Deutsche Bank’s results in 2022 were spectacular, showing the highest profit since 2007. However, the German bank drags some long-standing problems, although they seem to be largely overcome, when the off-risk takes over the markets and especially in banking, the Deutsche Bank becomes target of bearish investors. Why is the entity in the eye of the hurricane? Deutsche Bank has a strong exposure to complex derivatives on its balance sheet and a significant position in US office and facility mortgages. The potential impact of these two types of assets is huge, creating uncertainty when turmoil hits the markets.

Deutsche Bank’s share price plummeted last Friday as fears of financial contagion swept the market after the collapse of Credit Suisse and two US banks. Although German bank bonds rose on the stock exchange this Monday, everything indicates that there is a lot of nervousness in the market. When the markets are nervous, investors look for the weakest ones to throw their biggest claws.

Analysts believe that the choice of Deutsche Bank is due to its reputation, perhaps already outdated, sick bank of europe. However, other analysts say this is due to the composition of its balance sheet. The German bank ‘accumulates’ a significant portfolio of mortgage loans for offices in the US (also in Europe) and many trillions (yes, trillions with B) in notional value of derivatives.

Deutsche Derivatives Portfolio

A report published last Friday by the analysis house Autonomous Research, which shows the robustness of the German bank, also gave data on the large portfolio of derivatives that the German bank has on its balance sheet: they are currently 42 billion euros of notional value, the weight of this bag. However, it should be clarified that the notional value is the total value of the underlying asset of a security at its spot price.

It is important to make this distinction, as Deutsche Bank did not invest 42 billion in derivatives, it is the value that the portfolio would have taking into account leverage: the notional value distinguishes between the amount of money invested and the amount of money associated with the completed transaction. The theoretical value is calculated multiplying the units of a contract by the spot price. Derivatives make it possible to make an investment with a capital of one euro (for example) invested, even if the value associated with the operation is ten euros. Gains and losses will fall on those 10 euros, even if the capital contributed is only one.

On the specialist investment portal Seeking Alpha, they try to explain why these fears are partially unfounded: “DB’s total notional exposure to derivatives amounts to a staggering 42 billion euros. This is what worries some investors, but certainly DB is only a snowflake in a financial storm”.

These specialists explain that although the exposure of the balance sheet seems so great, what Deutsche Bank does, in large part, is to buy derivatives at the request of its customers, to whom it charges a commission, but in fact its risk in these operations is not even close to the value of 42 billion euros. On the other hand, many of these derivatives give the option to close the position or simply that the potential loss never occurs (the premium is lost in any case, as is the case with options). Therefore, DB’s real exposure to the derivatives market is much less than it appears and has also been reduced in recent years.

The notional value of the derivatives market is horrible. The latest Bank for International Settlements report on the matter indicated that “the notional or notional value of over-the-counter (OTC) derivatives in circulation has increased up to 632 trillion dollars at the end of June 2022, up from $598 trillion at the end of 2021.”

“This is the main reason why these notional exposures to derivatives are so large. These are just numbers for notional contracts and are not close to the actual exposure. Additionally, DB carefully manages its portfolio, which is primarily hedged by market risk ( as well as counterparty risk)”, say Seeking Alpha experts.

With regard to mortgage exposure of offices and commercial establishments, the numbers are lower. It is believed that around 16,000 million euros could be in American commercial real estate, against a total exposure of 49,671 million euros to real estate activities, as disclosed by Deutsche Bank itself in December 2022. Although these values ​​are lower than those of derivatives, they are perhaps a little more worrying given the crisis that this sector is going through. “If real estate continues to decline, it could be the next risk amplifier for banks and the wider market,” said Peter Garnry, strategist at Saxo Bank.

“One area of ​​concern, emerging at least in the US, is commercial real estate. Even if the real estate market in Europe is stronger, the financial linkages mean that losses in US commercial real estate could trickle into European bank balance sheets. . “, explains the Saxo Bank expert.

Lloyds and Banco Santander have the least exposure to commercial real estate, a Credit Suisse report revealed a few days ago, while Swedish bank Svenska Handlesbanked has the most exposure to the sector.

ESRB and ECB warn

The European Central Bank published a note at the beginning of 2022 in which it highlighted the high exposure of German banks to this type of property: 8% of total loans from supervised banks and more than 20% of total corporate loans In absolute values, the CRE exposures are particularly high in Germany, France and Italy In other countries such as Cyprus, Slovenia and Estonia, their relative size matters, with CRE exposures accounting for more than 40% of total corporate lending,” the ECB noted.

“Historically, commercial real estate (offices, premises, etc.) “, according to analysts.

Faced with this situation, the European Systemic Risk Board (ESRB) published an alert at the end of January on the vulnerabilities of the commercial real estate sector in the European Union: “Adverse developments in the commercial real estate sector could have a systemic impact on the financial system and the economy. real. These vulnerabilities can be amplified by cross-country contagion effects and interconnections between financial institutions.”

Additionally, this institution indicated that credit institutions, such as commercial banks, are particularly exposed to this sector through the credit risk of loans. Available data suggest that bank finance in this sector has high loan-to-value ratios in several European countries.

In short, the Autonomous analysts, who quickly came to the defense of Deutsche Bank, call for caution and guarantee that the German bank is in good health, although they admit that their quick intervention in defense of the DB may raise suspicions, the truth is that it is based on data: “Clearly, when an analyst feels it necessary to write a reassuring report like this, investor sentiment must be bad. We haven’t received many investor questions about Deutsche to date, but what they have received has focused on (i) on the bank’s exposures to US CREs and (ii) its large derivatives portfolio,” he said in a note published last Friday.

“Deutsche is likely to see some impact to its US CRE balance sheet, but that should be manageable.” On the other hand, these experts exposed the German bank’s liquidity, solvency and reserve ratios. The truth is that Deutsche Bank, to date, is an ‘overcapitalized’ bank (more than meets the requirements) and that it also has liquidity ratios that exceed the eurozone average. Having said all this and, above all, taking into account what happened to the Silicon Valley Bank in the USA, it can no longer be ruled out that a bank ends up suffering a liquidity crisis so diluted that it ends up generating a problem of solvency and sustainability in question of weeks.