By way of background, the Wall Street Journal reported that the Department of Justice was seeking a settlement of $14 billion with Deutsche Bank for mortgage-related abuses. The Journal also noted that the bank’s thinking was that it should pay only $2 or $3 billion. The day after the story broke, the German bank took the unusual step of saying no way would it pay anything close to $14 billion. That seemed like an unwise move, particularly since in the JP Morgan and Bank of America settlements, there were also leaks about the amount the government was seeking, and the final deals came in not all that much lower than the figures bruited about in the press.
Deutsche Bank also tried arguing that it was being treated unfairly, and pointed to smaller settlements by other banks. However, TheStreet (hat tip Jon M) looked at Deutsche’s CDO activity relative to that of other banks that settled, and found that it is consistent with that of other settlements.
Mind you, the press stories so far have characterized the settlement as being about mortgage liability, which would make readers think of mis-selling of residential mortgage backed securities, and Deutsche was not a top player in that market. However, it was one of the big kahunas in the subprime CDO market. And as we explained at length in ECONNED, it was hybrid (part composed of actual bond tranches, part “synthetic,” meaning of CDS) that enabled BBB risk to be sold largely at AAA prices which not only kept the subprime party going well beyond its natural sell-by date, but actually drove demand to the very worst mortgages.
And not only was Deutsche a major actor, it was a particularly bad actor. Deutsche worked actively with the subprime shorts like Magnetar and John Paulson, who were creating CDOs for the express purpose of betting against subprime, meaning they wanted the CDO to reference the dreckiest mortgage securitizations they could find. As Greg Zuckerman explained in his book, The Greatest Trade Ever, Paulson was up front about his intent to create CDOs that would fail. Even Bear Stearns, not known for having lofty moral principles, turned him down, but Goldman and Deutsche had no such scruples.
TheStreet also says that Deutsche could get a break if the German government were to intervene. But as we pointed out in Links yesterday, via Michael Shedlock, the German press is reporting that Merkel will not intervene on behalf of the beleagured bank, either to give it a bailout or to press to have the DoJ back off. This is consistent with what I’ve heard from German contacts, although they don’t think official thinking is terribly realistic. The plan is to stay hands off, at least through the German elections in 2017. However, it is hard to see how the slow-moving Italian banking crisis can be kept under control that long. Deutsche is next in line if Italian banks start keeling over.
And anything within hailing distance of a $14 billion fine would hit Deutsche hard. It has only €5.5 billion in litigation reserves, which is equivalent to a bit over $6 billion. It’s stock price is already battered, and with a market cap of a mere $18 billion, coming up with a few billion more would be costly..
However, as we’ve also pointed out, historically there has been a huge gap between the headline amount of mortgage settlements and the cash amount paid. The settlements have been larded up with gimmies to consumers like promises to modify mortgages and make short sales, which inflict costs on MBS investors far more than the bank making the settlement. However, Deutsche isn’t a large mortgage servicer, so it may have less ability to trade in non-cash goodies to give the DoJ the big number it seeks while minimizing hard dollar payments.
Key extracts from TheStreet’s article:
Deutsche Bank insiders quoted by The Financial Times have said the bank hopes it will be treated like Goldman Sachs (GS) , which ended up paying only about $5 billion….
Any attempt to get Goldman-like treatment could be tricky. In the pre-crisis housing market, Deutsche Bank appears to have been printing far more collateralized debt obligations. Deutsche created about $42.5 billion worth of the debt packages vs. about $25 billion by Goldman in 2007 alone, according to a 2010 Wall Street Journal report, which cited data compiled by Thomson Reuters. (Meanwhile, according to the report, Bank of America and JPMorgan issued about $65.5 billion and $44.3 billion in CDOs, respectively, over the period.)…
One of the striking similarities between the two banks is that they appear to have both allowed hedge fund billionaire John Paulson to bet against the housing market while promoting the market to clients. However, the Journal noted “a key difference” in their report: “Goldman told investors that the assets were picked by an independent third party; Deutsche didn’t use a third party or give its investors any assurances.”
Both Goldman and Deutsche Bank were also market-makers for traders interested in shorting the housing market more broadly, as they acted in that capacity through the ABX credit-default index… Deutsche Bank banker Greg Lippman…helped establish the index.
We’ve called Greg Lippman “patient zero” of the toxic phase of the subprime market, which started in the third quarter of 2005. From ECONNED:
Mortgage industry graybeard Lew Ranieri, who effectively created the mortgage-backed securities industry at Salomon Brothers in the 1980s, dates the toxic phase of subprimes to roughly the third quarter of 2005 through early 2007, and points to a sudden shift in demand and attitude toward the riskiest assets. That coincides almost exactly with when ISDA made credit default swaps on asset-backed securities and exposures like CDO tranches possible, in June 2005, after allowing for the lag required for the new hunger to result in more mortgage creation.
Goldman and Deutsche were the driving forces behind the new ISDA protocol.
So Deutsche might not get away with this as cleanly as it would like, although it’s hard to imagine that the German government will sit on its hands if Deutsche were to go wobbly. Perhaps it’s hoping that the usual European “kick the can down the road” approach will allow the DoJ settlement talks to drag out past the German elections, allowing for more, um, creative solutions.
But Mr. Market isn’t happy about the current state of play. Per CNBC as of Monday morning in Germany Live: Deutsche Bank shares slump 6% as Merkel reportedly rules out state aid. Note that CNBC pooh-poohs the Focus story that made the claim that Merkel would be hands off because it did not name any government sources. But as indicated, I’ve been hearing the same thing for weeks, so despite the fact that it would seem to be impossible not to bail out Deutsche, the political sentiment seems to be that it would be fatal for the already wobbly Merkel to do so. After all, she was at the helm during the crisis. She can’t pin the blame for the failure to fix the bank on someone else.