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Friday, October 28, 2016

Deutsche Bank is Dangerously Close to "Default Point"

Moody's Warns Deutsche Bank Is Dangerously Close To Falling Below Its "Default Point"

Oct 28, 2016 10:44 AM | Zero Hedge | Source

Authored by Rupert Hargreaves, originally posted at ValueWalk.com,

Moody’s Capital Markets Research issued a damning verdict on Deutsche Bank earlier this week. In a research report put together by the credit agency’s ‘Analytics’ research division, Moody’s analysts write that Deutsche Bank expected default frequency remains at one of the highest levels in the banking industry, despite the bank’s efforts to shore up its capital position.

In the report, Moody’s cites its Expected Default Frequency measure, which is a continuous measure of a firm’s default risk. The firm’s one-year EDF measure increased from 1.05% in January to its all-time high of 2.85% on February 9. Since then, the EDF measure has declined somewhat, but remains volatile, reflecting Deutsche Bank’s lingering financial problems. At present, the company’s current EDF measure is a 1.39%, which is still significantly above the Global Banks and S&Ls group’s optimal threshold level as calculated by Moody’s. The optimal threshold or value at which firms in the Global Banks and S&Ls Group should be flagged for additional review is 1.22%.

Deutsche Bank Is Dangerously Close To Falling Below Its “Default Point”

There are two key takeaways from the EDF measure of 1.39%. Firstly, only 15% of companies in the Global Banks and S&Ls group have an EDF measure above this level suggesting that, compared to the rest of the global banking industry, Deutsche’s default risk is relatively high. That being said, the second key takeaway is the fact that Deutsche’s EDF is only slightly above the trigger level, implying that the firm is not facing imminent risk of default but requires close monitoring.

Moody’s report on Deutsche’s default risk says a lot more about the wider banking sector in general than it does about Deutsche. Indeed, there are 1,323 firms in Moody’s Global Banks and S&Ls universe but despite challenges such as low or negative interest rates, tougher regulations, and weak economic growth, only 15% have an elevated default risk (according to calculated EDF’s), and only 21 financial firms in the group are currently showing a downward sloping EDF curve. EDF curves, which compare a company’s default risk to its peer group, are generally upward sloping in economic expansions.

Still, Deutsche’s rising EDF metrics says a lot about the bank and its financial stability, as Moody’s explains:

“The sharp increase in Deutsche Bank’s EDF measure can be understood in terms of the two key drivers of EDFs, market leverage (financial risk) and asset volatility (business risk). In contrast to some black-box statistical models of credit risk, the drivers of the EDF model draw on the fundamental approach to credit analysis while supplementing it with market information. Studying these EDF components reveals that Deutsche Bank’s high and volatile EDF measure is primarily caused by an increase in the default point and a decline in the market value of assets, which increased the firm’s market leverage. Market leverage summarizes a firm’s financial risk and is defined as the ratio of a firm’s default point to its market value of assets (expressed as a percentage). Unlike book leverage, market leverage reflects the forward-looking views of investors. One can view changes in the market value of a firm’s assets as investors’ collective view on the expected profitability of a company: when the market value of assets goes up, investors expect future cash flows to increase. The opposite is true when the market value of assets goes down, as in the current case.”

Deutsche’s risk has been steadily increasing since 2008, as the bank’s mounting losses and legal issues increase financial and business risk.

The bank’s market leverage, the ratio of a firm’s default point to its market value of assets, is in the 96 percentile, “making it one of the riskiest banks by that metric.” In fact, leveraged loan Deutsche is dangerously close to falling below its current “default point”.

“Since June 2008, Deutsche’s market value of assets has dropped by about 35% from $2.3 trillion to its current level of $1.5 trillion, significantly closer to its current default point of $1.4 trillion. Historically, when a firm’s market value of assets falls below the default point, it is highly likely that the firm will be unable to sell assets or raise additional capital to pay its creditors.”



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