By Kris Rosemann
Let’s walk through the situation with Deutsche Bank (DB) from mid-November through today.
The “5 Cs of credit” — character, capacity, capital, collateral, and conditions — is a widely-followed framework and generally-accepted guideline for lending to consumers, but for corporate entities, we think another C is much more important: confidence. In almost every situation where a bank has encountered trouble, it has resulted from a loss of confidence in the sustainability of the entity as a going-concern. The loss of confidence could originate from counterparties, intermediaries, depositors or clients, or from any other core stakeholder. Lack of confidence typically spreads quickly.
Quite simply, if the market does not have confidence in a banking entity, that banking entity will cease to exist.
In mid-November, Deutsche Bank had been asked by the US Department of Justice to pay $14 billion related to investigations into Financial Crisis-era mortgage securities. Though the eventual payment is now reported to be lower than the aforementioned preliminary figure, such an elevated sum surprised the market in a meaningful way, sending shares in a tailspin the past many months. After all, as of the end of the second quarter of 2016, the bank only had ~$6.2 billion in litigation reserves. Perhaps not surprisingly, Deutsche Bank came out with a statement shortly after receiving the DOJ request that stated it “has no intent to settle these potential civil claims anywhere near the number cited.” It seems as though it might be right.
That’s little reprieve. Shares of the German bank have still faced material pressure since the situation began unfolding in part to concerns over its capital position; said differently, confidence in the banking entity was hurt as a result of the potential aftermath of the litigation. Even worse (and a reminder of what happened to Lehman Brothers during the Financial Crisis), the German government had initially insisted it would not come to the bank’s rescue, even as later it was reported a rescue plan was available in the event the bank would be unable to raise adequate amounts of capital itself. The vague optimism, however, was still somewhat short-lived as confidence in the bank had been rocked again as news surfaced that hedge funds were cutting back their exposure to the bank. When intermediaries stop dealing, things really start heading south as we learned during the Financial Crisis. The system effectively seizes.
Now fast-forward to today: As quickly as the confidence was sucked out of Deutsche Bank, it returned the very day after hedge funds were reportedly reducing the extent of their relationships with the embattled German bank. A French news source reported Deutsche Bank has reached a settlement near $5.4 billion with the US Department of Justice, effectively restoring confidence in the bank for the time being and boosting shares during the September 30 trading period. Why are we telling this story?
Well, we’re using the news flow surrounding Deutsche Bank as a reminder to ourselves, and our members, of the reasons why we generally like to avoid individual exposure to constituents in the financial sector. Under adverse conditions (which almost seem like an eventuality for most banking entities these days), it is not the underlying fundamentals of a bank’s operations (pre-tax pre-provision earnings) that have the most impact to its share price, but instead it is its ability to retain continued access to money and credit, which is inextricably linked to the amount of confidence the market and counterparties have in the bank. This is an “unmodelable” dynamic, and a risk that’s difficult to mitigate even within a portfolio setting (e.g. Financial Crisis).
When it comes to exposure to the financial sector of the economy, we continue to prefer the protection the diversification of the Financial Select Sector SPDR ETF (XLF) offers. Shares of the Financial Select Sector SPDR ETF are included in the Best Ideas Newsletter portfolio and have contributed to the portfolio’s outstanding outperformance over the past 5+ years. We won’t be dabbling in Deutsche Bank’s shares anytime soon. There’s no need from where we stand.