Europe's financial system has a serious game of chicken on its hands.
The U.S. is said to be seeking $14 billion to settle a probe into the sale of residential mortgage-backed securities, a number so big it would surely push the bank into a costly and dilutive capital hike. Deutsche, understandably, is saying "nein."
The bank's shares and bonds have taken a beating, and investors are right to be worried. But it's worth remembering that Deutsche Bank's weakness may actually give it some leverage.
It should be obvious to everyone at the U.S. Department of Justice that Deutsche Bank can't afford $14 billion. Even if we take a more realistic figure of $8 billion -- which is what some investors now expect and is about in the middle of what dovish investors and hawkish U.S. authorities are looking at -- that would still blow through Deutsche's 5.5 billion euros ($6.2 billion) of provisions set aside for settlements and fines at end-June. Anything above $4 billion would put pressure on Deutsche's capital base, which is already weak relative to peers, according to JPMorgan estimates.
Strange as it may seem, that's actually not such a bad negotiating position to be in for Deutsche Bank. This is one of Europe's biggest and most systemically important institutions, and also one of its most scarred by the current environment of unpredictable financial markets, negative interest rates and tough capital requirements. The bank reported a hefty 2015 loss and the first half of this year has been pretty grim: Net revenues are down by 4 billion euros and profits down by 1 billion. Deutsche Bank is already on its knees -- the bank has a case to make that even an $8 billion payout will be as punitive a deterrent as $14 billion.
A lot still depends on the politics behind the scenes. A transatlantic claim of $14 billion will go straight into Angela Merkel and Barack Obama's in-tray, just as it did with Europe's claim of $14 billion from Apple as part of a crackdown on tax loopholes.
The current market selloff and the threat to Europe's financial system will likely prompt intervention from the German government, which again should help lower the bill. Germany will hopefully have better luck in this regard than France, which failed to prevent BNP Paribas' record $8.97 billion fine over U.S. sanctions violations. It's not a sure thing.
The risk here is that U.S. negotiators may very well feel emboldened by the prospect of Germany stepping in to insist on $14 billion, or something very close to that. It's another side to this game of chicken: if Deutsche Bank can't afford to pay a mega-fine, perhaps the state of Germany can.
But given the risks involved of saddling the bank with such a massive amount, it's still worth it for Angela Merkel to push for a reduced bill.
Of course, a reduced claim probably won't prevent dilution risk from rising at Deutsche Bank, whose shares are trading at a third of book value and may get even cheaper if the operating environment doesn't improve. But the bank is right to say it has no intention of paying "anywhere near" the DOJ's figure.
Every billion counts if the bank finds itself forced to tap shareholders for cash. Investors may be forgiving if they're given a concrete and acceptable litigation figure, a concrete strategy and a concrete plan for asset sales such as Deutsche's U.K. insurance business. Yes, investors are tired of the bank lurching from crisis to crisis. But an egregious settlement is not the kind of certainty they should accept.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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