The market bears have been brought out of hibernation early by the turmoil this winter, and a number have called the next crisis around the corner. Gold has been the standout performer of 2016. It beat virtually every other global financial asset by returning 5% in January.
Some argue that an almighty asset bubble inflated by central bank largesse is just waiting to be pricked by the spectacular collapse of some little understood, niche corner of the global markets, such as that currently being immortalised on screen by Christian Bale and co in ‘The Big Short’.
Still, as long as you didn’t buy anything with Deutsche Bank written on it last month you might be doing ok for now. Deutsche's share price has fallen 26% since January 4.
One of the more damning assessments following the German bank’s announcement of a €6.8bn annual loss last week came from Saxo Bank’s head of equities Peter Garnry, who labelled the bank a “complete mess” that would be in trouble “for years”. Ouch.
The FIG Short
But the more immediate problem for Deutsche is its AT1 bonds, which hit new lows on Monday as investors debated how long the decision to pay coupons would remain in the issuer’s hands.
Could AT1 be the market niche that causes the collapse?
“The AT1 market is in its infancy, and you could say will remain in its infancy until someone decides not to pay a coupon,” one investor told GlobalCapital on Monday.
He had a point.
Banks have done an impressive job of cultivating an investor base from scratch for this risky debt, educating early adopters and then gradually tempting bigger funds who were sceptical at first.
One remarkable development amid the turmoil triggered by the Greece crisis in mid-2015 was how stable the AT1 secondary market remained, convincing the product’s champions that a new influx of real money had helped it come of age.
However, late last year, and early this, that claim has been challenged, as AT1 failed to escape the broader market volatility and liquidity suffered as a number of banks simply gave up trading the notes altogether.
A poll of investors by Morgan Stanley's research team last year revealed that of those accounts that could buy AT1 but didn’t hold any, 100% of those from Asia said the reason was the product was “overpriced considering the risks”, while about half of the rest of the global sample cited this reason for not investing.
Now if you’re a holder of AT1 and you’re reading this feeling understandably insulted, consider this. BNY Mellon Investment Management conducted a survey of 356 individual US investors in December and found 40% of them didn’t know bond prices fall when yields rise. We call it how we see it.
But let’s be realistic. The subprime mortgage bond market was worth some $1.3tr in the second quarter of 2007. By comparison the AT1 market currently stands at less than a tenth of that size. And there are no collateralised debt obligations of AT1s. Yet.
Costly capital
Well, at just under €22bn, the German national champion’s market capitalisation is now comfortably below that of...Danish national champion Danske Bank.
Sadly Deutsche’s shrinking market cap does not make it less systemically important, and it has therefore been given a 3.25% Pillar 2 capital requirement, according to CreditSights, by far the highest of any European bank.
Achieving its common equity tier one (CET1) capital ratio target of 12.5% by 2018 would put the lender just 25bp above what could be a fully-loaded requirement (including Pillar 2) of 12.25% by 2019.
That's not big cushion, even if the bank beats targets on deleveraging.
Deutsche’s CET1 ratio slipped by a chunky 0.6% to 11.1% in the 12 months to December, and is expected to take a further hit this quarter as the bank enters what is has referred to as its “peak restructuring” year, and new capital rules start to bite.
Deutsche Bank reiterated its commitment to paying its AT1 coupons throughout 2016 last week, which gave some brief respite to the bonds in the secondary market.
The bank has €3bn-€4bn of AT1 still to raise, and will therefore be loath to miss a coupon (it isn’t paying a share dividend until at least 2017), but that may be put beyond management’s control.
Everything’s fine(s)
The problem for investors is that the coupon risk has been rendered something of a qualitative judgement, in analyst speak, or “guess” to everyone else.
The next fine could feasibly wipe out the €3bn of “available distributable items” the bank held as of the end of 2014 at a stroke, triggering a skipped payment.
While that may not bring about the end of the world as we know it, the implications for European banks’ capital raising efforts would be grave indeed.
BNP Paribas, just as an example, was bordering on being unfashionably late to the party when it finally made its AT1 debut last year, and like Deutsche has some way to go to fill its AT1 bucket.
Not unfamiliar with hefty litigation charges itself, the French bank wouldn’t thank its German rival for showing investors the true width of the line between "all’s well" and "ends badly".
European banks have raised an eye watering amount of capital since the crisis (at least, relative to what was considered pre-2007 sensible), but they have so far been doing so amid a general downward trend in the cost of that capital.
A missed AT1 coupon payment, from Deutsche or any other issuer, would be a game changer for both spreads and demand. The question then would be how many are still willing to play.