The Coming Pan-European Sovereign Debt Crisis

|
 |  Includes: BBVA, FXE, SAN, VGK
by: Reggie Middleton

Banks are the epicenter of the economic crises that face the developed and emerging nations over the last few years. Many appear to have allowed the media to carry the conversation away from the banks and into sovereign debt issues, social unrest etc., but the main issue still resides in the banks. Why, you ask? Well, because every single major country conducts its finances through the banks and when those finances become stressed, the banks will be the first to show it and usually show it in an aggrieved manner since most banks are still highly leveraged.

The fact that governments worldwide have made the (generally unwise) attempt to bail out their big banks by transferring bad debts and liabilities from the private sector and bank investors to the public sector and taxpayers, doesn't mean that the problem has been solved or even ameliorated.

As a matter of fact, I believe the problem has now been amplified, for now we have effectively increased the implicit leverage in the already excessively leveraged banking problems, as well as removed the natural firewalls that may have been in place by having the problems in individual financial institutions versus sitting on government balance sheets, able to affect all without the need of the "domino effect" that was feared from the Lehman collapse.

This leverage stems from the fact that most European sovereign nations are considerably "overbanked." The levered assets of the banks in many Euro-sovereign nations easily outstrip those nations' GDPs. So when the nations' banks get in trouble from bad banking practices (and a very large swath have), the nations themselves are not only helpless in attempting to truly save the banks (instead only instituting a bait and switch wherein private default risk/insolvency potential is swapped for public manifestations of the same), but are put at risk themselves, for the bank is actually more of a sovereign entity than the sovereign is - at least from an economic footprint perspective.

This is what happened in Iceland. If one were to take an empirical look at other nations in Europe, Iceland and Greece are merely the tip of the iceberg. I warned about this over a year ago regarding Spain and the Spanish banks (see The Spanish Inquisition is About to Begin...), and now the chickens are coming home to roost.

As it stands now, we have the most developed nations suffering from indigestion after bailing out their oversized banking industry, with many of the allegedly balance sheet bailouts actually being illusory and liquidity-based in nature. The US is case in point here, since most banks still have untold hundreds of billions of dollars of losses still sitting on their balance sheets, and the US taxpayer is stuck with the equivalent of hundreds of billions of dollars in losses simultaneously. Accounting rules have been relaxed to give the impression of record profits in lieu of what should be record losses.

We also have European countries such as the UK which have nationalized several of their largest banks, taking on significant losses on the taxpayer's balance sheet, but still facing the drag of a poorly performing banking system that is still too big for the economy as a whole. Just the non-performing assets of just the top banks in the UK amount to nearly 9% of their GDP! That is a very big chunk of dead money floating around in the system that literally invalidates X% of reported GDP.

The UK also has nearly $200 billion of exposure to Ireland, whose banks' NPA's are roughly 6% of that nation's GDP, the second highest in all of Europe save the UK (who has the same problem)!

The smaller sovereign nations that failed to keep their hands on the fiscal and budget reins during the global liquidity bubble are also facing issues. Greece is the current poster child for this scenario, having been downgraded by the ratings agencies, money and capital are fleeing from the country in a typical "run on the bank scenario", their debt being shunned by the markets with CDSs exploding and the big market makers in their debt refusing to accept their bonds as collateral.

This is Lehman Brothers (OTC:LEHMQ), part deux, which actually makes plenty of sense since the solution to the banks failing was the government taking the failing asset risk onto their balance sheets, hence now the governments are being seen as at risk of failing versus the backstopped private sector.

The larger sovereign nations are at risk of either having to bail out their less fortunate brethren or facing the fallout of having the repercussions of a domino effect reverberate across the EU and its major markets/counterparties. This goes deeper than some may suspect.

For instance, the weakest sovereigns in the euro area are still the central and eastern European nations, and the stronger sovereigns are heavily leveraged into these countries through their "overbanked" system. If (or when) these companies start to publicly exhibit cracks, quite possibly due to the domino effect of Portugal, Greece and Spain finally tipping, then you will find the Nordics showing stress through their banking system (the biggest CEE lenders) at a level that the countries may be hard pressed to backstop, for their banking systems are literally multiples of their GDPs.

I will attempt to illustrate the "Overbanked" argument and its ramifications for the mid-tier sovereign nations in detail below and over a series of additional posts.

Sovereign Risk Alpha: The Banks Are Bigger Than Many of the Sovereigns

(Click to enlarge)

image015.png

This is just a sampling of individual banks whose assets dwarf the GDP of the nations in which they're domiciled. To make matters even worse, leverage is rampant in Europe, even after the debacle which we are trying to get through has shown the risks of such an approach. A sudden deleveraging can wreak havoc upon these economies. Keep in mind that on an aggregate basis, these banks are even more of a force to be reckoned with. I have identified Greek banks with adjusted leverage of nearly 90x whose assets are nearly 30% of the Greek GDP, and that is without factoring the inevitable run on the bank that they are probably experiencing. Throw in the hidden NPAs that I cannot discern from my desk in NY, and you have a bank that has problems, levered into a country that has even more problems.

(Click to enlarge)

image009.png

There is a method to the madness: on to my perspective of the individual sovereigns.

We performed a pan-European scan to identify banks with rising loan losses from troubled exposure. We retrieved an initial list of 510 banks and applied a number of filters based on a) Banks' assets as % of GDP b) Texas ratio c) share price etc. to arrive at 40 banks for deeper analysis.

The selected 40 banks were organized into different sets for analysis based on the country of domicile.

1) Spain - Owing to serious issues surrounding Spanish banks, we analyzed the four Spanish banks separately. It is observed that Spanish banks are witnessing substantial increase in NPAs. Included in the list is BBVA which we have already covered (see The Spanish Inquisition is About to Begin..., which has turned out to be a most profitable trade). Among the four analyzed banks, the weakest bank had the highest Texas ratio of 51.6% and rapidly growing NPAs (increasing 132.5% over the last one year). Banco Santander (STD), Spain's largest (and arguably, strongest) bank, is also witnessing substantial increase in NPAs growing about 95% over the last one year. The Bank's Texas ratio stands at 37.5%, although low relative to other banks examined, it is still rich and the rising provisions for loan losses are depressing Bank's profitability. The stock has risen 86% over the last one year and is currently trading at Price-to-tangible BV of 2.1x. Banco Santander has an ADR. Download a tear sheet on all Spanish banks investigated here (pdf).

I will continue this post with banks and sovereign stress data for Austria, Belgium, Sweden, Denmark, UK, Greece and Italy as well as the countries in central and eastern Europe, Asia and other emerging markets over the next few days. In the meantime, let's compare Spain and Greece on an apples to apples basis...

(Click to enlarge)

spain_vs_greece.pngClick to enlarge

Subjective thoughts on the Spanish Situation: Embedded structural rigidities will prolong the downturn causing the oft sought after "V shaped recovery" to become an unlikely occurrence. The very high private sector debt levels most likely exacerbated the effects of global downturn. A round of consolidation and restructuring seems inevitable, as both the NPAs in its banks are increasing on a fundamental basis and the banks are forced to come clean with the true losses on their commercial and residential real estate in the form of increasing NPAs (see The Spanish Inquisition is About to Begin...) as well as the share of NPLs which are also increasing.

PWC expected the bad loans ratio to increase to 8% by the end of 2009. It is apparent that the sector will need refinancing. however, Spain's loan-to-deposit ratio of 130% is higher than the eurozone average of 115%, which shows Spain's high reliance of wholesale funding and securitization channels, both of which have dried up.

What is not publicly touted about Greece? Greek banks' exposure to emerging Europe poses an additional downside risk to the economy. Public debt stood at 94% of the GDP with the current account deficit rising to 14% of the GDP in 2008 (deteriorating public finances is another concern).

Disclosure: Author short bbva