Monday, August 28, 2006

Deutsche Bank Incurs Growth Pains Chasing Goldman

Bloomberg, Adrian Cox, 28 August 2006

Deutsche Bank AG is finding out just how hard it is to be more like Goldman Sachs Group Inc.

A decade after Germany's largest bank set out to reinvent itself as a Wall Street-styled securities firm, only New York- based Goldman earns more money from trading stocks, bonds, currencies and derivatives. And, there's little prospect that the gap between them will narrow anytime soon because Frankfurt-based Deutsche Bank eludes the risk-taking that characterizes Goldman.

While Goldman's sales and trading revenue almost doubled to $12.9 billion in the first half on big bets in the oil and stock markets, No. 2 Deutsche Bank could only manage a 38 percent increase to $9.7 billion during the same period with a trading strategy that's deliberately risk-averse.

``Deutsche Bank has made a lot of progress, but it will be a big task for them to take on the top tier of Wall Street,'' said Dale Robertson, who helps manage $1 billion in stocks at Edinburgh Partners in the Scottish capital, including shares of Deutsche Bank. ``They still have a ways to go.''

Wall Street's traders have been the engine behind more than three years of rising profits at securities firms, including Goldman, Deutsche Bank, UBS AG, Citigroup Inc. and Morgan Stanley. They typically account for about three quarters of investment-banking revenue, with the rest coming from underwriting securities and advising on mergers.

Market Swings

To make the most of trading opportunities for themselves and clients, firms have increased their so-called value at risk, a measure of how much they could lose in a day if the markets turned against them. While Goldman's value at risk was 40 percent higher in the second quarter than at the end of last year, Deutsche Bank's risk was almost unchanged, company filings show. Value at risk is calculated differently at different banks.

``We have made a strategic decision to pursue a client- driven approach to sales and trading, which has produced consistently strong returns for our shareholders in a wide variety of market conditions,'' said Deutsche Bank spokeswoman Rohini Pragasam. ``We believe we have the appropriate product suite, revenue mix and risk-management capabilities to continue generating superior performance for our clients and shareholders.''

Traders have made some of the quickest profits -- and losses -- in history. In 1992, George Soros's Quantum Fund made more than $1 billion betting that the peg between the British pound and the currencies of Europe would break. Long-Term Capital Management LP, a hedge fund run by former Salomon Brothers Vice Chairman John Meriwether, lost $4 billion in 1998 after a debt default by Russia. Securities firms don't normally disclose specific trades.

Profit Target

To enable Deutsche Bank to maintain its profitability target of at least a 25 percent return on equity before taxes, Chief Executive Officer Josef Ackermann, 58, is relying on Anshu Jain, 43, who oversees sales and trading as co-head of the investment- banking division with Michael Cohrs, 49. The bank can show only a 15 percent gain in its shares since Ackermann took over in May 2002, while profits have risen almost ninefold.

Even though Goldman's swings in trading revenue exceeded those of all its biggest rivals for five of the past six quarters, it has still posted three years of rising trading revenue. Deutsche Bank's quarterly sales and trading revenue, which fell in 2004, seesawed like that of its top four competitors during the past year and a half, rising 88 percent in the first quarter and falling 29 percent in the second.

``The more volatile the earnings, implicitly, the lower quality they are,'' said Keefe, Bruyette & Woods Ltd. analyst Matthew Clark in London.

Trading Loss

Sales and trading, which includes packaging, trading and selling securities such as credit derivatives and providing brokerage services to hedge funds, accounted for about half of Deutsche Bank's total revenue in the first half of this year.

``They're more dependent on their trading business than peers like the Swiss banks or the big French banks, largely because the rest of their business isn't as profitable,'' said CreditSights Inc. analyst Simon Adamson in London.

When Deutsche Bank on Aug. 1 reported a 100-million euro ($128 million) loss from equity trades for its own books in the second quarter, investors who shrug off greater swings from Goldman sold the shares, sending the price down 4.7 percent.

The loss followed a 400 million-euro gain in the first quarter and surprised shareholders who have become accustomed to Ackermann downplaying trading risk. He wrote in an August 2004 letter to the Economist magazine that Deutsche Bank had ``deliberately and dramatically reduced its dependence on risk- taking as a source of operating earnings.''

Merger Ranking

Investors would prefer ``a substantial profit stream from the operating business and not from the trading business,'' said Markus Barth, who helps manage about $8 billion at Hamburg-based Nordinvest GmbH and is a Deutsche Bank shareholder. ``The market doesn't like that kind of uncertainty.''

Deutsche Bank's first-half revenue from equities was $3 billion, far behind the $4.8 billion reported by Goldman, as well as Zurich-based UBS and New York-based Merrill Lynch & Co. and Morgan Stanley. In oil and energy trading where Goldman had estimated revenue of $1.5 billion last year, Deutsche Bank hardly trades a barrel.

In investment banking, Deutsche Bank is a laggard compared with Goldman, which uses its perennial No. 1 position in providing mergers advice and underwriting stock sales to win trading clients. Deutsche Bank is this year's ninth-ranked takeover adviser, and eighth in arranging share sales, data compiled by Bloomberg show. The German company is the third- ranked underwriter of international bond offerings, after placing first last year.

Profit Per Employee

Deutsche Bank has outpaced its European competitors, including UBS, Societe Generale SA and Credit Suisse Group, in sales and trading. The company last year leapfrogged UBS, Europe's largest bank, and New York-based Citigroup, the biggest U.S. bank.

``The European investment banks still don't have the strength in trading that you see at U.S. firms, where risk-taking and capital commitment has been a part of their capital markets business for decades,'' said Bruce Weber, a professor at the London Business School. ``European capital markets have been dominated by bank lending and debt instruments.''

Deutsche Bank's profit per employee in investment banking rose at an annual rate of about 28 percent during the past five years to 313,531 euros in 2005, said Simon Maughan, an analyst at Blue Oak Capital Ltd. in London. The closest competitor was Paris-based Societe Generale, France's No. 3 bank by assets, with 15 percent growth. UBS's profit per employee in investment banking fell 4 percent a year and earnings at Zurich-based Credit Suisse, Switzerland's second-largest bank, declined 20 percent. Goldman doesn't disclose comparable results.

`Generic Drug'

Deutsche Bank is more like its U.S. commercial banking rivals whose risk-aversion deters them from creating new products and investing alongside their clients, said Maughan, who moved to Blue Oak from Allianz AG's Dresdner Kleinwort unit in April.

Goldman's capital-markets revenue rose at an annual rate of 20 percent during the past three years, compared with 8 percent at Deutsche Bank, showing the U.S. firm has been ``more nimble at moving capital to the fastest-growing areas,'' such as derivatives on commodities and loans, he said.

``The big commercial banks are almost like generic drug companies that become the No. 1 player in the market when the product is widely available and balance sheet strength supplants intellectual capital as the driving force,'' Maughan said. ``The total pool of profits is greater but the monopolistic margin was captured a long time ago by the patent holder.''

Proprietary Trading

Jain told investors at a conference in London in May that Deutsche Bank needs to increase its commodities, residential mortgage-backed securities and U.S. cash equities businesses. About 30 percent of the company's sales and trading revenue comes from equities and equity derivatives, compared with almost 40 percent at Goldman. Another 30 percent is derived from the credit markets, and the rest is from interest-rate products and foreign exchange, money markets and commodities.

Less than 20 percent of Deutsche Bank's sales and trading revenue comes from proprietary trading, half the industry average, according to Jain's presentation.

Deutsche Bank's investment-banking unit accounted for 69 percent of the company's 14.8 billion euros of revenue in the first half of this year, up from 63 percent in the first half of 2004 before Jain and Cohrs took over. The rest comes mostly from consumer and small-business banking, private banking and fund management, where growth has been slower.

Eliminating Jobs

As Ackermann cut more than 19,000 jobs and sold at least $18 billion of assets since 2002, London-based Jain has combined fixed-income and equities, pruned the research staff in Europe, and added specialists in equity derivatives, prime brokerage and U.S. mortgages.

He has hired at least 24 executives this year in the U.S. alone, including Goldman's Arun ``Mel'' Gunewardena as head of a fixed-income prime brokerage unit, which caters to hedge funds. Jain's group also has invested in three U.S. and Mexican mortgage companies since March.

Jain joined Deutsche Bank in 1995 along with his mentor Edson Mitchell from Merrill, the third-biggest U.S. securities firm by market value, to build a sales and trading business. Mitchell died in a plane crash in 2000. Jain's background was as a fixed-income derivatives salesman. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

Bankers Trust

Deutsche Bank made its biggest push into Wall Street in 1999 when it bought New York-based Bankers Trust Corp. for about $9.5 billion, at the time the biggest foreign takeover of a U.S. bank. The purchase, which made Deutsche Bank briefly the world's largest financial company, included merger firm Wolfensohn & Co. and Baltimore-based securities firm Alex. Brown & Sons.

As Deutsche Bank's dependence on trading for itself and on behalf of clients has increased, so have concerns about its ability to weather a market slowdown. Rising interest rates and a stock market slide in May and June may be signaling an end to three years of near-perfect trading conditions, when the MSCI World stock index rose 50 percent and the market for credit derivatives grew fivefold.

Deutsche Bank is a leading trader of credit derivatives, a market dominated by contracts insuring debt against default, according to estimates by Fitch Ratings in November.

`Market Downturn'

``They have been gaining market share, but it's not clear how the investment bank has been dealing with the market downturn,'' said Helmut Hipper, who oversees 1.5 billion euros at Union Investment in Frankfurt, including Deutsche Bank shares.

Investors also are skeptical about Ackermann's ability to improve results in consumer banking and fund management. As Deutsche Bank expanded abroad, growth in its home market stalled. The company last year got 29 percent of 25.6 billion euros in total revenue from Germany, down from 69 percent in 1995.

Ackermann sought this year to expand retail banking at home and in emerging markets, agreeing in the past three months to pay 681 million euros for Berliner Bank and 420 million euros for Nuremberg-based Norisbank. Meanwhile, wealth management head Kevin Parker told investors in May that the division ``has seen the bottom,'' and pledged to increase revenue by investing in countries such as India and China.

That prompted Standard & Poor's to say on Aug. 22 that it may raise Deutsche Bank's AA- long-term credit rating if the company improves in areas such as retail banking and wealth management while maintaining earnings at the securities unit. S&P analyst Bernd Ackermann said trading was one of the threats to that outlook.

Relative Value

Deutsche Bank's stock trades at 9.26 times earnings, about the same as Goldman, the second-biggest U.S. securities firm by market value after Morgan Stanley, and 25 percent less than UBS, whose earnings are smoothed by its ownership of the world's largest manager of assets for millionaires.

Shares of Deutsche Bank are up 15 percent in the past five years, compared with Goldman's 90 percent rally, UBS's 72 percent advance, Societe Generale's 68 percent gain and Credit Suisse's 14 percent increase. The German bank is rated ``buy'' or the equivalent by 32 analysts who cover it. Eleven have ``hold'' ratings and five advise investors to sell its shares.

Trading fortunes ultimately follow those willing to gamble the most, Blue Oak's Maughan said. ``Where the risks are lower, the rewards will be commensurately lower.''