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Is Deutsche Bank in Trouble?

Published on: 17/09/2016

Market news in the past few days has been dominated by one name we’re not used to seeing much: Deutsche Bank. Germany’s No. 1 and one of the world’s biggest banks made the headlines as the US Department of Justice asked it to pay $14 billion to settle a legal case against the bank about mortgage deals that caused the 2008 global economic crisis.

Ah, remember 2008? Most of the world’s greatest banks were caught in various wrongdoings with mortgages for sums so great we are still feeling their ripples globally. Many of the incriminated banks have already settled their cases with the Department of Justice and now it seems it’s Deutsche Bank’s turn.

The bank has allegedly taken a wrong turn when handling residential mortgage-backed securities (RMBS). RMBSs are a financial instrument which basically boils down to the bank that issued the mortgage on your home selling the right to collect yield to outside investors. Normally, when you get a mortgage the bank gives you X amount of money that you can buy a home with, and in return you agree to give back X plus interest in monthly payments for a given period of time, say 30 years. This isn’t a very good plan for the bank, however, because they make a big payment at first only to receive a small yield over a long period of time – not to mention the possibility that you may default on your payments, in which case the bank has to take your home back, find a new buyer and begin the whole process again.

Naturally banks found a way around this. Instead of waiting on you to pay them back over 30 years, they figured that they can sell your mortgage to someone else, an investor. The bank would get its money back instantly, ensuring more liquidity and the possibility to use this money to give out even more loans and mortgages with it. The investors like this plan because they would receive your monthly payments with interest, making a profit at some moment in the future. It’s important to note that the bank would not just sell the mortgage of 1 family; they would bundle together lots of different loans, which would ensure that even if one person goes default on their mortgage, not everyone else in the bundle will, so profit won’t be at substantial risk.

The crisis of 2008 was in large part due to banks giving out tons of mortgages even to people who were likely to default. Big banks would sell these as securities to investors, collect their money and issue even more loans. They believed that RMBSs are safe because people won’t all go default at the same time.

This didn’t turn out very well, as we’ve learned since then. Over the past few years the US Department of Justice has been preparing and settling legal cases against the banks that engaged in this malpractice.

To the regular person this might sound normal: someone did a bad thing, they get punished for it. That’s the general principle. The issue here is that each bank has a sort of fund for rainy days to settle such legal matters. Deutsche Bank’s fund happens to be about three times lower than what the DoJ asked them to pay – and that could be a problem.

If the bank indeed has to pay so much more than it has available, it would have to resort to selling valuable assets or putting pressure on its financial backers, which could cause more problems in the future.

The stocks of DB have been dropping all week ever since the announcement came. Traders and investors seem to doubt the bank’s ability to meet DoJ’s demands. They are now down by 8% and are still volatile.

Still, DB representatives are trying to calm the air of speculation, and they may have a solid reason to do so. The amount of 14 billion dollars is just the first proposition for settlement issued by the Department of Justice. Other major banks such as JPMorgan, Goldman Sachs, and Morgan Stanley eventually settled for amounts 2-3 smaller than what was initially asked of them, so it is likely Deutsche Bank would be able to negotiate a better deal.

For Forex traders it’s important to know that as one of Europe’s principal banks, DB plays an important role in how the euro is valued. In addition, banks from the UK might also come under scrutiny by the DoJ in the coming days, increasing volatility in Great Britain even more.

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