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Liquidity-rich Deutsche Bank may be stronger than CDS suggest

Creditmarket fears about Deutsche BankAG are reaching levels not seen since the scare over its contingentconvertible bonds in February, but credit default swaps may be overstating theweakness of a company with more than enough liquidity to cover all of itsshort-term needs, analysts said.

Five-yearCDS for Deutsche's senior debt rose July 7 to as high as 252 basis points —meaning that it would cost $252,000 to insure against default on $10 million ofsenior debt — before easing in subsequent days, as investors were unsettled bythe U.K.'s vote to leave the EU as well as by fears over the Italian bankingsystem. CDS on Deutsche's subordinated debt jumped to 509 basis points, pushingthe spread between the two derivatives to 257 basis points. That was just 6basis points below the record gap reached Feb. 11, when investors feared thatthe bank's capital had fallen too low for it to continue making interestpayments on Additional Tier 1 CoCos.

DeutscheBank was identified by the IMF in June as the lender posing the to the worldfinancial system, and it has the highest CDS prices of any globallysystemically important bank. Rating agency DBRS it to A (low) from A on July8, just as its shares hit a record trough, citing its struggle to makesustainable returns at a time when its capital ratios are at the low end of itsglobal peer group. A U.S. arm of the bank failed a Federal Reserve stress test for the second yearin a row.

Theblowout by its subordinated debt CDS shows that the market is worrying againthat Deutsche might be forced to suspend AT1 interest payments to preservecapital, said Saxo Bank bond trader Michael Boye.

"Ithink the prices right now are reflecting the chance of some sort of event withthe CoCos," he said in an interview. "For Deutsche's senior debt tobe at risk is still an unthinkable scenario to me."

Lookingto ensure that bondholders and not governments bear the burden of futurefinancial collapses, regulators have pushed banks to sell AT1s, which convertinto equity or get written off if capital falls below pre-stated levels, and onwhich coupons can be suspended if necessary. Deutsche's bonds have beenpressured as investors fret over sagging revenues and tens of trillions ofeuros in derivatives exposures.

Thebank's fully loaded CET 1 capital ratio fellto 10.7% at the end of the first quarter from 11.1% three months earlier.First-quarter net profit more than halved year over year to €214 million, andDBRS said Deutsche may have to add to provisions of €5.4 billion against futurelitigation costs. Additionally, the firm's investment banking operationspotentially expose it to increases in capital charges if regulators tightenrisk-weighting calculations on trading books.

DeutscheCEO John Cryan told Der Spiegel onJuly 2 the bank had to generate between €2 billion and €2.5 billion inadditional capital per year until 2019 and that he "saw no problem"doing so.

Ugly restructuring

SebastianoPirro, a credit analyst at London hedge fund Algebris Investments, said anyworries that Deutsche might collapse are overdone. He noted that Deutsche'sliquidity reserves stood at €213 billion at the end of the first quarter,several times the level during the global financial crisis. Its liquiditycoverage ratio is 119%, meaning that it has more than enough high-qualityliquid assets to withstand the net cash outflows likely to materialize in acrisis situation.

"Yesit's weak, but banks fail because of liquidity," Pirro said."Deutsche has a lot of liquidity."

DeutscheBank is restructuring, slashing the size of its investment bank and targetingrisk-weighted asset reduction of €90 billion by 2018. It also aims to cut itscost-to-income ratio to 65% in 2020 from 89% at the end of the first quarter.

Successis not guaranteed, noted DBRS, which said restructuring will crimp medium-termearnings. Deutsche has also had to put the sale of German consumer lenderDeutsche Postbank AGon hold because of low equity prices.

"It'sa business model issue, and the bank has not found its way forward yet,"said Pirro, adding that investors see Deutsche as "a pretty ugly"restructuring story. But although the bank's performance, with first-quarterposttax ROE of 1.4%, is relatively poor, its derivatives exposure has meantthat CDS spreads exaggerate its riskiness, he said.

"Alot of people have counterparty risk with Deutsche because Deutsche is a bigderivatives counterparty. So, if you are a big asset management firm and CDS goup, in your model the risk increases and you need to hedge even more. Itbecomes a bit self-fulfilling," Pirro said.

"SeniorCDS is too expensive because it implies a probability of default which is toohigh. It's unrealistic simply because of the liquidity of the bank."