Deutsche's Future Down, but not Out

Deutsche Bank probably posted another loss in 2016. But the picture for Germany's largest bank still looks better than it did just a few weeks ago.

It's not easy to turn a multi-billion-dollar fine into something positive. But Deutsche Bank seems to have pulled it off.

After months of bad omens and plunging shares, the good news arrived before Christmas, when Germany's largest bank announced it would finally be able to resolve its biggest legal risk for $7.2 billion (€6.8 billion). The settlement agreed with U.S. authorities over mortgage dealings was significantly higher than that imposed on U.S. competitors guilty of similar offences, but it's still only half as much as the U.S. authorities' original demand for $14 billion.

Trading is all about expectations. Investors have responded with a sense of relief: "The agreement in the mortgage dispute has significantly improved attitudes toward Deutsche Bank. The burdens are much less severe than some pessimists had anticipated," said Neil Smith, an analyst with Germany's Bankhaus Lampe.

Other analysts are taking a similar cue: While most still expect significant losses for the year, their estimates are no longer as negative as they were before the settlement was reached.

Analysts now expect the bank to post a loss of €787 million for 2016, according to the average in a new survey the bank posted of 17 experts. In mid-December, they were still predicting a loss of €1.03 billion. Either way, it's a far cry from the record loss of nearly €7 billion that Deutsche Bank recorded the previous year.

Not that analysts are particularly sure of their answers this year. Estimates of Deutsche's net earnings for 2016 range from a loss of €1 billion to a gain of €1 billion. The third quarter of this year showed just how difficult it can be to get this right: At the time, experts predicted a loss of €570 million, but the bank eventually reported a gain of €280 million.

This could be the year the bank starts making money again, though it's also clear that 2017 will be another year of restructuring. Deutsche Bank is in the middle of cutting thousands of jobs and closing businesses in sectors and countries where it can no longer make a profit. Analysts are only predicting earnings of about €600 million for this year as a result. Their earnings forecast increases to €2.6 billion for 2018, though it's an optimistic estimate that might be characterized as premature praise.

Now, lower legal costs are one of the key drivers of the improved expectations.

At least the legal costs are starting to drop. The U.S. settlement was cobbled together at the last minute. For months, Deutsche Bank had been negotiating with U.S. Justice Department officials in Washington over a settlement for bad mortgage deals from the era leading up to the 2008 financial crisis.

The fear that the U.S. fine could be too much of a financial burden for the bank was one of the main reasons behind a spectacular plunge in Deutsche Bank's share price in the fall. At its lowest point, Germany's largest bank was only worth €18 billion in the market.

Now, lower legal costs are one of the key drivers of the improved expectations. The share price has recovered and gained more than 70 percent since its record low. On Monday afternoon it was trading at €18.06.

While the bank had already set aside a big chunk of additional money for the U.S. settlement, it was always expected to take an extra hit this year. Before the deal, analysts estimated the bank's extra legal costs for the year at €2.52 billion. By early January, they had reduced their average estimate to €2.36 billion. That's considered an improvement for a financial firm that has shelled out more than €10 billion in fines and settlements since 2012.

It helps that Deutsche doesn't have to pay everything at once. Although the U.S. fine amounts to more than $7 billion, Frankfurt-based Deutsche Bank is only paying €3.1 billion of the total in cash. Another €4.1 billion consists of financial relief for customers. It is precisely this aspect that Lampe analyst Mr. Smith sees as "especially important." This consumer relief means that the bank is not required to pay a specific amount directly, but can instead provide financial relief to homeowners in other ways, such as by extending the term of loans. As a result, the settlement will create less of a burden on the balance sheet than the nominal fine.

In the case of Wall Street firm Goldman Sachs, for example, the burden from a similar penalty turned out to be less than a fifth of the actual fine. What is more, the bank can stretch the amount across five years. Most of all, the Moody's rating agency assumes that the consequences of the U.S. settlement for the bank's capital base will remain manageable for now.

We continue to recognize relatively low basic profitability for Deutsche Bank. Jon Peace, Credit Suisse analyst

Another positive has since come from the European Central Bank, which is requiring a smaller capital buffer from Deutsche Bank than in the previous year. Shortly after Christmas, the lender announced that the ECB had set its mandatory ratio for equity capital at 9.51 percent, compared to 10.76 percent in the previous year. Like competitors, Deutsche Bank is benefiting from a new method the ECB is using to determine the additional buffers banks need to hold back for a rainy day – a change that could allow Deutsche Bank to reward investors.

"This means that it is more likely that the bank will also be able to pay the coupons for its equity-like bonds," Mr. Smith explained, because banks that don't achieve the capital ratio set by the ECB are barred from rewarding shareholders with dividends or paying interest on equity-like bonds.

Yet despite the ECB's moves, and relief over the progress made with legal risks, most analysts are still far from euphoric. Of the 36 financial experts who analyze the bank, half currently recommend selling the bank's shares, according to data from the Bloomberg information service. Only two of them, including Lampe analyst Mr. Smith, recommend buying the stock.

None of these analysts changed their investment recommendation for the share after the U.S. breakthrough, but there are some positives even within these more pessimistic groups. Since the settlement, six have raised their expectations for the bank's share price. Barclays issued the boldest prediction, raising their own forecast from €12.50 to €19.

There are various reasons most analysts have remained stubbornly skeptical. Most of it has to do with whether the bank will actually be able to turn a consistent profit over the coming years.

"We continue to recognize relatively low basic profitability for Deutsche Bank," said Jon Peace, who monitors the bank for Credit Suisse, noting that the profit targets presented by the bank in its original business plan for this year have been lagging behind its actual figures.

There are some bright spots when it comes to profits: The tailwind coming from the capital markets, a key source of earnings in the past, has helped. In comparison to the weak prior-year quarter, Mr. Peace is confident that the bank could have earned 50 percent more in this segment in the fourth quarter than in the previous year.

"In bond trading, business improved throughout the entire sector in the fourth quarter," Mr. Peace explained. This also likely benefited Deutsche Bank, he said, "even though it presumably still lost some market share."

But this, too, is small comfort. Mr. Peace fears that the bank may have trouble selling its Postbank retail subsidiary, for example, a move that has been considered essential to improving Deutsche's capital base over the longer term. If it can't sell Postbank, the fear is Deutsche may still have to look elsewhere to raise cash.

"It doesn’t seem impossible that the bank will have to complete a capital increase in the future," Mr. Peace said cautiously. He currently rates the bank as an underperformer, that is, as a share that is developing at a lower-than-average pace.

With that, Mr. Peace is addressing a concern that many share in financial markets. True, experts have improved their forecasts for the bank's core capital ratio – a key measure of its reserves – and they now expect a capital cover of 11.3 percent for the end of 2016. But Chief Executive Officer John Cryan is still shy of achieving his targeted ratio of 12.5 percent by the end of 2018. Hence the fears that a capital hike might still become necessary.

Mr. Cryan, who has been in charge of the bank now since July 2015, will get another chance next month to prove to investors that he has what it takes. The bank will present its numbers for 2016 on February 2. Investors will expect at least initial signs then for signs about the future – and how Mr. Cryan will adjust bank's strategy going forward.

"A convincing strategy that clearly bears the handwriting of Chief Executive Officer John Cryan is absolutely central," Ingo Speich, a fund manager with Union Investment, recently told Handelsblatt.

That would mark something of a change. Mr. Speich is critical of the bank for essentially adhering to a strategy "that was first presented in 2012 and has largely failed in the capital market." Mr. Cryan tweaked those plans, which involved cutting thousands of jobs and closing unprofitable businesses, when he took over, but there were no drastic moves. Only time will tell if Mr. Cryan has a change of heart.

 

Yasmin Osman is a senior financial correspondent covering Deutsche Bank for Handelsblatt in Frankfurt. Michael Maisch is Handelsblatt's deputy finance editor. Christopher Cermak of Handelsblatt Global contributed to this story. To contact the authors: [email protected] and [email protected]