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Bondholder panic contained as Deutsche rescue talk swirls

Thingshave gotten bad enough for Deutsche Bank AG for talk to surface of a possible staterescue plan, but although its shares have tumbled to three-decade lows amidfears that banks are "uninvestable," debt markets have held clear ofthe panic levels seen earlier in 2016 as investors bet that the lender willstrive to make payments on its riskiest bonds.

NewsSept. 15 that U.S. authorities are demanding $14 billion to settle civil claims over missellingof MBS kicked off the latest bout of Deutsche nerves, and Die Zeit reported Sept. 28 that the German government wasreadying a rescue plan in case a penalty drains the bank's capital. Alreadydenied by the government and dismissed by Deutsche itself, the plan wouldreportedly permit asset sales at favorable prices and, in an extreme case,allow for the state to take a 25% share.

Evenwithout the fine, Deutsche would face a hard slog to meet an ECB target of a12.25% common equity Tier 1 ratio by January 2019, bogged down as it is by asluggish investment banking business and retail operations that have beendepressed by negative official interest rates. Litigation costs might blow itoff target completely, but even if it is forced to pay the full $14 billion — asum it has vowed to haggle down — this would cut its CET1 no lower than 9% onceprovisions were taken into account, according to analysts at SocGen. The ratiostood at 10.8% at the end of June.

Missingthe supervisor's CET1 targets would force the bank to raise capital, dilutingcurrent shareholders. A mere €3.3 billion in litigation costs could cause acapital hole of between €4 billion and €5 billion in 2018, according toMediobanca. It could also exhaust reserves that can be used to pay interest onAdditional Tier 1 contingent convertible bonds, known as "CoCos." Itwas the fear of a CoCo coupon freeze that sparked market panic in February.

Thistime however, even though shares have fallen 53% year-to-date, compared to a25% decline for European banks as a whole, the bond market is holding its nerveslightly better.

Theyield on a $1.5 billion CoCo sold in 2014 rose to 11.2% on Sept. 27 from lowsof 9.5% earlier in the month, and although this remains a far cry from the 8%at which it started the year, the yield has not reached the highs of theFebruary scare, when it touched 12.5%. Five-year credit default swaps onDeutsche subordinated debt traded at 488 basis points, more than twice the 235basis points of the ITRAXX Europe CDS Financials Subordinated Index, but stilllower than the 529 basis points recorded Feb. 11.

DeutscheBank will try not to suspend coupon payments, but whether it is eventuallyforced to could depend on the timing of the settlement with the U.S. Departmentof Justice, said Rabobank credit analyst Claire McNicol. Coupon payments aredetermined based on the preceding year's results, so a litigation hit within2016 could theoretically wipe out a 2017 payment. But the longer the litigationbill takes to arrive, the more time Deutsche Bank has to find ways to bolsterits capital above the levels allowing it to keep paying interest, she said.

Thebank has reassured investors that the payments will be made. In addition to acost-cutting program, Deutsche Bank is also seeking to dispose of itsDeutsche Postbank AGsubsidiary. The saleof its Abbey Life insurance business for €1.09 billion, announced Sept. 28,should boost its CET1 ratio by about 10 basis points.

Fearsof a suspension of AT1 coupon payments have been confused by some investorswith default, making market reactions more extreme, McNicol said.

"Idon't think Deutsche has been given credit for how far they've come in the lastcouple of years, in terms of bulking up the capital they've got," she said.

Butalthough suspending AT1 coupons would help Deutsche repair its capital, such amove would send a shockwave through the market for the risky CoCos, which are akey component of the regulatory reforms introduced since the financial crisisand aim to help ensure that investors and not governments pick up the bill forbank collapses. It would also make it difficult for Deutsche to sell any moreCoCos, McNicol said.

Thebank appears to be about €1.5 billion short of the required AT1 CoCo bucket of1.5% of risk-weighted assets, though it could also make this up by sellingequity instead of bonds, she said.

Anyshare issue, though, would have to take place at a time when banks "arenot really investable as a sector," in the words of Credit Suisse CEOTidjane Thiam, who said Sept. 28 that investors are unconvinced that banks canmake enough money to cover their cost of equity. Fines like those facingDeutsche only make matters worse, he said.

Thelargest German lender reported a 98% fall in second quarter net income to €20million, as its global markets pretax income slid by more than €1 billion.

Butits troubles are not fatal, said a European equity analyst.

"DeutscheBank is not going to collapse. It's well-capitalized from a relative standpointcompared to where we were even two or three years ago. But it'sundercapitalized compared to its target and compared to its minimum regulatorylevel," the analyst said.