Deutsche Bank Struggles to Shake Winter Blues in Credit Markets

  • The cost of insuring bank's debt against default exceeds peers
  • Debt covered by credit-default swaps swells to most since 2014

For all of John Cryan’s efforts to reassure investors that Deutsche Bank AG is “rock solid,” credit markets are still signaling plenty of concern.

The cost of insuring against losses on Deutsche Bank’s debt is 69 percent higher than the average for 12 of its biggest peers. While that’s less than it was in February, the gap shows investors are still singling out the bank after worries emerged earlier in the year that declining profitability will erode its ability to keep paying coupons on its riskiest bonds. It’s also showing the difficulty of reversing the effects of a derivatives market where a rapid rise in credit-default swap prices can fuel even more hedging by the firms that trade with the bank.

Investors pushed up the price of credit swaps in February as Cryan, the firm’s co-chief executive officer, failed to generate confidence in his plan to cut costs and build capital. The strains are persisting, with the bank scheduled to report on Thursday a 29 percent first-quarter drop in trading revenue, its biggest source of income, according to analyst estimates compiled by Bloomberg.

“It seems that there currently is a fear factor with Deutsche Bank,” said Francois Lavier, who oversees $3.4 billion of bank debt including Deutsche Bank bonds at Lazard Freres Gestion in Paris. “Investors are cautious towards the name. They will continue to be cautious as long as it’s loss-making and at risk of not generating capital.”

Deutsche Bank spokesman Charlie Olivier declined to comment on the performance of the bank’s credit-default swaps and the lender’s relationships with trading counterparties.

Concerns about the bank’s financial strength and its ability to pay interest on certain debt securities sent yields on some of its bonds to record highs in February. Credit swaps tied to the bank’s debt surged to as much as 120 basis points more than the average for contracts on peers including Credit Suisse Group AG and Morgan Stanley, according to prices compiled by Bloomberg. While that has fallen to a premium of 64 basis points, the gap remains unusual in a market where, during the past five years, traders typically demanded 10 basis points less than they did for the the other banks.

Contracts on the bank’s debt also reflect the risk that senior bondholders will take losses imposed by regulators under a German law passed in November. It applies to new and existing bonds from the country’s banks. Still, it costs 52 basis points less to insure the debt of fellow German lender Commerzbank AG than it does for Deutsche Bank.

New Rules

The new law was partly to blame for the February selloff in the derivatives because the contracts were referencing securities that had become eligible for a bail-in, Cryan said at a conference last month.

Deutsche Bank has tried to restore confidence by committing to payments on its riskiest debt and buying back 1.9 billion euros ($2.2 billion) of bonds. Cryan told employees in a February memo that the bank was “rock solid,” only hours after Chief Financial Officer Marcus Schenck said it had “strong” capital and risk positions.

The amount of Deutsche Bank debt covered by credit swaps is growing. Contracts on Deutsche Bank covered a net notional $4.3 billion of debt on April 22, the largest amount since May 2014, up from $3.6 billion at the peak of the rout in February, according to the Depository Trust & Clearing Corp. No other bank had more than $2.9 billion outstanding.

Counterparty Hedging

Counterparties with Germany’s biggest bank have exacerbated the moves and added to the amount of trading, according to people familiar with the matter, who asked not to be identified because they’re not authorized to speak about it. Credit valuation adjustment, or CVA, desks at banks monitor the riskiness of trading partners and hedge against potential losses should they default.

The mandate of CVA desks varies, according to Kevin Liddy, a senior consultant at London-based Solum Financial Ltd. which specializes in derivatives advisory. Banks may have a policy that says they won’t buy credit protection on another counterparty unless the default swap spread breaches a certain level, he said.

“Large moves wider in credit-default swaps can be driven by market sentiment, but sometimes they can be driven by the act of hedging by the CVA desks,” said Liddy, previously global co-head of counterparty exposure management at Royal Bank of Scotland Group Plc.

Increased Costs

Deutsche Bank’s results will probably show the bank had to pay more to trade derivatives with counterparties because they were having to hedge their exposure to the lender, according to Michael Huenseler, who helps manage about 17 billion euros including the bank’s bonds at Assenagon Asset Management.

“It’s a vicious circle,” said Huenseler. “If the credit-default swap spread rises, it becomes more costly for financial counterparts to conduct business with Deutsche Bank.”

Cryan himself said that trading with others was affected by the wider derivatives spreads.

“I don’t think we were everyone’s favorite counterpart for a couple of weeks in February,” he said at the conference. “Generally on our counterparty relations, they’re fine. We’re a bit grumpy with some people but most of it was mechanical and most of it had to do with our CDS spread, and our CDS spread has come back down below where people were concerned.”

Job Cuts

Cryan is cutting jobs and eliminating outdated and overlapping information technology systems to lift returns. The overhaul has been complicated by a downturn in global markets as lower energy prices and concerns over cooling growth weigh on revenue.

Deutsche Bank has racked up more expenses for litigation and fines since the start of 2008 than any other financial firm on the continent, according to data compiled by Bloomberg as of January. Cryan has sought to raise capital buffers and pull back from capital-intensive markets businesses.

The bank is also having to contend with conflict between supervisory board member Georg Thoma and colleagues including Chairman Paul Achleitner. While the two men have worked together for more than two decades, they’ve clashed over strategic issues as well as small formalities, according to a person who has seen them squabble. The 20-person supervisory board was scheduled to meet this week and will probably discuss Thoma, who may come under pressure to step down, a person familiar with the matter said.

“Deutsche Bank’s cuts to investment banking are significant, and given how important that unit is, you have to ask, what will be left afterwards?” said Mark Holman, chief executive officer of TwentyFour Asset Management in London, which oversees 6 billion pounds ($8.8 billion). “There isn’t a clearly articulated strategy on exactly what Deutsche Bank wants to be in the future. I wouldn’t be able to justify holding Deutsche Bank bonds at the moment.”

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