On a day in which DB appeared set to tumble into the a abyss, we saw the defensive cavalry emerge in full force, starting with a letter by the CEO bashing “speculators”, a massive short squeeze with no locate available, a twitter rumor of a settlement being picked up as unconfirmed “news” by a reputable French agency (which apparently has better access to events in Germany than the German press), and moments ago Bank of America chimed in when it upgraded DB’s credit to “Neutral” even though BofA paradoxically admits that “DB’s credit profile likely to remain weak” saying that “we do not particularly like the profile of a credit where performance is skewed to an outcome that is so inherently unpredictable – in this case, guessing what a regulatory fine will be.”
BofA adds that in its view, the German bank “is now experiencing a nasty confidence shock which will likely impact its franchise into the medium-term. It could be that a capital increase is on the horizon, after the fines have largely been settled. In our opinion, DB is likely to be a weak bank for several years from now, though, even with a capital increase.”
It concludes as follows: “in our opinion, DB is likely to be a weak bank for several years from now, though, even with a capital increase.”
And after all that, it’s tap on the shoulder upgrade time.
Confused? Don’t worry: everything that happened today was only meant to make sure DB did not enter a 3-day weekend at its all time low price as hedge funds continue to withdraw any excess cash they have with the bank while buying up as much 1 Year CDS as they can find.
Here is the balance of the goalseeked piece:
Deutsche – wide enough. Upgrade to Neutral
With the strong spread widening that we have seen in recent days across the DB capital structure, we are recommending moving to a more Neutral or Marketweight positioning. We think the spread widening has gone quite far but we are not sure of the timing of any concrete catalyst to reverse the underperformance. We upgrade our ratings on the DB €5%, €2.75% and $4.5% T2 bonds to Marketweight from Underweight. We upgrade the €1.125% senior bond to Marketweight from Underweight. We upgrade our recommendation on Subordinated CDS to Neutral from Buy Protection. On AT1 instruments, we are Marketweight. We downgrade the $4.296% T2 bonds to Marketweight.
Whilst current spread levels point towards a significant level of stress at DB, we remain relatively sanguine. The weak point in DB’s credit profile is not asset risk or liquidity or even on the face of it capital. It is the size of any litigation-related settlements, especially the RMBS settlement with the US DOJ and when these end up being recognised. But even there, our base case has to be that this is a number that the bank can ‘afford’ without asking shareholders for more money – for we would have thought that there is no point setting a fine the payment of which is contingent on a transaction (i.e. a capital raise) that you can’t be sure will succeed. Still less do we subscribe to the idea that DB will seek state aid – it makes no sense at all for Germany in effect to transfer billions of dollars via DB to the US DOJ et al., which is what in effect any assistance to pay the fine would be, in our opinion.
Market expectations are already that the bank will add an additional €2-3bn to its litigation reserves in 2H16 – so this is already in the market. That puts the reserves at the end of the year at ~€8.5bn or so. BofAMLe currently sees a net loss of e.g. €3.7bn for the year as a result of this (though this does not include Abbey Life intangible writeoffs announced in the last week). Should the bank indeed raise its litigation reserves to nearly €9bn by year end (assuming there is no settlement before then), in effect on a reasonable assessment of the cost of settling, DB would be front loading the cost of the litigation – potentially even leaving the door open to being profitable again in 2017, if that doesn’t sound too far-fetched at this point of pessimism. In our view, the big risk to spreads now is that the actual fine(s) come in at more reasonable levels, since the market has already reacted to the possibility of a higher fine. Later on Friday, prices started to recover in reaction to this possibility, we think.
We do not particularly like the profile of a credit where performance is skewed to an outcome that is so inherently unpredictable – in this case, guessing what a regulatory fine will be. This is very different from the Jan-Feb sell-off in DB which was predicated on the non-payment of the bank’s AT1 coupon (inter alia). Hence, we aren’t really that interested in Overweighting DB bonds (again) at the present time in spite of the attractive valuation. Technicals too appear relatively unfavourable. In our view, DB is now experiencing a nasty confidence shock which will likely impact its franchise into the medium-term. It could be that a capital increase is on the horizon, after the fines have largely been settled. This may be a time to have another look at DB. In our opinion, DB is likely to be a weak bank for several years from now, though, even with a capital increase. There will be, we anticipate, future opportunities in its securities based on more conventional credit analysis.
Senior
DB’s senior €1.125% trade at levels comparable on a spread basis now to those of Jan-Feb, though the cash price of the bonds remains about 4 points higher. We see little bail-in risk for the senior bonds, though – the legislation governing this isn’t actually active until 2017 in any case.
Recent comments by Yves Mersch in Munich highlighted that German senior unsecured bank bonds may no longer be eligible collateral for the Eurosystem, we read – this could have implications for German bank liquidity pools which contain, we understand, a significant portion of other German banks’ bonds. Over time, we’d expect more uniformity in the approach to the use of senior bonds as resolution instruments, possibly coalescing around the “Tier 3” concept for those banks without holding companies.
Subordinated
With subordinated spreads now in the +500bps region, DB T2s will again screen as being extremely cheap for many clients.
We do not believe that DB is likely to hit the ‘point of non-viability’ which is a capital level at which the resolution authority would be entitled to call upon bondholders to contribute, if need be, to the bank’s resolution.
AT1s
In our view, the payment for DB AT1s primarily depends on its level of unconsolidated distributable items.
DB has previously guided to about €4.3bn of proforma payment capacity for the AT1s, though this excludes the impact of any potential loss at the unconsolidated bank level. “Final AT1 payment capacity will depend on operational results and movements in other reserves”. Our view remains that the bank is very focused on ADIs and highly incentivised to ensure that its AT1 coupons are serviced and we think AT1s will be serviced. Coupons are due on 30th April, after the unconsolidated accounts are published. The cost of paying the AT1 coupons in 2016 was €0.35bn.
Liquidity
Based on the bank’s most recent disclosures, we do not think that liquidity is a problem for DB. We are mindful of the significant improvements that have been baked into regulation on this front since 2007.
At the end of 2Q16, DB reported liquidity reserves of €223bn. These are cash, high liquid Govvies, and other central bank eligible securities. 56% of this number or €125bn was in cash. This number is likely to dwarf the withdrawal of prime brokerage deposits by hedge funds that was reported overnight by the FT.
The Liquidity Coverage Ratio (LCR) of the bank was 124% at the same date. The surplus above 100% is equivalent to €38bn. The LCR is designed to ensure that market shocks (such as the removal of prime brokerage deposits) can be covered by a bank’s liquid assets over a 30-day stress period.
Fines
DB has €5.5bn of litigation reserves in the consolidated balance sheet, of which €4.1bn is for regulatory enforcement. The bank has a further €1.7bn in contingent liability reserves. Litigation risk is very difficult to assess because understandably banks do not give guidance. Actual agreements may or may not be good indicators because they may or may not reflect elements that differ between settlements, such as whether there is any punitive element, or if there are any other offsets. Few believe that it is in the interest of any of the parties to destabilise a bank that is subject to a regulatory fine, because it just makes it less likely that they can pay it. At our recent Financials Conference, few banks would speculate about outcomes. Some don’t comment about it at all. However, most are anticipating that the bulk of the fines will have been paid by 2017.
Our equity analyst Andrew Stimpson’s current assessment is that DB may have to pay up to €9.3bn in various settlements out to 2017. See Table 1. He is also estimating a further €3.2bn of provisions will be taken this year which would negatively impact 2016e earnings – the bank has guided in any case to a loss this year. This would mean DB would carry approximately €8.7bn of litigation reserves into 2017, assuming that no settlement is reached in the coming weeks. Should settlements come in significantly higher than these baseline expectations, DB may have some flexibility, depending on timing. Recall that the revenue base of the bank, on the basis of 1H16 is about €30bn annually.
Capital
DB’s fully loaded CET1 ratio at end-June was 10.8%. At end 1H16, DB reported CET1 capital of €43.5bn and RWA of €402bn. If the CET1 capital reduced to €40.5bn (or -€3bn), the bank would still be able to report a FL CET1 ratio of 10.1%. On a transitional basis, the CET1 capital number is higher at €49bn, and RWA are €403bn (CET1 ratio of 12.2%). A €3bn reduction in transitional CET1 (for example) leaves us with an 11.4% transitional, still higher than the 2015 SREP of 10.75%. In our view, changes announced in the calculation of Pillar 2 this year is likely mutatis mutandis to lead to a lower 2016 SREP requirement for DB. In other words, we see a low risk of a breach of the transitional SREP ratio.
In terms of the impact on capital, there could be further disposals e.g. Hua Xia Bank or Abbey Life – these already add about 50bps to CET1 capital, for example.
via http://ift.tt/2dxtW70 Tyler Durden