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How Broken Are European Banks? Can They Be Saved?

By Investing.com (Clement Thibault/Investing.com)Stock MarketsJul 11, 2016 07:02AM ET
www.investing.com/analysis/european-banks:-how-toxic-are-they-200141001
How Broken Are European Banks? Can They Be Saved?
By Investing.com (Clement Thibault/Investing.com)   |  Jul 11, 2016 07:02AM ET
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by Clement Thibault

It’s been a rough decade so far for the banking sector. Beginning with the dramatic failure of highly-leveraged Bear Stearns and its subsequent sale to JP Morgan (NYSE:JPM) in mid-March 2008, through the collapse of Lehman Brothers in September 2008—the largest bankruptcy filing in U.S history—the world of banking has been unable to recover.

And the current economic environment isn't helping: low-to-negative interest rates, falling bond yields that don't seem to have a bottom, ongoing housing bubbles in a variety of global markets, oil-related insolvencies and underperforming loan portfolios mean the profitability, not to mention stability, of many international banks is in question. This is particularly true of European banks, which can't seem to catch a break.

If it's not a global financial crisis, it's bad oil loans, which for example have forced Bank of America (NYSE:BAC) to add a billion dollars to its rainy day fund as a contingency measure. And then of course there's the Greek debt repayment, of which $28 billion is held by a consortium of German banks, while France's Credit Agricole (PA:CAGR) on its own holds 3.5 billion euros ($3.86B), making it the most exposed of Europe's commercial banks.

And don't forget Brexit, the most recent hit to Europe's banks. It has ravaged the UK financial sector, causing banks such as the Royal Bank of Scotland (LON:RBS), Lloyds (LON:LLOY), and Barclays (LON:BARC), to drop tens of percents.

The charts of some European banks paint a grim picture that underscores a number of clear and rather stark truths. First, not a single European big bank has completely recovered from the 2008 financial crisis. While some American banks and financial institutions—such as Wells Fargo (NYSE:WFC) or JPMorgan—have managed to reclaim their highs prior to the crisis, things have never been the same for European banks.

Deutsche Bank (NYSE:DB), for example, traded at a high of $139 per share prior to the 2008 crisis. Its post-crash high during October 2009 was $73, a bit over half its previous value. It's currently trading below $13.

DB Monthly 2006-2016
DB Monthly 2006-2016

Credit Suisse (NYSE:CS) traded for about $75 dollar at its pre-2008 high, but never regained that level. The closest it came was $57 during October 2009. It's now trading at less than $10.50

CS Monthly 2006-2016
CS Monthly 2006-2016

It's worth noting that the post-crisis highs mentioned above were due to a rally in 2009, but neither bank ever stabilized at those prices.

Unfortunately, the financial crisis only started the downward trend. Even assuming you had succeeded in timing the market and bought DB or CS shares at each of their lowest points during the financial crisis, you would have paid $18 per share for Deutsche Bank and $17 per share for Credit Suisse. That looks expensive compared to today's prices.Clearly, based on current prices, the ECB's entire multiyear stimulus plan has neither fixed the core problems nor rehabilitated investor trust in the financial system.

Then, just when you think European banks have finally hit rock bottom, there's more to be concerned about. The results of the Fed's annual stress tests were released at the end of June, raising additional worries.

While just about all major US banks (except Morgan Stanley (NYSE:MS)) passed, the American subsidiaries of two European banks, Deutsche Bank and Spain's Santander (NYSE:SAN) failed, as they already had for the past three and two years respectively. Worse still, the IMF recently described Deutsche Bank as the biggest potential threat to the global financial system. And it's not alone. Credit Suisse came in third on the IMF's most dangerous bank list, right behind yet another European peer, London-based HSBC (LON:HSBA).

And another danger for major European banks approaches—the September re-evaluation of the Euro Stoxx 50 Index. According to SocGen analysts, both Deutsche Bank and Credit Suisse could find themselves kicked off the index because of their severely diminished market caps, which have gone from $48.3B to $17.7B and $57.1B to $20.3B respectively, based on the current share price of each vs their 52-week highs.

This would obviously be very bad news for both banks, and could likely trigger additional selling, making it even costlier for each to raise much needed capital. Which could ultimately trigger a death spiral for either...or both.

Right now, there really is only one question on everyone's mind: if any of the big European banks fail, will there be a bailout after all the QE that's already been injected along with the ECB's efforts to correct the problem? The answer is subject to fierce debate.

Some believe central banks don't have the firepower necessary to go bail out a major bank. Others argue that morally, they shouldn't. Plus, given the global reach of both Deutsche and Credit Suisse, a bailout would not necessarily be a strictly European affair. The US government, along with the Fed would have to get involved one way or another if a bailout effort was called for, simply to avert any domino effect that could have an adverse impact on the US economy.

If you believe that European banks won't fail, it's a good bet you may already own shares of the big European banks. And if you believe there will be a bailout, you're not wrong to invest in either bank, since each trades at a major discount right now. Deutsche Bank trades at 26% of its book value. That's four dollars of Deutsche Bank assets for every dollar you are willing to invest. Credit Suisse's magic ratio is 44% of book value. But it's a risky proposition.

Riskier still is the Italian banking sector, and no article about European banks would be complete without also considering the current state of Italian banks. Those who follow the market have surely noticed Banca Monte dei Paschi di Siena's (MI:BMPS) wild volume swings and stock price movement over the past three weeks.

BMPS Monthly 2006-2016
BMPS Monthly 2006-2016

This bank desperately needs some sort of public contribution to its recapitalization, but the EU's stance remains uncertain. Monte dei Paschi di Siena is just one example of the dire state of the Italian banking sector, as Italian PM Matteo Renzi's plea for an emergency 40 billion euro ($44B) bailout for the Italian banking sector has been vetoed by Germany.

Current estimates show that as much as 17% of loans on Italian balance sheets are bad, compared to 5% in the US during the 2008 crisis. The reputation of Italy's financial sector as corrupt and clubby will no doubt make it harder for Italy to secure European taxpayer money. Still, Banca Monte dei Paschi trades at 8% of its book value. Nevertheless, there may not be any way to profit from the failure of this institution, or perhaps others of similar caliber. Insolvency cases usually last up to eight years in Italy.

We assume many European banks will continue their downward spiral until additional, fresh stimulus—or a sizeable injection of public funds—is allocated for recapitalization of the weakest institutions. And while we're no longer living in the 2008 economic environment, and trillions of dollars have already been spent on QE to help rectify that situation, it would surprise us if Germany or Switzerland, either independently or as part of the European Union, would let their flagship financial institutions fail.

For Italian banks the situation is more precarious. Italy isn't a financial powerhouse which means Italian banks will continue to have trouble finding political support for an EU or other publicly funded intervention. Eventually the ECB and Fed will have to evaluate the extent of the possible systemic damage from the entire Italian financial system.

There won't be political favors incurred. And, should a bailout be extended, it will probably happen with much harsher terms than Deutsche Bank or Credit Suisse would receive.

How Broken Are European Banks? Can They Be Saved?
 

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How Broken Are European Banks? Can They Be Saved?

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Karsten Reuß
karstenreuss Jul 11, 2016 4:01PM ET
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It worries me. I think the banking industry in Europe will change a lot and it could cause an economuc earthquake. There are several challenges traditional banks face. E.g the low interest rates, customers organizing everything with internet and new types of fnancial services (Fintecs) becoming more and more attractive.
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Giuseppe Trussardi
Giuseppe Trussardi Jul 11, 2016 8:21AM ET
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You really don't know the situation of italian banks that is largest better than reported in this article. Last years they purchased a lot of italian tresury bond at lower price.In balance sheet they are valued at historical price. Now Italian banks haveenormous latent gains.
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Sam Samuels
Sam Samuels Jul 11, 2016 8:21AM ET
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Hey Giuseppe, rumor has it that bank runs have already begun in Italia.....
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Sam Samuels
Sam Samuels Jul 11, 2016 8:21AM ET
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Hey Giuseppe, rumor has it that bank runs have already begun in Italia.... Better get to the bank...
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Giuseppe Trussardi
Giuseppe Trussardi Jul 11, 2016 8:21AM ET
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Hallo Sam, that rumors are wrong ...you will see.... the saving of italian people is high and it is totally intermediated. by banks. The recovery in Italy is in progress and new bad loans decrease helped by Atlante Fund created by italian banking system.. When all are selling you must buy.......
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