European Banks: Too Big To Fail Redux

by: Vincent Deluard, CFA

European banks have been the whipping boy of equity markets. The iShares MSCI European Financials Index (NASDAQ:EUFN) is down 23% for the year, against a gain of 1.2% for SPDR (NYSEARCA:SPY). A quick scan through the sector shows the extent of the decimation. 40 of the top 50 largest European banks trade for less than their book value. In theory, a price to book value ratio of less than 1.0 means that a company is worth more dead than alive, i.e., an investor could scoop up the bank, sell its assets, pay all its liabilities and turn out a profit.

Of course, this analysis depends on whether banks tell the truth about the value of their assets - a big “if” given the likely large haircuts that many European sovereign bonds will suffer.

The fate of European banks is intrinsically tied to the outcome of the sovereign debt crisis, which is why most analysts would not touch the sector. In my quick review of analysts’ recommendations on the sector, sell recommendations outnumbered buys by a ratio of 3 to 1 (which should be reason enough for contrarian investors to take a closer look at the sector). No doubt the bearish case for European banks is impressive.

  1. Large exposure to insolvent European governments: for example, BNP Paribas’ exposure to Greek sovereign debt is estimated at €5 billion, or 8% of the bank’s equity.
  2. Miserable prospects for retail banking. Spanish GDP growth is essentially zero and the French government just cut its 2012 growth forecast to 1.0% (still above most economists’ predictions)
  3. Large exposure to moribund real estate market: about 70% of residential house sales in Spain are linked to repossessed properties, which will prevent any meaningful recovery of the sector in the short-term.
  4. Rising funding costs: no Spanish bank was able to obtain funding for less than 4% this year. Issues have been extremely light as most Spanish and Italian banks have relied on the European Central Bank for financing.
  5. Negative impact of upcoming regulation: European banks will need to raise a lot of capital to comply with Basel 3 requirements, which will dilute future earnings. The European Banking Authority’s stress tests revealed a €26 billion capital shortfall for Spain alone.

However, this negative outlook is already baked into banks’ current stock prices. 18 of the top 50 European banks trade at a price to book ratio of less than 0.5. These banks could write down their assets by half and still look cheap.

In addition, many of these banks offer dividend yields in excess of 5%: Société Générale (OTCPK:SCGLF) 9.3%; Crédit Agricole (OTCPK:CRARF) 8.7%; BNP Paribas (OTCQX:BNPQY) 6.7%; DnB NOR Bank (OTCPK:DNBHF) 6.1%; Banco Santander (NYSE:SAN) 5.2% - something to consider in a yield-starved world.

Investors and analysts are so focused on what could go wrong that they forget the few bright spots for the industry. Some of these banks are unfairly lumped with the European debt crisis even though they derive most of their earnings from emerging markets. BBVA (NYSE:BBVA) derives more profits from its Latin American activities than it does in continental Europe. Standard Chartered (STAN) derives 90% of its revenues from emerging markets. But these two banks still suffer from the discount applied to European banks, trading at 0.7 and 1.2 times book value, respectively.

The bears are right to point that the fate of the sector ultimately depends on the resolution of the European debt crisis. They are also right to believe that things will get a lot worse before they get better and that there is no silver bullet to the crisis. But they are wrong to conclude that investors should avoid the European banking sector altogether.

Most of these banks are genuinely too big to fail. Crédit Agricole, Société Générale and BNP Paribas collectively account for about 53% of all French deposits. BBVA (BBVA) and Banco Santander (SAN) are staples of every Spanish retail investor’s portfolios. After the experience of Lehman Brothers in 2008, which European government would think that it is a good idea to let a large bank fail?

Investing in European banks is putting a lot of faith in the action of European governments. The awkwardness of the Merkozy duo, the tragic farce of Italian politics and the repeated communication gaffes of the European Central Bank are not exactly inspiring trust. But whether you like it or not, you are already exposed to the European debt crisis. Your money market fund already owns European banks’ commercial paper. Your bank is a big counterparty to these European banks. If Italy or Spain goes under, the International Monetary Fund, and ultimately your tax dollars, will be called to the rescue.

Since we are already exposed to the downside end-of-the-world scenario, why not get some upside by playing the rebound on some of these names? In many ways, European bank stocks are trading like U.S. banks did in late 2008. Nobody believes that they are telling the truth about their books, leading to extreme volatility. Rumors spread like wild fire. The “b” word is on everybody’s mouth. Analysts are as bearish as can be. Your gut tells you to run for the hills. Buying banks in this environment feels terribly scary.

Yet there was more money to be made on the upside than on the downside: most U.S. bank stocks doubled in the second two quarters of 2009.

Disclosure: I am long BBVA.

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