Written By: Darren Morris – Corporate Finance
The US Department of Justice wants Deutsche Bank to pay $14 billion to settle various probes relating to poorly underwritten mortgage securities sold by the bank during the financial crisis. The settlement amount that the government has proposed shocked many and immediately triggered a selloff in Deutsche Bank stock. First, $14 billion is on the highest side of payments that other banks paid to settle parallel claims. Second, Deutsche Bank investors didn’t expect the Justice Department to quote such a hefty figure, even if it is only a preliminary bid.
After making its opening bid of $14 billion to settle the set of mortgage-securities claims, the Justice Department invited Deutsche Bank to make its counterproposal. It is routine that governments open with tough positions in these kinds of settlements. In the case of JPMorgan Chase and Bank of America mortgage settlements, the Justice Department suggested that the banks pay $20 billion each to resolve the claims facing them. Though the banks ended up paying less than what the Justice Department had proposed, it wasn’t less than half the requested settlement amounts. The reason the government opens with hefty settlement bids is that it is a way to convey the seriousness of a violation. The huge settlement request is also designed to pressure the accused to put a substantial amount on the table as a counterproposal to resolve the claims.
Deutsche Bank has said that it will push back against the government’s settlement proposal. But there is no guarantee that the bank will succeed in reaching a settlement that it is comfortable with. Assuming that Deutsche Bank doesn’t get what it wants in the settlement negotiations, the bank could be disrupted in multiple ways. The settlement amount that the government is seeking is way above Deutsche Bank’s litigation reserve, which stood at about $6 billion at the end of the June quarter. Though Deutsche Bank has insisted that settlement negotiations have only begun and that it doesn’t see itself agreeing to pay an amount anywhere near what the government has proposed, it will be a tough showdown to bring down the settlement amount.
Insiders have indicated that Deutsche Bank is willing to enter a settlement in the range of $2 to $3 billion to resolve the mortgage probes by the Justice Department. With that, it goes without saying that if the government insists on a settlement amount above $4 billion, the bank could face serious capital risk. The hefty settlement amount proposed by the government shows that Deutsche Bank is still a long way from resolving the mortgage claims. But prolonged legal disputes only add to uncertainty in the bank’s future. For a bank already rattled by shrinking profits and an uneven economic environment in Europe, a settlement above what the bank is willing to pay would put serious strain on its balance sheet. Further, a huge settlement could further dent the confidence that investors and customers have in Deutsche Bank.
If the government insists that Deutsche Bank pay an amount beyond what the bank is ready to pay, the bank might be forced to raise additional capital, including through equity offering. However, that would contradict the bank’s executives who have been categorical that they don’t plan to raise capital this year. Further, a capital raise through equity offering would dilute the stock and destroy value for existing shareholders.
The major US banks have already reached settlements with the Justice Department to resolve allegations that they misled investors with toxic mortgage-backed securities just before the collapse of the housing market in 2008. Bank of America has paid the most fines in connection with the toxic mortgage-securities scandal, parting with close to $17 billion so far. Goldman Sachs reached a $5 billion settlement over its role in the collapse of the housing market, with $2.4 billion of the settlement amount being in cash and the rest being in the form of relief for struggling borrowers affected by the housing-market collapse. Citigroup, Morgan Stanley and JPMorgan paid a combined $23 billion to resolve claims of their involvement in misleading investors with poorly underwritten mortgage securities that later gave way to financial crisis.
When the government reached a settlement with banks to resolve issues of toxic mortgages, the payments were mostly structured as part cash and part consumer relief. In the case of Deutsche Bank, it is not yet clear how much the Justice Department will demand in cash payment. If the cash component of the settlement is small, it could be a bit more palatable for the bank, given its small litigation reserve and a portfolio of pending legal issues.
What is keeping analysts and investors in Deutsche Bank on the edge is that the settlement proposals by the Justice Department are not necessarily based on the size of the bank. That might seem to be the case considering that Goldman and Citigroup paid less than Bank of America and JPMorgan to settle their toxic mortgage-securities claims. Instead, the government quotes its settlement amount based on the weight of the evidence it has against a bank. As such, if the evidence against Deutsche Bank is strong, then the bank might have a tough time negotiating for a settlement that is significantly smaller than the $14 billion the government has proposed.