Translation note: Originally published in Spanish in El Mercurio Inversiones, October 2016. Translated into English by the author.
The US Department of Justice demanded $14 billion from Deutsche Bank to settle claims relating to the underwriting and sale of mortgage-backed securities (RMBS) between 2005 and 2007 — exposing a capital base already weakened by $7.4 billion in losses in 2015.
Deutsche Bank's loan book was substantially refinanced through the ECB's Asset Purchase Programme — covering covered bonds (CBPP) and asset-backed securities (ABSPP). A bank both too big to fail and too reliant on central bank support to stand alone.
Deutsche Bank was trading at just 30% of net asset value. The question haunting markets was not whether the bank would settle — but whether it could. Capital increase, asset sales, and DOJ negotiation were the only paths forward.
In early September 2016, several hedge funds withdrew their investments in Deutsche Bank shares in order to reduce their exposure. The reason: between 2005 and 2007 — that is, in the years preceding the financial crisis — Deutsche Bank underwrote and sold residential mortgage-backed securities (RMBS) while deliberately misrepresenting their content. Following several years of investigation, the US Department of Justice demanded that Deutsche Bank pay $14 billion to settle claims related to that underwriting and sale. Deutsche Bank announced this on 16 September, after which its share price fell 8%.
For context: Morgan Stanley had settled with the DOJ for $3.2 billion, and Bank of America for $16.7 billion — the latter having also paid fines to the Federal Housing Finance Agency (FHFA). Deutsche Bank itself had already reached a $1.9 billion agreement with the FHFA in 2013. The $14 billion demand was of a different magnitude entirely — one that appeared to threaten the bank's financial stability. Deutsche Bank refused to pay. The question hanging over markets was whether it did not want to, or whether it simply could not.
"The question haunting markets was not whether Deutsche Bank would settle — but whether it could."— Dr. Verónica Pollak, El Mercurio Inversiones, October 2016
In 2015, Deutsche Bank recorded losses of $7.4 billion. Adding to this: according to Thomson Reuters, Morgan Stanley, and The Economist, Deutsche Bank was trading at approximately 30% of net asset value. At the time of writing, the bank was officially exploring a 25% capital increase, the sale of certain assets, and a negotiated reduction of the DOJ settlement amount.
What must be understood is the structural context in which Deutsche Bank was operating. Together with Commerzbank, it is one of the largest lenders in Germany and Europe — a role that had been reinforced since 2014 by the European Central Bank's Asset Purchase Programme (APP).
The APP comprised a third phase of covered bond purchases (CBPP3) — following CBPP1 (June 2009–June 2010) and CBPP2 (November 2011–October 2012) — and an asset-backed securities purchase programme (ABSPP). In March 2015, the ECB extended the APP to include public sector securities (PSPP). Between March 2015 and March 2016, the APP involved monthly asset purchases of €60 billion; from April to June 2016, this rose to an average of €80 billion per month.
The APP had a profound impact on the ECB's balance sheet, as well as on those of the public and private sectors, since it involved balance sheet expansion on both sides — the buyer (ECB) and the seller (public and private sector alike). From the perspective of the private sector specifically, the CBPP and ABSPP positively enhanced lending capacity: institutions could refinance a significant portion of their loans by subsequently issuing covered bonds and asset-backed securities.
Deutsche Bank was not untouched by the APP's benefits. While its risk-weighted asset ratio — at 10.2% rather than 12% — was lower than comparable institutions, indicating a degree of resilience, a substantial portion of its loan book was being refinanced through the ECB. The bank's position was thus doubly exposed: legally, through the DOJ proceedings; and structurally, through its dependence on central bank liquidity support.
"Until Deutsche Bank resolves its legal situation with the US Department of Justice, its shares will remain hostage to market uncertainty — and shareholders will bear the losses, whether through declining valuations or dilution from a capital increase."— Dr. Verónica Pollak, El Mercurio Inversiones, October 2016
The conclusion was straightforward, if uncomfortable: until Deutsche Bank resolved its legal situation with the US Department of Justice, its shares would remain exposed to market volatility, and its shareholders would continue to bear losses — whether through a declining share price or through dilution in the event of a capital increase. The too-big-to-fail question was not academic. It was live, and it was European.
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