Last week, the situation of Deutsche Bank (DB) kept the entire financial world busy as a $14B fine was hanging like a sword of Damocles over the company’s virtual head. We have to admit we had a good chuckle when the mainstream media were falling over themselves to report on Deutsche Bank’s problems, because most open-minded people in this sector already knew the company was one of the weakest links in the entire financial system, with the possibility to infect dozens of other players.

Source: armstrongeconomics.com

A weak link indeed, but most definitely not an unimportant link considering Deutsche Bank isn’t just ‘too big to fail’ but ‘waaaaay too big to be allowed fail’, and the existing problems very likely are just the tip of the iceberg. The markets were suddenly spooked by a potentially massive fine related to the sale of toxic mortgage bonds, but the concerns seemed to alleviate after the CEO of the bank published an open letter emphasizing the bank still has plenty of liquidity and reserves of in excess of 215B EUR.

It does look like the term ‘reserves’ has been used in quite a loose way, considering the majority of these so-called reserves are actually debt, and the market shouldn’t confuse ‘reserves’ with ‘liquidity reserves’. Even if you have 200B+ in liquidity, there will be a point in time when a company has to repay its creditors or refinance the existing debt, so relying on borrowed liquidity is usually just kicking the can further down the road. Indeed, after checking the H1 financial results of Deutsche Bank, the equity portion of the balance sheet is just a fraction of the 215B EUR in claimed reserves. The total shareholders equity was just 62B EUR as of at the end of June, with an equity/total assets ratio of just 3.3% compared to 12.2% at Bank of America (BAC) and 12.75% at Citigroup (C). Even Banco Santander’s (SAN) equity/total assets ratio is twice as high as Deutsche’s!

Source: Deutsche Bank

Die Zeit reported earlier this week the government and financial authorities were already preparing a rescue plan in case the bank could not meet its commitments by raising cash on the open market, because even selling the Abbey Life insurance group to Phoenix Life holdings for approximately $1.2B last week won’t move the needle in case of a huge liquidity crunch.

Indeed, the market wasn’t buying CEO Cryan’s optimistic speech, and on the open market the 6% CoCo bonds fell to less than 70 cents on the dollar, indicating a lot of debtholders wanted to get out of these CoCo’s as fast as possible, and the price of these bonds recovered slightly after the rumor about a $5.4B settlement was in the making.

Source: Telegraph.co.uk

We are uncertain about why the market thinks a $5.4B settlement would be good news. Sure, it’s less than the $14B the DoJ was originally seeking from Deutsche Bank, but even if the $5.4B number would be correct (Morgan Stanley thinks the total settlement will be closer to $6B, which we consider to be more likely considering Citigroup was slapped with a $12B fine, but settled for $7B), it would wipe out the entire provision on the balance sheet! Indeed, at the end of the second quarter of this year, the total amount of provisions on Deutsche Bank’s balance sheet was just 5.5B EUR ($6.1B), so a $6B settlement would wipe this out completely.

If you really believe a $5.4-6B settlement would solve all problems, think again. Selling toxic mortgages isn’t Deutsche Bank’s problem, but the exposure to the derivatives market is.