Why the Market Lost Trust in Deutsche Bank

October 3, 2016 Updated: October 6, 2016

Why is the market so obsessed with Deutsche Bank? Yes, they will have to pay a billion-dollar fine to the U.S. Department of Justice (DOJ). So did Goldman Sachs and Bank of America. Yes, they don’t have much capital to speak of. Neither do most Italian banks. Yes, they have placed financial bets on trillions of dollars of underlying assets. So has JPMorgan.

But no bank has all of these factors in the magnitude that Deutsche Bank has. Add to this shady accounting practices and a shrinking business model, and it’s hardly surprising that the German bank is teetering on the verge of bankruptcy.

At the moment, rumors about a settlement with the DOJ and the magnitude of the fine make the bank’s stock move 10 percent up or down. The settlement, however, won’t break Deutsche Bank’s back, even if the full $14 billion will come due. Contrary to popular opinion, the bank is still profitable, and the rest of the money will come out of shareholders’ equity, which stood at $75 billion at the end of the second quarter of 2016.

The market has already discounted equity in the bank to $17 billion—and it may go to zero if the $2 trillion balance sheet starts to unwind.

It’s the Balance Sheet

This is where Deutsche’s real problem lies. The market will forgive a couple of quarters of losses and even substantial legal fines if the bank’s balance sheet is intact.

However, many analysts have voiced concern about Deutsche’s shady accounting of its $2 trillion in assets.

“Deutsche Bank’s accounting interpretations are ridiculous. They have certain assets, loans, and obligations that are backed by collateral. These obligations have counterparties, but they don’t rate the risk of these counterparties, and they don’t adjust the valuation of these transactions,” said Reggie Middleton, CEO of fintech (financial technology) company Veritaseum.

In practice, this means that some of the companies that Deutsche lent money to won’t be able to repay their loans or obligations to the bank, and their inability to pay is not reflected in the current numbers.

If this figure were only 10 percent of Deutsche Bank’s balance sheet, it would lose $180 billion, and all the book equity would be wiped out more than two times over. The DOJ fine is nothing compared to it.

Loss of Confidence

Because of the shady accounting practices and the possible impairment, market participants don’t want to wait around to see how this is going to play out. They have lost confidence in the bank’s ability to manage risk and account for it.

This is why at least three large hedge funds stopped trading derivative contracts with the bank last week, according to a Bloomberg report, and moved their money elsewhere.

If more funds do the same, the bank will face an institutional bank run and eventually won’t be able to pay back everybody who wants to pull their money out. It was under these conditions that Lehman Brothers filed for bankruptcy protection, or protection from creditors wanting their money back. Not because of financial losses wiping out shareholders’ equity.

Black Box

The other big unknown at Deutsche Bank is its betting book of financial contracts on interest rates, currencies, and every other sort of financial instrument. Although gains and losses are netted out, it’s the largest of its kind and the underlying assets are worth $51 trillion.

This so-called derivative book has been shrinking, and it’s down from a record high of $75 trillion in 2013. Foreign banks’ derivative claims on German banks (including Deutsche) have also decreased by $96 billion to $312 billion from the first quarter of 2015 to the first quarter of 2016, according to Bank for International Settlements (BIS) calculations.

The deleveraging could be good; it is reducing risk at Deutsche Bank. But not only is it reducing risk, it is also reducing profits and liquidity. The fewer contracts outstanding, the less opportunity Deutsche has to work with the collateral posted for the trades.

And again the quality of the bets Deutsche made comes into play. Similar to the asset quality on the balance sheet, it’s no problem if derivative contracts mature and they were winning bets. Then you just collect and keep the profit. But what if most of them are losing? Then you have to come up with the difference, and you don’t have a chance to bet again because your playing partner just walked away.

Given the market pressure on Deutsche Bank, chances are that most of the unwinding bets weren’t winners. And the more counterparties like the three hedge funds walk away, the more intense Deutsche’s liquidity struggle will become.