You can see the (so far totally inadequate) preparations for a Greek default slowly falling into place

10/07/2011 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

This is how it starts. With the strongest banks announcing bigger write-downs. With weaker banks breaking into pieces, putting the healthier parts up for sale, and looking to create a bad bank to house the worst assets. With governments extending guarantees and promises of guarantees in an effort to calm financial markets. With some governments pushing hard to recognize hard financial truths. With other governments going into a defensive crouch.

Yes, this is how preparations for a Greek default begin. So far the moves are slow and piecemeal, aimed at preventing a panic that would spread destruction across weak and strong European banks alike. And there’s certainly nothing yet that resembles a unified EuroZone response.

And the lack of a common response isn’t actually the worst problem in the early preparations for a Greek default. So far all the effort is aimed at stabilizing the banking sector with no credible preparation that I can see on preventing a Greek default endangering Portugal or Italy, the two most vulnerable EuroZone members. While guaranteeing Europe’s banks is necessary to prevent a Greek default from taking down the EuroZone’s financial system, it is by no means enough to tackle what long ago ceased to be a Greek debt crisis and become a euro debt crisis.

The real danger now is that the political and financial leaders of the EuroZone will decide that getting the regions banks ready for a Greek default is enough. If they don’t figure out a way to build an effective barricade in front of Portugal and Italy at a minimum and Spain and France as well to be absolutely safe, then, in my opinion a Greek default will quickly lead the financial markets to start pricing in other defaults.

There’s still time to put those barricades in place, but the carpenters seem already fully occupied with the work of building the scaffolding to protect the banks from a Greek default. It’s by no means clear that this effort will be in time or adequate. But I sure don’t see any signs of a work order for protection for the EuroZone’s troubled countries. (For my most recent take on when Greece will default see my September 23 post http://jubakpicks.com/2011/09/23/greece-will-default-when-its-in-the-countrys-self-interest-sometime-in-2012/)

Let’s see what we can learn from the hammering and sawing now going on about the work being done to prepare for a Greek default and how much more needs to be done.

For the EuroZone’s strongest banks, preparing for a Greek default means writing down Greek government debt even further, announcing a big hit to profits, and tightening costs another notch or two. For example, Deutsche Bank (DB) announced on October 4 that it would write down its Greek debt holdings by another $250 million. That write down will be reflected in the bank’s third quarter earnings report scheduled for October 25.

Forget about that full–year target for pre-tax profits of $13 billion. Third quarter results will be lower than expected although the bank would remain profitable for the period, said CEO Josef Ackermann. To cut costs going forward the bank will eliminate about 500 jobs in its corporate banking and securities division over the net six months.

Not pleasant certainly (especially for those getting let go into a slowing global economy—most of the job cuts will come from outside Germany.)

For the EuroZone’s weakest banks, preparing for a Greek default means breaking up, selling off what can be sold, and creating a bad bank stump.  At least that’s the plan being forced on Dexia, the French-Belgian lender. (I say lender instead of bank because most of the company’s business is in arranging financing for municipalities although it does operate a retail bank in Belgium, a private bank in Luxembourg, a retail lender in Turkey, and an asset management business.) Dexia required a government rescue in the dark days following on the Lehman Bros. bankruptcy in 2008. Now Dexia is back at the table again, looking for government support that would save it from losses in its portfolio of almost $28 billion in debt from Greece and other troubled EuroZone countries. That portfolio has made it impossible for Dexia to fund its operations by borrowing in the financial markets. Again.

What went wrong on Dexia? In a nut shell the lender ran out of time to fix the problems left over from 2008.

In the years before the mortgage-backed asset, real estate lending boom burst in 2008 Dexia had padded its profit margins by funding itself with cheap short-term money raised from money market funds and similar sources of short-term cash. That was great—borrowing really cheap in the short-term markets and lending less cheaply in the long-term markets can be very profitable—until the short-term markets froze and no one would lend Dexia money any more. At the time of the first Dexia bailout, the lender needed to tap short-term markets for about $350 billion to fund its operations. That was $350 billion that the lender suddenly found itself unable to borrow.

Dexia would up borrowing $58.5 billion by the end of December 2008 from the U.S. Federal Reserve (yes, in 2008 the Fed acted as lender of last resort to the world in order to avert a meltdown of the global financial system) and also received an $8.4 billion bailout from France and Belgium.

The new management team brought in after France and Belgium bailed out Dexia in 2008 worked to reduce the lender’s reliance on short-term capital. By late June the funding gap was down to $140 billion. Huge progress but not enough when the short-term capital markets shut down again—at least for companies such as Dexia—this summer.

Now the plan is to put roughly $130 billion in troubled assets (clearly more than the $30 billion in troubled sovereign debt) into a bad bank. The bank would be backed by guarantees from the French and Belgian governments. In addition the governments will guarantee that customers of the Belgian retail bank won’t lose any money.

Additional funding would come from money raised from the sale of its healthy divisions such as the asset management business and the Turkish retail lender, DenizBank.

The municipal lending business will either be allowed to run down or merged with the French sovereign wealth fund or the retail-banking arm of the French post office. (Not so coincidently some of Dexia’s biggest municipal customers are French.)

For the rest of Europe’s banks, preparing for a Greek default means figuring out which of these two alternatives—Deutsche Bank or Dexia—describes the real state of any specific bank.

You see the Dexia collapse presents just one tiny challenge: Dexia got a clean bill of health in the second new and improved stress test run by the European Banking Authority on European banks back in June. Not only did Dexia pass the test but it also got one of the highest scores passed out. Out of the 91 financial institutions tested Dexia came in 12th with a core tier one capital ratio of 10.4%. That was more than double the 5% level required to pass.

If Dexia needs a bailout in September after passing the stress test in July, there’s a really good chance that the test either got its math wrong or tested for the wrong things. In either case Dexia’s collapse so soon after passing the test means that the global financial markets don’t have a clue what banks—beyond a handful of high profile banks with big retail deposit bases such as, oddly enough considering the troubles Spain is in, Spain’s Banco Santander (STD) and Banco Bilbao Vizcaya (BBVA)--are sound and what banks aren’t. The safest thing to do is say, “The hell with all of them and refuse to do business with any European bank.”

No wonder then that the BIG topic at the recently concluded meeting of EuroZone finance ministers was boosting bank capital. Exactly how seems, if you’ll pardon the expression, vague.

There’s no credible talk of another round of stress tests and the fall back position seems to be let national bank regulators do it. Of course, these are the folks who, in France, to name just one instance, have helped banks such as BNP Paribas, Credit Agricole, and Societe Generale resist demands to write their Greek debt down to market prices.

“Time is running out” to establish if recapitalization is necessary, German Chancellor Angela Merkel said today. Troubled banks should first attempt to raise capital on their own and then call on national governments for help. Of course, financial companies are understandably reluctant to admit that they’re undercapitalized. The unrealized losses in Dexia portfolio came to $11 billion compared to the company’s equity base of $21 billion. Tangible equity estimated at $9.8 billion falls to $7 billion after write-downs on Greek and Italian sovereign debt, the Financial Times calculates.

Dexia should have known it was in trouble long ago.

Strikes me that Merkel’s making a wish rather than stating a plan. She has said she’s in favor of recapitalizing European banks “if there is a joint assessment that the banks aren’t adequately capitalized.”

Which is, of course, exactly what there isn’t.

Right now the prospect is that some countries, Germany most prominently, are pressing ahead on their own to force weaker banks to raise capital at the same time as the government is putting back in place the system that it used to create bad banks after the Lehman bankruptcy in 2008.

Other countries, France most prominently, still seem to be in denial about problems at the country’s biggest banks. Dexia isn’t an indicator of potential problems at BNP Paribas or Credit Agricole or Societe Generale seems to be the French position.

And creating barricades to prevent any default by Greece from rippling out to Portugal or Italy? Even vaguer than the plan to recapitalize European banks.

I think there’s a good chance that the EuroZone’s AAA-rated countries will force Greece into default or that Greece will decide the pain isn’t worth it anymore sometime in early 2012. (I hope it’s not in December but it could be that early.)

How confident do you feel that, at this pace, Europe will be ready?

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund didn’t own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

 

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