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What would be the worst investment today in an investor sentiment poll? Nuclear energy companies? The US dollar? Spanish real estate? Greek banks would certainly be a top contender.

We all know the commonly accepted narrative that a 2008 financial crisis caused an economic crisis. Banks in the US, Ireland, and Spain recklessly lent to homeowners and real estate builders, bought toxic structured securities, and applied leverage that wiped out their equity. The US bailout was possibly a qualified success; the Irish bailout was an unqualified disaster. Both countries’ debt-to-GDP ratios exploded as a result of these bailouts.

Greece stands as a stark example of where the problem was the opposite. The irresponsible Greek government wreaked havoc on otherwise conservative Greek banks, which held its sovereign debt. If (or probably when) Greece defaults, can any of the Greek banks survive?

Background

There are four major Greek banks: National Bank of Greece (NYSE:NBG), Alpha Bank (OTC:ALBKF), EFG Eurobank, and Piraeus Bank (OTC:BPIRF). NBG is by far the largest and the oldest (founded in 1841). According to “Handbook On the History of European Banks,” the bank served as a de facto national central bank until 1928, when Bank of Greece was established. Therefore, its place is secure in the Greek national psyche.

National Bank of Greece Group is structured as a holding company with three subsidiaries: National Bank of Greece, Finansbank (operating in Turkey), and a southern Eastern Europe unit comprised of a number of smaller banks in Bulgaria, Serbia, Romania, Albania and Macedonia. While the bank group is nominally Greek, the operations are certainly international.

[Click all to enlarge]

Revenues and assets per unit 2009/2010 (SSE - South Eastern Europe):

Only the Turkish subsidiary has been solidly profitable in 2010, while Greek and Eastern European operations took large write-offs and impairment charges due to rising defaults and deteriorating balance sheets.

The good

NBG management would have us believe that failure is not an option: “Strong capital position: Group’s tier 1 ratio at 13.1% [€8.96 billion], while its core ratio is at 12.0% [€8.19 billion]. Strong liquidity: Loan-to-deposit ratio is 103%; Greece 94%.”

For comparison, JP Morgan’s (NYSE:JPM) tier 1 ratio is 9.5%, while Bank of America’s (NYSE:BAC) is 11.3%.

Sure, defaults are up ... especially in Greece, which is mired in a three-year long recession with no end in sight. However, the bank set aside 55% of capital required to cover 90 days past due delinquencies (NPL). According to Goldman Sachs Research, the European bank average was 57% in 2009 (last available figure).

Delinquencies were high at 8.5% at the end of 2010 and still growing, but the rate of its growth is likely to slow down as the economy is bottoming out:


Finally, NBG can always sell a 95%+ stake in the hugely profitable Finansbank, which is trading today at about €5.4 billion on the Turkish stock exchange. NBG has been planning to sell 25% of its stake for several months but so far showed no sense of urgency to do so.

The bad

As one might expect, NBG was an eager buyer of Greek sovereign bonds. The bond exposure is slowly trailing off as it is no longer replacing maturing bonds, but it’s still a whopping €13.7 billion plus €5.7 billion of “Titlos” bonds (more on this in the next section).

While the bank took some impairment charges on Greek bonds, its 88% average book value is very optimistic: A five-year Greek bond was trading at 55% last week.

Modeling a market mark-down on bonds, NBG could lose another €3 billion of core capital based on mark-to-market prices. If Greece default can be postponed until 2013, when a new European Stability Mechanism bailout facility is in place, the NBG exposure will be reduced to €9.7 billion.

The ugly

Unfortunately, NBG is a counterparty in a notorious off-balance sheet swap transaction arranged by Goldman (NYSE:GS) for the Greek government to hide part of its debt. Goldman arranged a Special Purpose Vehicle called Titlos PLC, which issued €5 billion bonds back to NBG. I was amused to discover that one of the meanings of the word “titlos” is an inscription giving an accusation of a crime (those Goldman folks have a sense of humor, don’t they?). The prospectus of this complex deal is available here. I am currently engrossed in reading this monumental document.

I am not yet clear yet if NBG may face an AIG-like situation, when it will be required to post extra collateral as a counterparty to the transaction or is “on the hook” in some other yet-undisclosed way. On March 9, Titlos PLC was downgraded to B1 by Moody’s. I do not see any evidence that NBG reserved any capital against Titlos exposure.

Conclusion

It’s not an easy task to assess if NBG will remain solvent. On the one hand, the bank was very conservative in its lending, especially in Greece, and can still raise additional capital (over €5 billion from the sale of Finansbank). On the other hand, the exposure to Greek government debt is much more severe than its balance sheet shows (and a shady “Titlos” deal only adds to the uncertainty).

My hunch is that NBG is likely to survive, as even a bankrupt Greece needs at least one bank. Looking at its ADR price of under $2, a good strategy may be to buy stock and sell a long-term covered call option, taking advantage of extreme price volatility. Should the bank go under or issue a lot of new equity, the option premium would lessen the blow.

Disclosure: I have a long position and NBG stock and short position in its option calls.

Source: Can National Bank of Greece Survive?