News of coordinated central bank action has sent shares of European banks soaring, but does this action really mean investors should buy European banks? The chart below shows shares of Deutsche Bank (DB) over the past week. Other Eurozone banks such as UBS (UBS), Credit Suisse (CS), Barclays (BCS), RBS, and Banco Santander (STD) have seen similar rallies.
Should you buy into these rallies?
The answer is unequivocally no. While central bank actions may help to stem off any immediate failure of a major European bank, central bank actions do not solve the sovereign debt crisis that is weighing on banks. The difficulty European banks are having in terms of funding themselves are symptoms of debt crisis. However, there have also been developments in terms of fighting the debt crisis itself. Germany and France have started on working on a plan for closer unity within the EU. The plan would presumably make it so that the ECB could step of its bond buying program. The IMF has also signaled that it might play a significant role in bringing the crisis under control. While IMF help, fiscal unity, and increased ECB buying could put an end to the run on sovereign debt, it will cause a different problem for Eurozone banks. Any solution to the debt crisis seems to involve massive austerity on the part of PIIGS. As discussed here, the insistence on austerity could be deadly for the Eurozone economy as a whole.
If none of the PIIGS default, it will likely be because Germany decides to bail them out. Germany will only bail out these nations if they agree to strict spending reduction. With the economies already facing difficult times, government spending cuts will almost certainly push the entire Eurozone into an ugly recession. This recession will cause spikes in defaults on credit card debt, mortgage debt, and low end business credit. This combination is nearly as deadly for European banks as the default of PIIGS sovereign debt. The reason that the Greek default has had such a major impact on the European banking system is that the European banks are over leveraged. If consumers default instead of countries, the problem still remains that the defaults are likely to be larger than the equity value of EU banks.
In the end, the European banks are in a lose-lose situation. Either sovereign nations default, or Europeans default on individual debt. For this reason all European banks should be sold into the recent rally. DB, RBS, BCS, STD, UBS, CS. If one wants to go long banks, then American banks offer a much better risk reward profile as discussed here. Also, preferred shares are a better way to bet on European banks than common shares. While a recession could be ugly, it is likely that preferred shareholder would be better protected than common shareholders. For more on why preferred shares are a better bet than common stock click here.