Time To Get Back Into The Euro Financial Sector

by: Alicia Damley, CFA

It may have taken too long, but the European Union has made much needed progress in addressing its bank sector problems and staying the worsening sovereign debt crisis. The fifteen page statement released yesterday (10/26/2011) provides a game plan, target figures and most importantly deadlines by which they must be addressed.

First, the bank recapitalization plan to achieve a core Tier 1 equity of 9% preempts local national negotiation, bring the sector in line with international peers and provides a much needed cushion against sovereign debt write-downs and weakening economic conditions. The €106 billion bank recapitalization plan is credible (see here), manageable and national driven making implementation easier. It includes €30 billion of earmarked Greek bank recapitalization, leaving new funding requirements of €76 billion of new funding. Realistically, this buys the political process more time to resolve sovereign debt issues. Banks have a tight deadline – provide a plan for capital-raising by Dec 2011 with completion by Jun 2012, ensuring sector compliance a year ahead of Basel III requirements.

The resources of the European Financial Stability Fund ((EFSF0) are to be further bolstered up to €1 trillion through a combination additional public and private market resources and leverage (projected 4x – 5x). A risk insurance scheme will also enable purchasers of new debt to purchase protection though operational details are currently sparse.

On the larger sovereign front, detailed requirements on fiscal measures, strengthening the economic union commensurate with monetary union and identifying changes to the existing treaty have also been agreed. The European Council and Eurogroup are mandated to producing a roadmap to achieve this by Dec 2011 and finalize the implementation plan by Mar 2012. As the painful and meandering negotiations to get to this point have revealed, these are critical requirements for the EU.

Market response has been understandably positive and the euphoria can last. The changes to be made are quantified and manageable, returning confidence in the sector and reversing its downward spiral. There are several strategies to participate in this upturn. First, a lack of meaningful discrimination on the way down means that nearly all names will rise. Commensurate with risk-appetite, a fine-tuning of this strategy would seek out names where price/book multiples have been the hardest hit. A preferred strategy would be to combine market nervousness driven by related balance sheet concerns despite a strong banking franchise. Names to consider here are BNP Paribas (OTC:BNOBF), Credit Suisse (NYSE:CS) and Intesa San-Paolo (OTCPK:IITOF). Core names to continue to own include HSBC (HBC) and Svenska Handelsbanken (OTCPK:SVNLF). While performing better than banks, the European insurance sector has followed a similar downward trajectory, despite offering strong opportunity. Strongest franchise positioning in the sector is found in Allianz (OTCPK:ALIZF), Generali (OTC:GDEUF) and Munich Re (MUV2-GR).

Disclosure: I am long HBC. Long ALV GR, MUV2 GR, SHBA SS