Archive for July, 2011

Euro-zone Banks Problems

Tuesday, July 26th, 2011

In my previuos blog, I mentioned that many Continental European banks in the Euro-zone had balance sheet issues, owing to their large holdings of peripheral countries’ sovereign debt. With Greece effectively defaulting last week and having its ratings reduced to their lowest ratings by Fitch and Moody’s, E20 bn of the E109 bn bailout package had to be used to recapitalize Greek banks. Europe’s biggest banks outside Greece own E98 bn in Greek debt, on which they are estimated to lose E20.6 bn (21%)  if everything works out as the authorities hope. Most observers are more pessimistic, pencilling in losses of between 50% and 75%, or E-50-75 bn, enough to put a sizable dent in banks’ capital. And that’s before taking losses on positions in Ireland and Portugal into account.

While the Stoxx banks Index jumped 5.7% last week on news of the rescue package for Greece, Portugal and Ireland, it is still selling at only 0.8 times published book value, and has been the worst performing of the 18 Stoxx industry sectors in Europe over the last 18  months according to Bloomberg, down 18% since the beginning of January 2010. An article on Bloomberg today (July 26th) about the second largest French bank Societe Generale (GLE-FP) notes it has E2.5 bn in Greek exposure, approximately 5% of the E56 bn of the total Greek exposure of the French banking system, which includes E15 bn of sovereign debt. This makes France the largest holder of Greek debt in Europe, according to the Bank of International Settlements (BIS)., which is why Societe Generale and two other French banks were put under review by the ratings agencies in mid July in anticipation of a Greek rescheduling.

Societe Generale, which lost E4.9 bn in 2008 when rogue trader Jerome Kerviel made E50 bn in unauthorized trades, also owns 88% of Athens based Geniki Bank (TGEN-GA), which lost E441 m last year, and another E99 m in the first quarter of 2011. Geniki has never made any money for Societe General since its acquisition in 2004. It has lost another E450 m in its 700 branch Russian subsidiary between 2008-2010, and wrote off E2.1 bn in 2008 on US debt securities, a small part of its E11 bn in writedowns since 2007. It still has E29.5 bn in legacy assets, risky securities which were badly affected by the global financial crisis and which are in run-off mode.

Yet Societe Generale is a world leader in equity derivatives, and anchored by its profitable Frennch retail bank, which has made at least E1 bn a year every year since 2005, it was profitable through the crisis, making E2 bn in 2008 and E679 m in 2009. Being paid out in full on its E11 bn of Credit Default Swaps (CDS) it had bought from AIG when the US government bailed out the giant insurer helped a lot; Societe Generale was the largest AIG creditor made whole by the US. Despite its losses in Greece and the Middle East this year, it still made E916 m in the first quarter of 2011, down 14%. In other words, Societe Generale has been one of the better European banks.

A realistic write-down on its Greek positions would be a major problem for Societe Generale, and when added to exposure to Spain, Portugal and Italy, it becomes apparent why investors have been cautious about buying seemingly cheap European banks. Dexia (DEXB-BB), the Belgian bank which was the largest user of the Federal Reserve’s emergency liquidity facility in late 2008, is selling for only 0.4 times book value, but who can trust a historic book value where debt from the PIIGS is valued at par? Societe Generale will lose E500m if the 21% write-down in Greek debt turns out to be accurate, wiping out 15% of this year’s earnings. There’s a reason that it sells for one third of its 2007 price, and the same caution applies to other Euro-zone banks.

Greek Tragedy Part II

Monday, July 25th, 2011

My family and I returned to Canada last week from a 3 week vacation in Italy, France and England, staying with friends and seeing family, as well checking out possible schools in England for the children. We were in Europe at the height of the Euro-zone debt crisis, yet it was remarkable how little effect the impending implosion of the peripheral economies such as Greece, Portugal and Ireland seemed to have on French and Italian citizens and visitors. It was hard to discern any concern about the collapse of the Euro on the French Riviera amongst the well dressed and prosperous-looking holidaymakers strolling through the streets of Antibes or Nice. Likewise the elegant and stylish inhabitants of Milan and the tourists flocking around the Duomo and La Scala didn’t appear gripped by angst over the potential return of the lira.

Over the next couple of weeks, I will be examining some of the issues that have emerged as the Euro debt crisis has developed, including the outlook for the Euro and European banks,  few comparisons between the cost of living in Europe and North America and some individual company ideas that emerged from our travels. Of course, in Europe, July and August are holiday time, when half of Paris leaves for the month of July and the other half for August, causing horrendous traffic jams (“Bouchant”(kissing), as the Auto-route signs phrase it) on the roads down to the Mediterranean.  Germans and Scandinavian tourists descend en masse on beaches in Spain, Italy and Greece, although the latter has not been too popular this year with all of the strikes affecting it, while hard drinking British youths infest Majorca and Minorca and just about anywhere else that is cheap to fly to and has cheap beer and wine. A lack of interest in arcane financial dealings is understandable, and the crisis in Greece and the other peripheral Euro-zone economies such as Portugal and Ireland has been rumbling on for over a year.

However, the realization that holders of Euro-zone debt were becoming increasingly worried about Spain and Italy, as it became apparent that the E110 bn ($150 bn) bailout of Greece last May, let alone the E78 bn for Portugal and the E65 bn for Ireland, had not worked, finally struck home in Brussels. As yields on Spanish 10 year debt rose above 6% and above 5.25% for Italy, the Eurocrats were staring over the edge of a debt precipice. Neither Spain nor Italy could afford to fund their budget deficits at these rates and maintain their existing social and industrial policies, while it finally sank in that Greece Ireland and Portugal were trapped in a a classic 1930s style “paradox of thrift” debt deflation. As Keynes pointed out, what is logical behaviour for individuals and companies, cutting expenditures and practicing austerity, was doomed to failure, as one person’s expense was another person’s revenues. Thus attempting to cut your way to solvency merely saw revenues falling even faster than expenses and the deficit widening, not shrinking, as Greece and Ireland have been demonstrating over the last eighteen months.

With the E109 bn package announced last Thursday, July 21st, 2011, Germany, the heart of the Euro-zone and the banker of the whole Euro project, has accepted the logic of the Euro experiment for the first time. Within a currency union such as the Euro-zone, unless there is a willingness on the part of member states to contribute resources to other member states when they run into financial difficulty, then the only solution for the countries in difficulty is to leave the currency zone and devalue to regain competitiveness. This, in effect, is what the UK did in September 1992, when George Soros and other “speculators” helped drive the pound sterling out of the predecessor to the Euro, the ERM. Sterling was devalued by 30%, making Mr Soros several billion dollars as he became “the man who broke the Bank of England”.

Within a few years, however, the British economy was booming as reduced imports and rising exports contributed to an export led manufacturing boom, reinforced by rising tourism revenues and capital inflows as the UK became a very cheap place to visit and live. In the end, last week’s rescue of Greece and the other PIIGS may yet end up with the weaker countries leaving the Euro, which reverts to being what it originally was; the Deutschmark by another name. Germany’s immediate neighbours in the Benelux countries and France will form part of a currency bloc which is driven by the performance and needs of the German economy, and not weighted down by Mediterranean economies which cannot remain competitive with Germany.

Of course, the rescue package also effectively created a European Monetary Fund in the European Financial Stability Facility (EFSF), whose E440 bn of capital can now be used to buy sovereign bonds in the secondary market and issue “precautionary” loans to countries that face liquidity pressures. It will also offer borrowers longer maturities and lower interest rates than those with which their bonds originally were offered.

This is a default by Greece, soon to be followed by Portugal and Ireland. The private sector, in this case largely French, Spanish and Italian banks, will be forced to accept longer dated bonds with lower interest payments than those they had on their balance sheets. Of the E109 bn, E35 bn will need to be kept in a contingency fund to ensure that the new bonds will be repaid and that lenders will be willing to accept the new bonds, while another E20 bn will be needed to recapitalize Greek banks which hold the old bonds as capital. It is estimated this will be equivalent to a 21% “haircut” or loss, but more realistic estimates indicate that losses will run between 50% and 75%.

in my next posting,  I will look at some of the consequences of this decision and what it means for investors in European markets.