One of my colleagues in Washington testified in Congress that the way to finance Fannie Mae and Freddie Mac was for them to issue Contingent Convertible (CoCo) bonds. A CoCo bond, also known as an enhanced capital note (ECN), is a fixed-income instrument that is convertible into equity if a pre-specified trigger event occurs. Sounds good, but I tried to warn him that financial hybrids like CoCo bonds are never as simple as he thought, particularly in bad times.
A case in point.
(Bloomberg) Deutsche Bank AG, seeking to shore up capital, has said it wants to sell or spin off German retail-banking unit Postbank. Standing in the way: bonds known as CoCos.
Blame it on conflicting accounting rules. While Deutsche Bank has taken a multi-billion-euro writedown for Postbank in accounts based on international standards, it hasn’t done so on its income statement prepared under local rules. A sale of the unit, whose estimated value is about half the purchase price, would force an impairment charge on its German books as well. Because those accounts determine whether a firm can pay the coupons on contingent convertible bonds, also called AT1 notes, that writedown could block payment.
Concerns about whether the lender could continue making CoCo payments already rattled investors twice this year, leading to steep declines in its stock and bond prices. Although Deutsche Bank has reserves to tap, it’s facing a bigger hit from U.S. authorities, who initially sought $14 billion to settle allegations of misselling mortgage securities. The bank has been struggling in recent quarters to generate profit to shore up reserves and improve capital ratios.
“They’ve completed a range of small asset sales, but to really reach its capital goals, Deutsche Bank needs to sell Postbank,” said Bridget Gandy, a managing director at Fitch Ratings, which last week placed the bank’s credit rating on watch for a possible downgrade, citing its difficulty generating profit and boosting capital. “The bigger question is what the value of the retail-banking franchise is, especially given the structure of Germany’s banking market.”
Additional Tier 1 bonds are the first bank debt to suffer losses in a crisis. Issuers can skip interest payments and, if a lender burns through financial reserves, impose losses on the principal through write-downs or conversion to equity.
Deutsche Bank’s 1.75 billion euros ($1.93 billion) of 6 percent AT1 bonds rose 0.3 cents to 76.5 cents on Monday. The notes hit a record low of 69.9 cents in September.
European bank stocks have fallen about 32 percent since April 2015, when Deutsche Bank announced plans to sell Postbank. Even before then, the unit’s value was much less than the roughly 6.5 billion euros Deutsche Bank paid. The business lost money in 2014 and 2015, company filings show. In June, analysts at Kepler Cheuvreux and Royal Bank of Canada valued it at about 3 billion euros.
Deutsche Bank has said it’s in no rush to sell Postbank or arrange an initial public offering and will wait for markets to recover. Ronald Weichert, a spokesman for the Frankfurt-based lender, declined to comment about whether the convertible bonds are making a sale more difficult.
Chief Financial Officer Marcus Schenck said on Friday that the firm isn’t wavering on its plans to sell Postbank. If a sale can’t be arranged, Schenck said on a call with investors, the bank would look for alternative ways to reach capital goals.
“If we could not sell it, it mathematically would have an impact on the capital development and the bank would then have to identify, and would do so, other measures to compensate for that,” Schenck said.
Europe’s largest investment bank agreed to buy Postbank in 2008 from the national postal service just days before the collapse of Lehman Brothers Holdings Inc., which triggered a global financial crisis. The idea was to diversify trading and advisory revenue with more retail banking. A lot has changed since then.
An overhaul of global banking regulations increased capital requirements for many business lines. Postbank takes German retail deposits and makes home loans with those funds. Under pre-crisis rules, mortgages required little capital because they were seen as low-risk. Starting in 2018, a new leverage ratio will require that all assets on a bank balance sheet be backed by some equity regardless of risk. That will increase the capital needed for Postbank assets.
Low interest rates — below zero in the euro zone since 2014 — have hurt banks’ interest margins, especially in Germany where there’s a savings glut, further undermining Postbank’s value.
Deutsche Bank wrote down its retail business by 3.6 billion euros last year, most of that attributed to Postbank. The writedown, called a goodwill impairment, reflects the difference between how much a firm thinks a unit is worth today and the premium paid over book value at the time of purchase. In all, Deutsche Bank recorded 5.8 billion euros of such writedowns on multiple businesses last year resulting in a 6.8 billion-euro loss.
But that was all in the income statement it calculates using international reporting standards, known as IFRS, which consolidates subsidiaries. In the statement for the parent company prepared under German accounting standards, the impairment charge was only 1.6 billion euros, with no explanation of what investments were considered impaired. That enabled the parent company to break even in 2015. The impairment didn’t include Postbank, according to a person familiar with the accounts.
IFRS accounting, which requires annual tests of asset values, forces companies to take impairment charges more quickly, said Felix Fischer, a consultant at the German affiliate of PricewaterhouseCoopers. Under German accounting rules, a company doesn’t have to take a writedown if the unit is still generating cash. It can wait until a divestment occurs and record the price differential between the purchase and the sale as the impairment. German firms typically use local accounting for each unit based in the country as well as to calculate domestic tax payments.
The German accounting statements are also the basis for determining whether a bank can pay the coupons on its convertible bonds. While the European Union has specific rules about this, German law is even tougher because the triggers are lower.
Deutsche Bank has about 5 billion euros of reserves in its parent-only accounts it can tap for losses such as a Postbank writedown or a U.S. mortgage settlement, according to estimates by analysts at Keefe, Bruyette & Woods. Deutsche Bank has said it won’t pay the $14 billion the Justice Department initially demanded, and analysts expect the final amount will be significantly less. Anything more than $5 billion would eat into the reserves, and a settlement of $10 billion would leave almost nothing for a Postbank writedown.
AT1 notes are hybrid capital instruments that help banks meet some capital requirements without issuing additional stock because they count as capital in calculating leverage ratios. In normal times, they pay interest in quarterly or annual coupons. In bad times, they’re written down to absorb the firm’s losses.
Time may be running out for a Postbank sale as Deutsche Bank faces increased capital requirements from European regulators at the beginning of 2018, according to RBC’s Fiona Swaffield. The company needs the Postbank disposal to reach the required minimums by that time, Swaffield wrote in June.
Deutsche Bank has struggled to make money. Last quarter, when Wall Street experienced a surge in fixed-income trading, the German bank benefited less than most of its rivals. Postbank was supposed to help with that by providing a steady stream of retail-banking income but no longer can.
Here is the security description of Deutsche Bank’s 6% coupon CoCo bond.
Which is now yielding twice what the issuance yield.
The ECB zero interest rate policies aren’t helping matters.
Especially when Deutsche Bank has fallen over 80% since June 2007. And DB has plenty of company.
While CoCo bonds represent one way to finance operations, one has to be careful to careful about what happens when the bottom falls out.
“Hey Leondardo! Is that a huge iceberg ahead?”
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