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German banking might turn a corner

| December 14, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The German government is contemplating altering tax or accounting laws in order to facilitate a sale or merger of Deutsche Bank without imposing large mark-to-market charges. Deutsche Bank branches in New York and London could potentially find themselves outside of a ring-fence built to support the ailing lender, but the debt issued by those entities looks protected since the legal issuing entity is in Germany.

The German government may re-shape their banking industry

There is a confluence of events in Germany that seem to be aimed at reshaping the banking industry there. The headline story of course, is the growing support by the German government to coordinate or aid in helping Deutsche Bank (DB). Deutsche Bank has been in decline for years, after having built a large international investment banking business with heavy exposure to securities trading. This created significant leverage on a balance sheet that had little to no transparency. In recent years the balance sheet has been gradually if erratically shrinking, and capital is up modestly. However it is fair to note that the year-end 2009 total assets were €1.50 trillion compared to the current balance of €1.38 trillion, which has seen undulations in that time. This dwarfs the asset size of Commerzbank, which had only €493 billion in assets at 3Q18, of which only €41 billion were derivatives, compared to the €323 billion in derivatives at Deutsche Bank.

Not only does DB pose some questions around balance sheet risk, but the company has been materially challenged to break-even in the last couple years. In fact, the last profitable year for DB was fiscal year 2014 and the last twelve months earnings are negative as well. Commerzbank by contrast, has generated positive though modest returns since it reported small losses in 2012.

The news from this week held few meaningful revelations other than the fact that officials in Germany are discussing altering laws or accounting rules that would allow DB to enter into a merger where mark-to-market charges would not require a taxable event to occur. This news helped DB debt and equity securities see a pop up in valuations, given the higher likelihood of a workable plan. Nevertheless, this also confirms that the bank could have large unrealized losses that will eventually require some kind of charge.

While nothing official seems close to being proposed, there is some risk that not all DB bonds will be treated the same. Any bonds issued from the US bank branch could face the wrong side of a ring-fence. First, consider that with the German government involvement, it will face the least amount of political and ECB resistance if the actions taken on behalf of DB are for the greater good of the German market. This could require a ring-fence of German banking assets and thereby leave the New York and London branches outside that shell. The NY branch has been the issuer of a number of bonds, such as the Oct 1st sale of the “long” 2-year DB 4.25% ’21 at +148 bp, but now trades +245 bp.  For the short time to maturity, this seems like a solid value at these levels. As we highlighted in our “2019 Outlook” call and note, the Yankee banks seem to be well-oversold at this point. Another interesting play could finally be the DB 7.50%, though they have risen 3 points to $85 since the news first broke. Given our thoughts on the risk of ring-fencing, we favor these notes given the German domicile for the legal issuing entity.

Landesbanken are bad on their own, so why not merge them?

For decades the German banking system was supplemented – or hindered depending on perspective – by the local state-owned and state-guaranteed Landesbanken. These publicly-owned institutions were designed to service commercial lending needs and the greater public purpose. The greater good was harder to service after the financial crisis when guarantees on debt obligations expired and banks took large losses on US MBS holdings and even Iceland bank bonds. The more recent collapse of the shipping finance market left HSH Nordbank and Commerzbank holding billions in toxic loans. HSH was broken up with the “good bank” slated for a sale, which may end up as part of the larger amalgamation. NordLB has been reviewing a list of potential bidders, which could potentially bring it together with Helalba, and then ultimately with other Landesbanken.

Assuming the Landesbanken group can be cleaned-up and “zombie assets” are shed, that will help drive more lending again, which has positive implications for the German economy, though could create a more meaningful challenge for a Deutsche-Commerzbank entity.

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