Why Deutsche Bank Is Not Lehman Brothers

by: J Rae Chi

- Deutsche Bank's derivatives exposure is often misrepresented in financial reports.
- Deutsche's leverage is high.
- Deutsche's portfolio is far more diversified than Lehman's was.

I hear more and more chatter about Deutsche Bank's (NYSE:DB) financial woes, and so I decided take a look and see if I can make sense out of the claims that Deutsche Bank is the next Lehman Brothers.
Last month, Zero Hedge published an article that predicted the next financial crisis, as started by the supposedly imminent collapse of Deutsche Bank and ensuing financial crisis. All of this would be because of Deutsche's large derivatives book. Another article by APAC Investment News stated that the bank is in serious trouble and could take the whole industry down with it.
Zero Hedge cited a chart pattern called a "head and shoulders" that can historically be a topping formation. They showed it spanning twenty years. I don't usually give technical analysis much consideration unless fundamental analysis backs it up because one fundamental event can override technical analysis. Furthermore, a lot has happened in twenty years, and I've never seen a head and shoulders chart used that way before.
Admittedly the chart still does not look good to me, but let's dive into the fundamentals and see if we find a reason for an imminent collapse of Deutsche Bank and the rest of the banking sector with it.
First of all, just based on the financial turmoil in Europe - with Brexit and Germany selling negative yield bonds, it's a no-brainer that Deutsche and the rest of European banks are in trouble and rightly selling at cheap valuations. They're definitely not value plays. It's also true that Deutsche is the worst off out of the European banking sector, but that doesn't mean it's Lehman Brothers.
It's important to remember that Lehman Brothers went bankrupt because the firm became insolvent. If Deutsche is the next Lehman Brothers, there will be evidence of future insolvency risk, which this analysis will look for.

Like Zero Hedge and APAC Investment News, most analysts who think Deutsche is going to zero compare it to Lehman because of derivatives exposure, so let's look at that first.
Deutsche's 2015 annual report cites a derivatives book worth 41.9 trillion euro ($46 trillion), which is down from 2013 and 2014. That number means that Deutsche has a total of 41.9 trillion euros in derivatives outstanding on both the long and short side. However, longs and shorts can offset each other, so the firm is not actually risking 41.9 trillion euro. It is in this way that this value is often misrepresented, probably because derivatives are complicated financial objects and often misunderstood.
The number we need is the "net" derivatives exposure, or the difference between the long and short positions. In fact, Deutsche's net derivatives exposure is just 18.2 billion euro ($20 billion).

Though it still seems like a large number, it's not nearly as daunting, and in fact it's not even the largest derivatives book in the world.
With a gross exposure of $50.6 trillion, J.P. Morgan Chase (NYSE:JPM) eclipses Deutsche. But wait! DON'T go sell your JP Morgan shares! J.P. Morgan's net exposure is also much smaller, at $6.9 billion. (Note: Deutsche's accounting follows IFRS, and JP Morgan follows GAAP).
Remember that Lehman was aggressively pursuing proprietary derivatives trading in 2007, and that made up about 13 percent of the investment bank's revenues in 2007. According to their annual report, Lehman's revenues were $19.26 billion in 2007. That's $22.12 billion in 2016 dollars.
The 2007 net derivatives risk of Lehman in 2016 dollars was $2.93 billion. That is much less than the $6.9 billion of J.P. Morgan and almost one tenth of the $20 billion on Deutsche's book, which is why there is chatter about a looming derivative-caused financial crisis.
Remember that Lehman was doing "proprietary" derivatives that made a profit. When used properly, banking derivatives do not bring in revenues, and it was actually a similar style of side-bets that contributed to the bankruptcy of Enron. When used correctly, derivatives hedge risk.

There is absolutely no evidence that Deutsche or J.P. Morgan are intentionally profiting off derivatives like Lehman was doing in 2007. In fact, there is evidence to the contrary, suggesting that they are indeed using them for what they're for: minimizing risk.
Though swaps got a bad reputation after the financial crisis, banks typically use credit default swaps as a type of insurance against the possibility of higher-risk loans (which are assets to banks) defaulting. That is, the purpose of a credit default swap is to reduce risk.
Also remember that risky derivatives worked in Lehman's favor until the underlying loans began defaulting. At that point, the bank began writing (selling) mortgage-backed securities.

They accumulated a portfolio of $85 billion ($ 2007) mortgage-backed securities, which was more than any other firm.
This pushed their leverage to astronomical levels, and Lehman's severely over-weighted mortgage-backed securities stake is what bankrupted the company when the assets had to be written down. What value do you give a company with worthless assets? $0.00.
So in order to judge whether or not there is another Lehman out there, we should look at leverage. Leverage will tell us if the bank can afford to write down assets, including derivatives, without going bankrupt in case of some unforeseen event such as the entire country deciding not to pay their mortgage.
A Closer Look at Lehman, Deutsche, and J.P. Morgan  
(All numbers are in $ millions adjusted to 2016, except percentages)Lehman BrothersDeutsche BankJ.P. Morgan
YoY % Increase in Revenues8.69%-8.26%-2.45%
Total Assets793,6851,769,7352,351,698
Total Debt767,8551,688,9402,104,125
Total Stockholder Equity25,83068,088247,573
Leverage29.73 x24.81 x8.50 x
Net Derivatives2,92620,0006,900
Net Derivatives as % of Revenues13.23%42.23%7.69%
Net Derivatives as % of Assets0.42%1.13%0.29%
Mortgage & Asset-Backed Securities29,7592,6842,878
MABS as % of Revenues134.5%5.67%3.21%
MABS as % of Assets4.31%0.15%0.12%
Fixed Income Securities / Loans*9,647130,241416,000
Fixed Income as % of Total Assets1.23%7.36%17.69%

* Fixed Income Securities / Loans includes credit cards, auto loans, fixed rate mortgages, small business loans, consumer loans, and corporate loans.
Leverage of J.P. Morgan is less than half of Lehman Bros. Deutsche's is only a little bit lower, which is probably another reason analysts think the stock is going to zero.
There is one more main difference between Lehman and Deutsche, though, and this one saves Deutsche from bankruptcy. Deutsche's portfolio of assets is much more diversified than Lehman's was. This is also our major clue that Deutsche (and J.P. Morgan) are using derivatives to hedge, not turn a profit. Note: mortgage-backed securities on the books at Deutsche and J.P. Morgan are mostly left over from the 2008 crisis.
Both Deutsche and J.P. Morgan appear to be able to write down assets without going bankrupt.
Nobody wants to write down an asset, and shareholders certainly won't like it - but the stocks are not going to zero if one part of their business erodes.
Admittedly, Deutsche's derivatives exposure still looks somewhat large, but if we assume they will have to cough up that entire $20 billion this year, they can pay it with revenues they are generating. In other words, there would be no debt issues or solvency issues if that $20 billion derivatives had to be paid immediately.
Further, if we discount Deutsche's negative revenue growth out in time, they won't have less than $20 billion in revenues until 2026 assuming inflation remains unchanged. However, a lot can happen in a decade.
It gets even more relieving when we realize that the rate of decline of Deutsche's derivatives exposure is larger than the rate of their revenues decline. In other words, their derivatives exposure is eroding faster than their revenues are dropping. It is therefore unlikely that Deutsche will be worried about derivatives even in 2026.
Deutsche's assets are a portfolio of consumer loans, business loans, auto loans, fixed mortgages, subprime mortgages, and credit card loans. These assets are debt issued to customers from different economies all over the world.
Bank insolvency, or bank failure, happens when a bank must write down assets to the point where its liabilities are greater than its assets, or where it can no longer meet its obligations. We can certainly see that neither bank is on the verge of insolvency today.
What would it take for Deutsche to fail? In short, it would take an asset write down of $80.795 billion, or 62 percent of Deutsche's diversified portfolio of assets, for the bank to become insolvent.
When Lehman Brothers collapsed, all it took was for one market (housing) to collapse.
Deutsche needs a simultaneous catastrophic global collapse of more than one market in order to fail. Though most of the growth in the world appears to be slowing down, that's not likely to happen.
Now that we know that, should you be buying the stock? No way! Deutsche will bear a large exposure to European volatility for months, or even years! There is no way to know where the bottom is for the stock, except that it is greater than $0.00.
Deutsche has been proactive in addressing its financial woes and has been asking for a bailout, which would tremendously help Deutsche and the rest of the European banks. However, even if no bailout comes, they do not appear to be going bankrupt.

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