Coronavirus crisis threatens Deutsche Bank's 'bad bank' wind-down

By Matt Scuffham

LONDON (Reuters) - Deutsche Bank's <DBKGn.DE> biggest headache from the coronavirus downturn is likely to come from difficulties offloading problem assets from the last financial crisis rather than bad loans piling up in the latest one.

The German bank, still considered by regulators to be one of world's the most important in terms of financial market stability, is trying to recover after five consecutive years of losses totalling more than 15 billion euros ($16.22 billion).

Crucial to the bank's recovery is its efforts to shed 44 billion euros worth of complex assets held in a so-called "capital release unit" or "bad bank" that have plagued its balance sheet for years.

But the coronavirus crisis is gumming up the market for the types of exotic derivatives Deutsche Bank is trying to sell, which means the biggest threat to the lender's capital levels is likely to come from its bad bank, analysts, derivatives experts and sources within the bank said.

Last year, Chief Executive Christian Sewing unveiled a plan to return the bank to profitability, shrinking its investment bank and axing 18,000 jobs globally, but the virus now threatens to delay his ability to execute it. The bad bank is central to Sewing's plan, enabling Deutsche Bank to shed unwanted assets such as risky and illiquid derivatives and delinquent loans that have been a drain on its balance sheet for years and free up capital to support its core businesses.

Deutsche said its plan to offload most of the assets within the bad bank by 2022 was on track.

The bank said it "continues to see active participation in its disposal programme" in the second quarter.

"Thus far we do not see the current market conditions as a major impediment to our plans," it said in an emailed statement.

COMPLEX ASSETS

The fallout from the coronavirus crisis has led analysts and derivatives experts to question whether the bank may need to swallow bigger losses.

"It will be more difficult to unwind these positions," said Robert Cranmer, a partner at financial services consultancy Sionic. "Without the market volume and with bargain-hunters abounding, there will definitely be additional cost."

The bad bank held 74 billion euros of risk-weighted assets when it was created last year. Deutsche Bank has since exited its equities trading business, transferred staff and assets from its prime brokerage and electronic equities businesses to BNP Paribas <BNPP.PA> and sold equity derivatives portfolios to Barclays <BARC.L>, Goldman Sachs <GS.N> and Morgan Stanley <MS.N>.

It is now working its way through portfolios of assets, including complex long-dated interest rate swaps, currency swaps, options, credit derivatives and residential mortgage-backed securities (RMBS) which are expected to be harder to offload, sources close to the sale process said.

Even prior to the coronavirus outbreak, the current year had been seen as critical for the bad bank wind-down, testing whether Deutsche Bank can offload the more complex assets without losses spiraling.

The bank has previously said it aims to slim it down to 38 billion euros of risk-weighted assets this year.

"The task this year is not just creaming off the top of the de-risking but getting to grips with unwinding the whole thing," said a Deutsche Bank source with knowledge of the plan.

Deutsche Bank has not revealed the expected cost of shedding the assets but has said it would be covered by its overall restructuring budget of 7.4 billion euros. The bad bank made a pretax loss of 767 million euros in the first quarter.

Separately, Deutsche said last month that funds set aside to cover bad loans rose to 500 million euros in its latest quarter, more than three times higher than a year ago, as the economic impact of coronavirus intensified.

WIND-DOWN DELAY

Delays to the wind-down could be costly for Deutsche Bank, which is under pressure to protect its capital buffers, having warned last month it may miss its capital requirement target this year.

"The last thing Deutsche Bank would want to do in a crisis like this is weaken its capital ratios unnecessarily," said DBRS analyst Sonja Forster.

Another Deutsche Bank source said the bank would make decisions on a "case-by-case" basis, weighing the anticipated losses from sales against the cost of keeping the assets.

Some of the assets have 30-year durations and were previously housed in an earlier bad bank set up by Deutsche Bank in 2012, meaning the bank has already been trying to sell them for eight years without success, one of the sources familiar with the plan said.

Potential buyers will be harder to find, analysts say. Rival banks are focused on coming through the crisis unscathed while private equity firms can take their pick from any number of distressed assets.

"There are a lot of other more appetising things to do," said David Hendler, an analyst at New York-based Viola Risk Advisors.

(Additional reporting by Tom Sims in Frankfurt. Editing by Jane Merriman)