But first we need to comment on the end of Q1 2019 earnings and, with it, the top of the rally in the bond market. Since October the Street has been rotating out of risk assets such as collateralized loan obligations (CLOs) and into safer corporate paper, causing a short term rally in both the bonds and related spreads.
The policy pivot by the Federal Open Market Committee, however, has interrupted a large asset allocation shift, leaving managers around the world wondering: What the do I do now? Managers of mortgage assets are asking the same question, especially as prepayments rise and loan retention, when homeowners refinance their mortgage, is falling.
“In Q1 2019, fewer than one in five homeowners remained with their prior mortgage servicer after refinancing their first lien,” said Black Knight’s (BKI) Data & Analytics Division President Ben Graboske. He adds:
“That is the lowest retention rate we’ve seen since Black Knight began tracking the metric in 2005. Anyone in this industry can tell you that customer retention is key – not only to success, but to survival. The challenge is that everyone is competing for a piece of a shrinking refinance market, the size of which is incredibly rate-sensitive, and therefore volatile in its make-up.”
The Q1 rally in the bond market pretty much stopped at the end of April, concluding the bull case both for mortgage finance and bonds. A number of more astute players have rightly taken the Q1 bond market rally as a “transient” phenomenon, to borrow the words of Fed Chairman Jerome Powell regarding inflation, and took the gains off the table. Have a look at the 10-Q for New Residential Investments (NRZ) is this regard.
The big question that faces owners of mortgage assets as well as bonds is do we hedge and which way do we lean? Chairman Powell’s comments about asset prices not being “inflated” certainly does not add to the FOMCs credibility when it comes to providing guidance or managing soft landings. The big losers in the proverbial policy mix seem to be weaker credits that need to raise capital, but sadly the market already has moved away.
The science project/automaker known as Tesla (TSLA), for example, has suddenly reversed previous public statements and now is in the market with a $2 billion capital raise. Of course the true believers in the audience pushed the share price up after the announcement, but TSLA is still down 25% for the past year.
The challenging situation facing Elon Musk’s love object TSLA is as nothing, however, compared to the task facing Deutsche Bank, which has been trying to raise new capital for years without success. With the failure of merger talks with Commerzbank AG (CBK), the lack of progress at Deutsche Bank presents a growing risk to the global financial system.
In our conversation, Dübel reminds us of the obvious, namely that the largest “bank” in Germany is not really a bank at all when compared with US institutions. Even the $2 trillion asset JPMorgan Chase (JPM) is still more than half core deposit funded and boasts a significant loan book focused on small and medium size enterprises (SMEs). A fatal flaw in the business model of Deutsche and many other private German lenders has led to the present juncture, where Deutsche seems so toxic that it cannot raise new equity capital or combine with another institution.
“In a nutshell, German (and Japanese) banks are traditionally bond buyers and not lenders, notes Duebel. “All of them, not just Deutsche and Commerzbank AG. Germany doesn’t have a pension system, so much of our surplus has to go through bank deposits and bonds bought by banks.” He notes some of the structural differences between banks in Germany and the US, but cautions that these disparities are not sufficient to explain the decline of German banks.
“Structurally they didn’t build up international retail and SME lending as opposed to, for example, BNP Paribas (BNP). As their corporate client base increasingly became banks themselves, Deutsche thought they could compensate through trading income,” he notes. “Of course the strong cooperative and public banking system made the domestic retail/SME market difficult, but that is no excuse. Consider the international success of BNP or Société General (SG) against strong domestic co-operative bank competition. German banks used to be internationally strong in Latin America, Russia and the Middle East, these markets are history today.”
Once the focus on traditional corporate and SME lending started to fade, Deutsche Bank and others were lured by the big returns of global investment banking, notes Dübel. “Being securities-overweight, they jumped into extremely crowded investment banking, where banking is dominated by the soccer model (most profits end up with staff, not shareholders),” he relates. Dübel notes that Deutsche and other German banks reaped a large share of their profits from taking market as opposed to credit risk, which is extremely curve- and volatility-sensitive. In addition, due to weak regulations, the German banks pushed up risk levels across their portfolio, with disastrous results.
“Where they ventured into credit risk especially,” Dübel notes, “Deutsche focused on the synthetic market where it didn’t have a natural hedge due to the absence of a real credit portfolio. They ran into legal troubles when seeking those opportunities in local governments, retail investors, etc. They were brutally hit by adverse selection in bonds from Anglo investment banks during the crisis. And they contributed to inflating the economy of our neighbors and the U.S. via the bond markets. With ZIRP and only low-yield alternatives in the bond market, Deutsche effectively was bailed out by American and German governments without any consequences.”
Dübel believes that the key issue as first mentioned is the unhealthy structural development, that is, management mistakes at Deutsche. “Achleitner (Allianz, Goldman) fired Cryan because he wanted to correct the investment banking bias. Now he trapped himself into something worse,” says Dübel. “I believe in contrast that the money laundering allegations against Deutsche Bank are mostly politically driven. Look who is talking. Details are very hard to verify.”
Dübel adds: “Also let us not forget that international banking is as brutal as international oil. German banks were strong for example in Russia and Iran – these countries were lost as clients due to political pressure. One serious mistake they made is to leave everything in between Central/Eastern Europe to Italian and Austrian banks. So bizarrely, today Unicredit (CRIN) of Italy is a more serious contender for a Commerzbank takeover today than Deutsche.”
As we’ve noted in The IRA previously, Deutsche has been struggling to make a bad business model work for over a decade. Faced with the fatal structural flaws in the business, the bank has drifted without clear direction from its board of directors and management.
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