Here's how things could really go wrong for Deutsche Bank

A sign reading "cash desk" is pictured next to the Deutsche Bank headquarters in Frankfurt, Germany, September 30, 2016.
Kai Pfaffenbach | Reuters

Conventional wisdom about embattled German institution Deutsche Bank is that even though it's short on capital, it's in no danger of failing because it has enough assets to sell to pay off any liabilities on the horizon.

The longer-term problem, though, is that a capital problem can morph into a liquidity problem.

While that's arguably a worst-case scenario for the current difficulties in which Deutsche finds itself, it's not a remote one. Virtually no analysts at this point seriously entertain the possibility that the bank might fail, but the specter of a sudden freeze in the rapid-fire world in which big banks conduct business has frayed nerves in the market.

The storyline goes something like this: Let's say you're selling a guitar. You're selling it because your music room is getting too crowded, not because you need the money. You offer the guitar to a friend for what you want, not what you need. In essence, you're setting the price.

Alternatively, imagine you're selling the guitar because you are low on cash and need the money to pay the rent this month. Suddenly, you're not setting the price anymore, the buyer is.

Such can be the case in the fickle financial marketplace, particularly in a case like Deutsche's. The bank has some valuable tangible assets on its balance sheet — Postbank, Deutsche Bank Asset Management and a stake in China's Huaxia Bank, to name three — but also has a high level of hard-to-value derivatives.

Representatives from Deutsche Bank were not immediately available for comment. The bank has countered worries over its stability, repeatedly emphasizing that it has a "stable financial position."

The valuation trap

Sounding the alarm on Deutsche Bank

If pushed to raise liquidity, the bank would be selling at a time when the rest of the market knows it needs the money, particularly with a costly settlement on the horizon with the U.S. government.

"While the near-term issue is the potential for a settlement with the U.S. Department of Justice, the longer-term issue is the depressed level of profitability of the bank and their inability to grow capital through earnings or raise capital in the market," KBW analyst Frederick Cannon said in a research note.

Most recently, the bank sold insurer Abbey Life to Phoenix Group Holdings for $1.2 billion, a sale that actually happened at a $897 million pretax loss but which nudged up Deutsche's highest-quality capital level. The sale helped because Abbey's balance sheet held risky assets that counted against so-called tier one capital.

The future, though, gets murky when it comes to assessing how much help Deutsche's assets would provide to its diminished capital base. (The end-of-year financial statement in 2015 said the bank has $73.6 billion in financial assets available for sale.)

Deutsche faces a tough negotiation with the DOJ over the bank's mortgage-backed securities infractions. Reports are that the department wants $14 billion, a potentially crippling number for Deutsche that almost certainly will be pushed downward, though no one knows how far.

A 'profitability crisis'

Banking analysts worry that Deutsche is caught in the same profitability trap as its European peers. Deutsche's return on tangible equity for 2016 is estimated at just 3.4 percent, worse than all but a handful of other banks in Europe and half the total of 6.8 percent for all institutions on the Continent, according to financial services firm Keefe, Bruyette & Woods. U.S.-based banks are projected to have a 10.6 percent return.

"We believe that what is occurring is a profitability crisis in global banking, particularly in Europe, as opposed to the balance crisis which occurred during the financial crisis," Cannon wrote. "Market indicators of risk appear to be linked to reduced bank profitability, which makes retaining and raising capital difficult for banks."

Deutsche in particular, but banks in general, also face a political problem.

The Deutsche issues merely compound an image problem heightened during the financial crisis but exacerbated most recently by revelations of illegal sales practices at Wells Fargo and a general feeling in Washington that it's time to go after big banks.

In the U.S., influential Sen. Elizabeth Warren and others recently called again for criminal investigations for Wall Street financial executives and big-bank breakups. In Germany, Chancellor Angela Merkel faces intense political pressure not to bail out Deutsche Bank, even though it's clearly the most systemically important European financial institution.

"Ill-considered public statements, whether made directly or on background to the news media, serve to erode confidence in markets and in specific financial institutions," Christopher Whalen, influential banking analyst and senior managing director at the Kroll Bond Rating Agency, said in a note. "We believe that political leaders who seek to obtain partisan political advantage by making such statements play a very dangerous game."

Whalen said his firm views Deutsche as "both financially stable and having more than adequate liquidity." Ultimately, he thinks regulators and public officials will see that bailing out debtholders at systemically important banks is "far less costly and destructive to society as a whole than engaging in a forcible debt liquidation."

Correction: Deutsche Bank recently sold insurer Abbey Life to Phoenix Group Holdings. An earlier version misspelled Phoenix Group Holdings.