The Deutsche Bundesbank, Germany’s central bank, is reportedly poring over Deutsche Bank’s (NYSE:DB) accounts for the last few years along with German financial regulator BaFin to substantiate allegations that the largest German bank hid losses to the tune of $12 billion at the peak of the global economic downturn.  The investigation was triggered by complaints filed by three of the bank’s former employees with the U.S. SEC over 2010-2011.  The complainants claimed that Deutsche Bank incorrectly valued a credit derivatives portfolio to side-step billions in unrealized losses which could have potentially forced the bank to seek a government bailout.
This investigation raises bigger questions about the actual financial condition of the world’s biggest banks since the recession, as the complexity involved in valuing the asset portfolio of the mega-banks inevitably results in investors having to blindly accept the valuations presented by the banks.
We stick to our $54 price estimate for Deutsche Bank’s stock for now while recognizing that the investigation presents a notable downside risk to this figure. The significant difference to current market prices can be attributed to the negative sentiments towards European banks in the wake of Cyprus’ botched bailout by the European Union.
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The importance of sales & trading to Deutsche Bank becomes immediately evident from the chart above, which shows that the business contributes to nearly half of the bank’s total value. But the business is also known for being extremely volatile, with the trading portfolio adding a substantial risk to the bank’s business model. There are ample examples of banking giants going belly up almost overnight due to huge losses to their security holdings during the 2008 recession.
And although regulators around the globe strive to achieve more transparency from the banks about the quality of their assets, the complex nature of various financial instruments offered by the banks comes as a major stumbling block. Derivative products, for one, are notoriously difficult to value. And it is this difficulty that Deutsche Bank allegedly exploited to get itself out of a tight spot at the time of the financial crisis.
The derivatives portfolio in question had a notional value of $130 billion, on which Deutsche Bank apparently should have booked losses of $12 billion – losses arising from the accounting requirement of marking the portfolio to market.  That’s a huge figure given that the bank reported a pre-tax loss of €5.7 billion ($8.4 billion) in 2008. And the portfolio continued to be valued in a similar manner till 2010.
While the SEC and the German regulators are yet to find any actual evidence of Deutsche Bank’s wrong-doing, in the event that the allegations are found to be true, the bank could be staring at millions in fines and penalties. This would drag down margins for its investment banking division (shown in the chart below) for the year such a fine is imposed.
But a worse implication of a fraud of this magnitude would be that it would cast serious doubts about the quality of Deutsche Bank’s assets, eroding the bank’s credibility.Notes:
- German regulators probe Deutsche Bank accounts: sources, Reuters, Apr 4 2013 [↩]
- Deutsche hid up to $12bn losses, say staff, Financial Times, Dec 5 2012 [↩] [↩]