Stocks and Shares

The huge investment bank that has everyone worried

Stock investors have completely lost confidence in one of the world’s most important investment banks. If it did come crashing down it could start a new global financial crisis across Europe, the USA and beyond. But are the fears massively overdone? It depends if you believe its new boss. If you do, the bank’s stock could actually be a great investment.

The bank in question is Deutsche Bank (DB), by far Germany’s largest bank. At the end of March this year it had assets of 1.7 trillion euros (US$1.9 trillion). That puts it in the same league as giant US banks such as JP Morgan Chase, Bank of America, Citigroup and Wells Fargo.

At 11.54 euros, DB’s share price is down 62% over the past year. It’s taken a big hit since Britain voted to leave the European Union in a referendum on 23rd June. But most of the price fall happened well before that, as this chart shows.

Deutsche-bank-Price-Collapse

DB’s assets are equivalent to over 50% of German GDP. By comparison, JP Morgan Chase’s assets – being the largest US bank – are equivalent to around 20% of US GDP (using the same accounting rules). In other words, DB is a much bigger deal for Germany than JPMC is for the USA.

DB isn’t just a “German” bank though. It has a huge, global investment banking business that trades securities and derivatives throughout the world. It’s interlinked with every other large financial institution in the US, Europe and Asia.

So it’s clear that if Deutsche Bank has a solvency problem then the implications would be huge. This is “systemic risk” writ large. If DB was allowed to fail it would be far worse than when relatively small Lehman Brothers went down in late 2008. Other banks would fail as well.

Clearly, DB’s stock investors are deeply concerned about its prospects. But the bank hasn’t announced any major new losses or financial distress – at least not yet. So the question is whether this is just a product of over excitement and market rumours? Can Deutsche Bank really be in so much trouble that it’s about to need a bailout?

It’s certainly priced that way. Using financial results from the end of March, DB stock is priced at 0.3 times book value. Book value – also known as net asset value or shareholders’ equity – is the sum of all assets less the sum of all liabilities. In other words, all that a company owns less all that it owes.

Put another way, in theory you could buy the whole of the bank, liquidate its assets, pay off its debts, and you’d make a profit of 233%. You’d get more than three times your investment back.

There’s only one way that the market could have got this right, and that’s if Deutsche Bank is in desperate need of new capital. If that’s the case then it would have to issue billions of euros of new stock, perhaps tens of billions – either to the German government or investors. That would leave existing shareholders owning a much smaller piece of the pie.

Enter the highly respected new CEO John Cryan. As recently as May he said that “We’re convinced we can realise this transformation with our own funds.” In other words, without raising new capital.

So let’s look at the evidence.

A lot of what happens hinges on the credibility of John Cryan. He was parachuted into a joint CEO role in June 2015 with a mandate to restructure and save the bank, and has been sole CEO since May this year.

Cryan, aged 55, is a softly spoken British banker, who speaks with a modest and self-deprecating tone. He’s also fluent in German, having moved to Germany “for love” in his late 20s.

He’s known as a workaholic. One ex-colleague is reported to have said: “Most managers can drink people under the table. John can work people under the table.”

His track record is also impressive. Cryan started as an accountant at Arthur Andersen, a top accounting firm at the time (now defunct). Next he was an investment banker from 1987 to 2008 at UBS and predecessor firms, rising to be head of the global “FIG” team, or Financial Institutions Group.

(UBS is a huge “bulge bracket” investment bank and wealth manager, headquartered in Switzerland – and where I previously worked for 15 years. I don’t remember ever meeting Cryan when I was there, although I did work for his boss at one point.)

FIG bankers are the deal makers that advise big banks and insurance companies on company takeovers and capital raising. They work punishing hours, and have brutal international travel schedules.

Most junior investment bankers can’t hack the pace after a few years and leave. To end up running a global sector team shows incredible ability and staying power.

In the depths of the financial crisis in 2008, as UBS was starting to rack up huge losses that eventually ran to around $50 billion, Cryan was called on to become UBS’s chief financial officer. He stuck in the job until 2011, taking a key role in managing the crisis and keeping the bank afloat.

His boss at the time, ex-UBS CEO Oswald Gruebel – a gritty Swiss banker not known for heaping praise on anyone – showered compliments on Cryan when he departed.

So it’s no surprise that Deutsche Bank tapped Cryan in their hour of need. Put simply, if Cryan can’t sort out Deutsche Bank then it’s doubtful that anyone can.

Cryan has launched a huge restructuring of DB’s businesses, under the moniker of “strategy 2020”. It’s all about making the business simpler, more efficient, less risky, better capitalised and more disciplined.

Cryan has launched a huge restructuring of DB’s businesses, under the moniker of “strategy 2020”. It’s all about making the business simpler, more efficient, less risky, better capitalised and more disciplined.

Two thirds of the top three tiers of managers have been replaced. Non-core businesses have been sold or are for sale, including Indian asset management and a stake in a Chinese bank. The bank’s presence is being closed or reduced in 10 countries.

Across Spain and Poland 43 bank branches have been shut down. In Germany around 200 further branches will be closed. The balance sheet is being scaled back. Around three quarters of the bank’s computer software systems have been removed. The overall aim is to cut costs by about a third.

Make no mistake, this is a massive transformation that Cryan has taken on. In the meantime the bank is still dealing with huge lawsuits for various past misdemeanours – the multi-billion dollar legacy cost left to Cryan by his predecessors. But he says he’s confident most of the remaining ones will be resolved this year.

Deutsche Bank clearly has an impressive and highly respected CEO at the helm. The question is whether he’s been brought in too late to tackle this huge task.

The bank itself sailed through the 2007-2009 financial crisis relatively unscathed. It’s only loss making year was in 2008, when it wrote down assets by 10 billion euros and reported a net loss of 3.9 billion euros. Most of its peers lost a hell of a lot more over a few years – in some cases over 50 billion.

This relatively benign result was a surprise to many, since DB had a reputation for taking huge trading risks. I remember a senior fixed income trader at UBS once telling me, around 2004, that he couldn’t believe the complex and risky derivative trades for clients that DB had happily taken on, and which UBS has flatly refused.

Thus it appeared that DB had escaped the worst of the crisis due to great trading skill, or luck, or both. But there were less charitable conclusions. For a time there were serious rumours that the bank had cooked its books. We’ll never know the truth.

In the following years the bank took more lumps due to various fines and trading losses from legacy positions. But it stayed profitable (just about) until 2015, when Cryan got to work clearing out the stables.

Last year it reported a loss of 6.8 billion euros (US$7.5 billion). In a presentation on 31st May Cryan said it “may not make a profit this year”, having made a small profit in the first quarter.

If DB has incurred huge losses I’d expect a profit warning to come out in the next week or two, ahead of the full announcement. But for now there’s silence.

Second quarter results are due to be announced on 27th July. If DB has incurred huge losses I’d expect a profit warning to come out in the next week or two, ahead of the full announcement. But for now there’s silence.

There is, however, one little sign of potential trouble. As of today the bank’s head of foreign exchange and emerging market debt trading is leaving the firm. Did DB find itself making currency bets on the wrong side of Brexit currency turmoil?

After all, the British pound plunged around 10% on the “surprise” result, which is bound to have caught out some traders, and Deutsche Bank is one of the biggest currency traders in the world (if not number one).

For now we’ll have to wait and see if there’s a huge loss lurking in the accounts. Should we trust Cryan or the markets?

If you trust John Cryan then Deutsche Bank stock could offer an excellent profit opportunity for investors. If you trust the current view in the markets then it’s toxic waste. Next time I’m take a closer look at whether the massive potential profit is worth the substantial risk.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.