Michael Derrer Fuchs
Credit Suisse (NYSE:CS) is currently trading at 0.23x Tangible Book. Deutsche Bank (NYSE:DB) is trading at 0.3 times tangible book value. These are very worrying ratings for banks, including European banks.
However, CS is in deep trouble due to a steady stream of risk management scandals at its investment bank, including the Archegos Capital fiasco that cost it over $5 billion. I have previously written about this episode here and noted the following:
Beyond the financial loss, there are other significant downstream impacts on CS in the short and medium term. While the current stock price looks attractive in the context of the stock’s long-term valuation, I’m not ready to buy the price drop just yet. There seem to be major risk management issues plaguing the investment bank, and fixing these issues is likely to be a lengthy and costly process.
DB, on the other hand, is in excellent shape and has excellently implemented the strategy that DB CEO Mr. Sewing was striving for. It is on a credible path to earn more than 10% RoTCE by 2025, driven by strong tailwinds from the paradigm shift in interest rate hiring in the Eurozone. It also has a low-risk business model, meaning it’ll likely sidestep the kind of banana peels CS has stepped on.
The problems with the business model of Credit Suisse
At first glance, CS has a very attractive business mix, based around a capital-poor wealth management business (~ two-thirds of the bank) complemented by a reasonably sized investment bank (~ one-third of the bank). It almost sounds like a European version of Morgan Stanley (MS), but of course there are differences.
The CS investment bank is primarily focused on credit markets and capital markets issues. These are areas that are quite challenging in the current macro environment. Also, due to the Archegos Capital debacle, it was forced to withdraw from the prime finance business, which is usually a very lucrative and profitable line of business for investment banks. Even in the current environment, its strengths in leveraged finance, M&A and SPAC deal activities are very muted. CS has also taken significant (but not yet quantified) losses on its leveraged buyout of Citrix. On the other hand, CS has little exposure to FX, interest rates and commodities, which are more stable annuity-like trades. These businesses are currently benefiting greatly from recent market volatility.
Along with the colossal mistakes in risk management, the investment bank CS is now in a whirlpool. This drives up financing costs and can easily turn into a death spiral if key rainmakers abandon ship. This has already begun with the departure of key executives to Citigroup (C) and others who are “pursuing other opportunities.”
The management team has no choice but to restructure and downsize the investment bank, and to do so as quickly as possible. CS is expected to present its strategy update on October 27th.
The problem is that restructuring an investment bank is a long, drawn out, risky, and costly process. First, CS needs to raise a significant amount of capital, and in the current environment and considering its market cap, this will be extremely dilutive for existing shareholders.
Second, CS will likely need to set up a non-core bank where it would seek to settle long-term trades spanning multiple years and/or sell them at significant losses. This non-core unit is likely to be loss-making for many years, as evidenced by the multi-year DB and Barclays (BCS) restructurings.
Third, the management team must figure out how to retain key employees, especially as US banks expand aggressively into European capital markets.
Finally, regulators will extract their pound of meat, too. CS must present a credible multi-annual program to improve its control infrastructure. This will take years and be very expensive.
In summary, this will likely be a multi-year story with no guarantee of success. Importantly, shareholders are last on the priority list as CS needs to balance the demands of other stakeholders.
The restructuring of Deutsche Bank is a success
After several failed attempts, Mr. Sewing stabilized Deutsche Bank’s ship. The management team implemented the cost reduction program with typically German efficiency. The investment bank focuses on the bread and butter of trading earnings, which includes forex, interest rate and credit trading. The investment bank thus appears to be sustainably earning its cost of capital and continuing to gain market share. DB has completely withdrawn from the stock trading business and has therefore managed to sidestep some of the risks that CS faced. It is important that the provisions of DB’s commercial and private banks develop well and show strong growth in sales.
DB is on track to achieve 8% RoTCE for 2022 and a credible path to more than 10% in 2025, despite macroeconomic headwinds and the expected deep recession in the Eurozone.
There is also a strong tailwind for DB. Mainly it is the long-awaited move away from negative interest rate settings in the eurozone. Negative interest rate hikes completely disrupt deposit institutions’ maturity transformation business model and are a major reason for the decades-long underperformance of European banks compared to their US counterparts.
DB predicts that it will generate another EUR 700 million in 2022 and EUR 2.5 billion by 2025 from interest. Clearly, given Deutsche Bank’s market cap of only ~EUR16 billion, this is very material.
In addition, DB is to return 8 billion euros of capital to shareholders by 2025.
Finally, DB’s credit risk profile is extremely conservative and should perform well even in a deep recession scenario. Most of his book consists of moderate LTV German mortgages, as seen below:
I’m going without CS for the time being. At least until the strategy is outlined on October 27th. I expect a capital call to be made soon — there’s no real way to restructure the investment bank without raising equity. There is no quick fix, this will be long and costly, and shareholders’ interests are not necessarily paramount. In view of the uncertainties, I assume that the share price will continue to fall. At some point, CS could become investable again or even become a takeover candidate. The asset management franchise is extraordinarily attractive for many interested parties. In the meantime, I expect the bleeding to continue, including the departure of key employees to competitors. The investment bank is seriously threatened with a death spiral.
On the downside, DB is an extremely attractive risk-reward play right now. I expect the stock price to double when/if the macro uncertainties pass and the benefits of interest rates start to feed into the financials. In my view, the perceived risks are exaggerated. There is no longer a restructuring risk premium at this bank and therefore the current share price does not make sense. I remain very optimistic, although I expect a deep recession in the euro zone in 2023.