Deutsche Bank Should Cut Its Dividend

NEW YORK ( TheStreet) -- European banking conglomerate Deutsche Bank ( DB) should cut its dividend after revising weak 2012 earnings downward to reflect rising legal costs at its U.S. mortgage lending operation and unspecified regulatory investigations.

While Europe's largest bank by assets is sharply cutting 2012 profits and lowering its reported capital ratios, Deutsche Bank isn't prepared to cut the its EUR0.75 annual dividend, which equates to a payout far in excess of last year's annual profit.

On Wednesday, Deutsche Bank said it would have to set aside an additional 600 million euros to account for legal costs and regulatory investigations, in a move that will more than halve the bank's annual profit to about 300 million euros.

The earnings revision also means Deutsche Bank's Basel III Tier 1 capital ratio will fall from 8.0% to 7.8%, as the lender continues to cut risky assets and prepare for more stringent capital rules. The bank reaffirmed expectations of a Basel III Tier 1 ratio of 8.5% by March 31, and it said the earnings revision will reduce legal reserves by 500 million euros to 1.5 billion euros.

Although Deutsche Bank could have minimized the capital hit of its earnings revision by cutting the dividend, the bank remains committed to a payout that would be unlikely to pass the Federal Reserve's muster in the United States.

Deutsche Bank's rising legal costs and signs that regulatory probes may soon hit the bank's pocket book -- after large recent settlements at competitors Barclays ( BCS), HSBC ( HBC) and UBS ( UBS) -- come at a time when the bank's finances remain a large concern for analysts and ratings agencies.

The financial revision also comes as turmoil surrounding the bailout of Cyprus raises the prospect of a return to crisis within the European financial system, after the European Central Bank helped to stabilize balance sheets across the region with nearly 1 trillion euro's in bond guarantees in late 2011.

Deutsche Bank remains committed to a cash dividend that exceeds payout ratios from better capitalized European competitors and most U.S. counterparts.

Were European banks to return to a state of uncertainty, as they did at certain points in 2012, Deutsche Bank's dividend yield could fall in-line with the best capitalized U.S. players such as Wells Fargo, even after the Federal Reserve gave a clean bill of health to most large lenders and allowed bigger payouts, earlier in March.

Unfortunately, while Deutsche Bank is a bellwether for the European banking system, it also is reflective of seemingly risky payout policies across the region, as EU bank balance sheets remain among the biggest concerns for global investors.

Other conglomerates, including Banco Santander ( SAN), Banco Bilbao Vizcaya Argentaria ( BBVA) and Intesa Sanpaolo are hanging on to large payouts.

Meanwhile, struggling investment banks such as Societe Generale ( SCGLY), UBS ( UBS), Credit Suisse ( CS) and Barclays ( BCS) are in the process of either reinstating high-yielding payouts or forecasting big dividend increases to shareholders.

For lenders such as Deutsche Bank, dividend policies appear to come before the painful work of raising capital to solidify balance sheets, as U.S. banks have done.

It's no surprise, then, that investors continue to question the stability of the eurozone financial system, as zeitgeist in the U.S. shifts to post-crisis strategy.

While the Fed's tests propelled U.S. lenders into dilutive equity offerings years ago, some analysts say a large equity offering remains in the cards for Deutsche Bank.

JPMorgan bank analyst Kian Abouhossein, Fitch Ratings and a Reuters Breakingviews analysis all highlight a shortfall at Deutsche Bank's U.S. investment banking subsidiary as an added concern to the bank's capital position that's yet to be addressed by co-heads Jürgen Fitschen and Anshu Jain, who are ahead of schedule on restructuring and recapitalization targets.

Deutsche plans a 90 billion euro reduction in risky assets, layoffs and an exit from some capital-intensive businesses, in coming years.

While Abouhossein of JPMorgan took Deutsche Bank's initial 2012 earnings to reflect improving capital under Fritschen and Jain, the analyst highlighted mark-to-market writedowns on risky pre-crisis mortgage and buyout loans as a continued risk for the bank.

Wednesday's announcement appears to vindicate such concerns.

Meanwhile, a proposal under consideration by the Federal Reserve to boost the cash balances of foreign banks operating in the U.S. might put conglomerates like Deutsche Bank at a disadvantage, according to a late January analysis by Fitch Ratings.

"Deutsche Bank's capitalization is weaker than most of its global peers on a 'look-through' Basel III common equity Tier 1 ratio and adjusted-leverage basis," wrote Fitch Ratings, in a note that expressed optimism the bank's capital position will continue to improve.

At a time when eurozone banks are gorging on emergency European Central Bank loans as a way to handle asset sales, writedowns, rising non-performing loans and bailout politics in countries such as Cyprus and Italy, the dividend payout of Deutsche Bank and lenders across the region are a reminder of what put banks into a state of crisis five years ago.

In fact, payouts as high as 10% at the likes of Santander, 5% at BBVA and a forecast of a 4% payout at Societe Generale indicate that European lenders are in a race to the bottom when it comes to capital planning.

Given Deutsche Bank's size and its shaky finances, we should all hope that the lender doesn't finish at the head of Europe's dividend heat.

It's time for Deutsche Bank to cut its dividend and wait another day to make large payouts to investors.

-- Written by Antoine Gara in New York

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