volatility persists. This year is on track
to be one of the most volatile on record. Here is a quick summary of key
factors driving this sell-off:
Decline in Oil prices
With oil prices hovering around $30 per barrel there is concern about what
effect this may have on producers of oil who are struggling to finance their
operations. Many exporting countries are selling their investments in
foreign securities in order to finance their battle for market share in the
face of huge oil oversupply (attributable to the US shale revolution). With
OPEC (organization of petroleum exporting countries) unwilling to agree to
any restriction in supply and Iran eager to increase its capacity there is
little hope of seeing $50 per barrel in the foreseeable future. The fear is
that this loss of earnings will not be absorbed by the sector and knock on
effects will spread to other areas of the economy.
Uncertainty over interest rates set by central banks (Or monetary
policy in general).
There are fears that the Federal Reserve (US central bank) will raise
interest rates too quickly and endanger the growth of the US and global
economy. An increase in interest rates would strengthen the dollar and
leave many emerging economies (many of which also rely on oil exports)
unable to pay the interest on their dollar-denominated debt leading to
defaults. It could also cause problems to the corporate bond market,
higher interest rates would make the corporate bond market look
significantly overpriced (Companies would struggle to issue debt).
However, if the Fed diverts from its monetary policy trajectory it could be
interpreted that the US and global economy is still frail and unnerve
financial markets. Janet Yellen (Fed Chair) has a tough job of reassuring
market participants that interest rates will not rise too quickly whilst
reaffirming a positive outlook for the US economy.
In Europe, the ECB ( European central bank) is desperate to prevent
deflation and increase economic growth. It is continuing its quantitative
easing programme and holding negative interest rates with limited
efficacy. Other central banks have also cut their interest rates into
negative territory such as the Bank of Japan and the Swedish central bank.
PBoC (people's bank of china) is also having a tough time at creating
financial stability which leads us to the next factor.
Fear of a China slowdown

With China growth slowing there is a worry about what would happen if
the second largest economy in the world fell into recession. The mixed
macroeconomic data coming out of China is making economists life
difficult and adding to the uncertainty. China is depleting its huge foreign
exchange reserves ($4 trillion) in an attempt to stem outflows in
investment and to support its currency (Selling dollar assets to purchase
its own currency). China is a big importer of oil, slowing growth weakens
the demand for oil and puts additional pressure on oil prices.
The current geopolitical environment also puts pressure on markets but at
this time, no singular issue applies as much pressure as the factors above.
The uncertainty surrounding a Brexit is a contender, but I think this has
been reflected in share prices for some time and further gyrations are
likely to occur closer to the vote.
Deutsche bank
The banking sector has been hit particularly hard this year over fears that
sustained low central bank interest rates will continue to hurt profitability.
This is because banks profit from the difference in the rate they lend
money and their own cost of borrowing. Low central bank interest rates
reduce the margin banks make on their lending activities (As an
investment bank it primarily provides credit to businesses). A small
change in interest rates makes a huge difference to banks bottom line.
JPMorgan calculates that a 1% rise in interest rates would add $2.8bn to
its net interest income (which was $39bn last year).
Investment bank valuations have also been hurt by the cost of the
numerous litigations many of which are yet to reach closure. These fines
have amounted to billions of dollars being paid out to regulators and have
severely dented banks performance. It is the fear of future litigation costs
that has been burdening the sector. I would like to point out that I am in
no way sympathetic to the position banks have found themselves in. By
threatening the integrity of financial markets, not acting in the interest of
the consumer and engaging in uncompetitive behaviour banks have
become under heavy scrutiny by regulators. The scale and variety of
abuses, excessive risk taking, misconduct and criminal behaviour carried
out before and after the 2008 recession has been truly prolific. The fines
imposed are little consolation to the millions of people who were severely
affected by the actions of a few.
Deutsche bank (Investment banking giant based in Germany and
foundered in 1870) has faired particularly badly posting a 6.7bn loss for
2015. Clearly the 5.2bn litigation cost for the year explains away a lot of
this loss. The share price has taken a significant nosedive in reaction. The
share price has fallen from its lofty heights of 100 (2007 pre-crisis) to
hovering around 15. The recent decline has led to prices falling below
Eurozone crisis levels of 2012. But a clear distinction needs to be made,

the shares trade below Eurozone crisis levels but this serves as a very
poor indicator for suggesting we are heading into another banking crisis. I
want to highlight why Deutsche bank is a poorly run business with bleak
prospects at returning value to shareholders. I do not think Deutsche bank
is the next Bear Stearns/Lehman Brothers and I think the systemic risk
posed is limited.
One of the reasons the systemic risk is lower is because risk-taking has
not been excessive. An example of this is in the energy sector. Banks have
not been lending too heavily to oil producers, most of the funding has
been directly from investors. This is important as the banks are not
exposed to much of the sector's debt. If they had overleveraged in a
similar fashion to the 2007 sub-prime crisis, then the recent decline in oil
price would have potentially led to a banking crisis. Instead, a sustained
low oil price may lead to a 2000 style recession where the dot-com bubble
burst. In 2000, investment banks did not hold too many Dot-com shares
on their own accounts and investors absorbed the losses (the value wiped
off technology stocks in 2000 was higher than the total value of subprime,
al-A and jumbo mortgages ($2.8 trillion)).
Regulators have worked hard to reduce the risk banks pose to the
financial system they have raised the capital requirements with the
introduction of Basel II regulations. The increasingly prudent Basel III
regulations are currently being phased in (2013-2019). The need for banks
to raise their amount of capital led to the widespread issuing of
convertible contingent bonds (CoCo bonds). CoCos are a type of
bond/share hybrid security. They were designed to help banks in a time of
crisis. Banks issued CoCos in favour of issuing equity and in the current
low-interest environment investors were very happy to buy them. CoCos
offered a much higher interest payment than bonds of the same seniority
(pecking order in the event of liquidation). This is because CoCos can be
converted into common equity (shares) in times of distress, this reduces
the debt burden and raises the capitalisation of the bank thus helping the
bank absorb any loss and protect deposits without the intervention of the
taxpayer. There are multiple triggers for what would cause a CoCo to
convert and more detail can be found in CoCo: A primer.
The current European CoCo bond market is valued around 100bn.
Recently CoCos whipped up a media storm, there was concern that
Deutsche bank could not make an interest payment due for this April. This
was following the posting of the 6.7bn loss. In the annual report, it stated
that it had sufficient capital to pay this year's forecasted litigation cost
and to service its debt. But investors were spooked and there was a rush
to ditch the riskier and untested CoCos. The price of CoCos dropped to
record lows and in an effort to reassure investors the co-CEO recently
appointed John Cryan said that Deutsche bank was rock solid. Unnerved
by similar statements of confidence before the collapse of Lehman
Brothers Cryans words did little to soothe CoCo holders. At this time the
share price was plunging new depths, common equity (shares) are the last

thing you want to be holding in the event of a collapse (assets are sold to
pay off bondholders first and nothing normally ends up in shareholders
pockets).
The cost of insuring against Deutsche bank defaulting on its CoCo
payment shot up (measured by credit default swaps). The market was
behaving like Deutsche bank was actually under existential threat. The
risk started to affect the price of some of Deutsche banks more senior
debt. Eventually, Deutsche bank had to step in and say it would offer to
buy some of the debt back from bondholders ($5 bn) saying it had
sufficient funds to do so. This did reassure investors and prices stabilised.
When Deutsche bank actually came to offer to buy the bonds many of the
bondholders refrained selling reflecting an upswing in sentiment. I find
this a bit ridiculous, the market was not assured by John Cryans
statement (Or the German finance minister stating he was not concerned)
they forced Deutsche banks hand, and then are suddenly happy to hold
onto the same debt they were worried about the week before. I think the
irony is that CoCo bonds are probably more of a headache than a help for
regulators. They were designed to add stability, instead investors are left
with a security with a short history and many questions surrounding what
actually happens when triggered. A problem with CoCos is many are noninvestment grade (credit rating lower than BBB-) and are not held
extensively by large institutional investors this makes raises the question
of CoCos liquidity (availability to trade).
Deutsche bank has been a poorly run business, whilst other banks seem
to have done some effective restructuring over the past few years
Deutsche bank appears to have been left behind. In terms of operations,
the bank seems to be encumbered by the state of its IT infrastructure,
with 45 operating systems many of which are outdated. The bank
attempted to dominate in the derivative market but has been hurt
recently by its exposure to recent declines in equity prices. The bank is
not on best terms with investors as they fear litigation costs will lead to
further issuing of equity. The strategy 2020 launched last summer was
lacking in detail on how the strategy would be implemented successfully.
At its core, the strategy involves simplifying the bank targeting fewer
products, clients and locations. It wishes to move towards becoming less
risky and increasing its capitalisation and establishing a fully accountable
management team. A plan probably welcomed by regulators but leaving
shareholders wondering where there return on equity is going to come
from. Some worry Deutsche bank could become a middle sized
investment bank, unable to compete with its peers and lacking in
innovation making it venerable to developments in financial technology
(Fintech). Dividends have been suspended until 2017 weakening
prospective returns for shareholders. Morale within the bank is low, and
the withdrawal of bonuses may make it increasingly difficult for Deutsche
bank to retain the talent it is desperately in need of. Restructuring is
expensive and tough on the workforce, with many divisions being
significantly cut. John Cryan was appointed last year to lead Deutsche

banks new strategy, he was in charge of overseeing UBSs restructuring


after 2008 so is no stranger to a challenge.
Despite all of what I have said I currently hold shares in Deutsche bank
(See disclosure). Why? Well after Deutsche bank announced its plans to
buy back bonds I took the opportunity to buy some shares. Deutsche bank
doesnt even need to succeed in delivering its 2020 plan to see a
significant upside in price. The CoCo pop truly highlights the negative
sentiment weighing on the share price at the moment.
I have highlighted why the share price should be low but I think we need
to get an appreciation of how low it is at the moment. It is trading at 0.3 of
its price/book value. Book value is the value of all of its assets minus all of
its liabilities (debt). Oversimplifying things that means that the market is
pricing in that 70% of loans that deutsche bank has made will not be paid
back if deutsche bank went bankrupt. Deutsche banks P/B ratio is far
below the level it was in 2012 and looking at the historical P/B ratios for
US banks gives you some perspective. It is currently lower than most of its
other European peers which face similar difficulties (Barclays = 0.4, Credit
Suisse = 0.5). If the earnings per share estimates are achieved at 3.2 for
2018 and the share trades at a conservative P/E ratio (share
price/earnings per share) of 8 would give a valuation of 25.2 for that year
( P/E of 8 is well below historic industry averages). Obviously this a very
rough back of an envelope estimate and the future share price pivots on
how many more quarters of losses Deutsche bank incur, how quickly can
they achieve profitability, the effect of reputational damage on future
business and whether the restructuring is successful. But the point is that
if Deutsche bank survives its restructuring it is not unreasonable to see
the P/B rise closer to one (45). Deutsche bank doesnt have to do a lot to
impress, if the outlook financials picks up in the next few years Deutsche
bank has a lot to gain as it is weighed down at the moment by a vague
strategic plan and frustrated shareholders.

Figure 1. Deutsche bank price to book value range from last 5 years.

Figure 2. Historic graph showing the price to book value of the US


financial sector.

Figure 3. Graph showing the variation in P/E ratio of Deutsche bank.


I have broken a rule of thumb never try and catch a falling knife (dont
buy a share on a sustained downwards trajectory hoping to enter as the
share price bottoms out). Also showing disregard to the wise words of
Warren Buffett tell It's far better to buy a wonderful company at a
fair price than a fair company at a wonderful price. This is my rationale
for holding Deutsche bank shares:
1) short term upside. If the global economy looks a bit rosier the investor
sentiment could carry this above the 23 (2012 low).
2) Maybe this isnt the bottom but timing isnt essential if I choose to hold
as an investment rather than a speculation (hold for 3-10+ years), some
people think Deutsche bank could be as valued low as 7 (or nothing in

the extreme case) but the long term prospect is higher than 15. Im
going to hold till next quarters results and reassess whether I should hold
for the long term or ditch and take the loss/profit.
3) Holding Deutsche bank forces me to keep on the ball with market
developments. Im interested in how news and data moves markets. This
gives me a good excuse for refreshing fastFT (Financial times app)
multiple times a day! I might get round to doing my own fundamental
analysis at some point but my accounting knowledge is limited and banks
are notoriously difficult to price.
4) I am optimistic about the state of the global economy. In 2016 equities
may trade flat for the year and financials may struggle recover, but I dont
think we are about to enter a sustained bear market. The state of
European banks are not comparable to 2008 or even 2012 and there has
been a significant increase in safeguarding measures with the ECB
keeping a watchful eye.
If Deutsche bank truly goes down and Im wrong about its financial
stability it will mean all the attempts by regulators have been fruitless. We
could get an absurd situation where the bankers actions in 2008 causes
two financial crashes, the second due to the litigation burden of the first
one! Bankers would be blamed for their incompetence as opposed to their
greed.
Disclosure
Please do not make any investment decisions based on anything written
in this opinion piece. Banking sector share price movements are very
volatile and should only be considered by those with a very high appetite
for risk. Always consult a professionally qualified adviser before making
investment decisions. I have no formal education in economics or finance
(apart from AS Business and Economics). The money invested is a family
members, as part of a small portfolio I have built up over the last four
years and manage on their behalf.

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