The Coming Pan-European Soverign Debt Crisis

Reggie Middleton's picture

Banks are the epicenter of the economic crises that face the developed
and emerging nations over the last few years. The fact that governments worldwide have made the (generally unwise)
attempt to bailout 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 effective 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 institution 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' GDP's. So when the
nations' banks get in trouble from bad banking practices (and a very
large swath have), the nations themselves not only are helpless in
attempting to truly save the banks (and instead only institute 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 have 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 laxed 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 has 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
bank's NPA's are roughly 6% of that naion'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 reigns 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
their debt being shunned by the markets with CDS
exploding and the
big market makers in their debt refusing accept their bonds as
. This is Lehman Brothers, part deux, which actually makes
plenty of sense since the solution to the banks failing was the
government taking the failing asset risk onto the 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 bailout
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


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.


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)
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
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 Satander , 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, 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
Satander has an ADR. Subscribers can download a tear sheet on
all Spanish banks investigated here: Spanish Banking Macro Discussion Note Spanish
Banking Macro Discussion Note 2010-02-09 02:48:06 519.40 Kb

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...


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
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 (I will get into this in detail for subscribers later on this
week). Public debt stood at 94% of the GDP with the current account
deficit rising to 14% of the GDP in 2008 (deteriorating public fiances
is another concern).