European Debt Crisis: Are You In or Out?

The European debt crisis has been one long slow-motion train wreck. On Monday, Martin Wolf, the chief economics commentator at The Financial Times, suggested that a breakup of the eurozone now looks possible. Even if the eurozone remains intact, the crisis will almost certainly continue to drive money back and forth as global equity markets alternately race into and out of risky investments. That's particularly true for the source of huge risk  -- and opportunity -- at the crisis's heart: the banking sector.

The risk: eurozone banks
The euro crisis could disrupt the European banking system and financial markets far more than the fall of Lehman did in the United States. At least in that case, the U.S. government and the Federal Reserve reacted quickly and forcefully to a fluid crisis situation. But the European Union is built on bureaucracy and lengthy consensus-building; in many cases, individual countries have veto rights. It's difficult to think of an organization less suited to crisis management, and there is no established mechanism for a country to leave the eurozone. It would be fantasy to expect any exit to occur in an orderly manner.

Too many cooks are spoiling this bailout, with 17 national governments and central banks, the European Central Bank, the European Union ,and the International Monetary Fund all vying to have their say. Amid that kind of cacophony, it's not surprising investors are spooked.

Who's the basket case here?
The resulting confusion has produced some seemingly paradoxical situations -- and the potential for substantial mispricings. It's rather odd that the largest banks in France and Germany, the two pillars of the eurozone, should trade on lower book value multiples than those of Spain:

Company

Country

Price-to-Tangible Book Value Multiple

Banco Bilbao Vizcaya Argentaria (NYSE: BBVA  ) Spain 0.99
Banco Santander (NYSE: STD  ) Spain 0.82
Deutsche Bank (NYSE: DB  ) Germany 0.62
BNP Paribas France 0.51
Commerzbank Germany 0.38
Societe Generale France 0.33

The opportunity: non-eurozone European banks
Within the eurozone, the distinctions between core country banks and those in peripheral countries -- the so-called PIIGS of Portugal, Italy, Ireland, Greece and Spain -- have become blurred. However, countries' place inside or outside the eurozone remains a critical distinction. Western European EU members that haven't adopted the euro include Sweden, Denmark, and the U.K., not to mention the highly developed banking sector in Switzerland. The banks in these non-euro countries have much lower risk, and some of them look attractive.

One of Sweden's top four lenders, Swedbank, earned a 12.5% return on its common equity. It's also well-capitalized, with a Core Tier 1 Capital ratio of nearly 15%. Despite this, the shares change hands at roughly their tangible book value, and less than five times the forward earnings estimate. For reference, JPMorgan Chase (NYSE: JPM  ) , which also trades near its tangible book value, only mustered an 11.4% return with higher leverage (its Core Tier 1 ratio is 10.1%). Core Tier 1 Capital is the highest-quality capital; on that basis, Swedbank's balance sheet is leveraged less than seven times, whereas JPMorgan's is leveraged 10 times.

UBS (NYSE: UBS  ) shares also trade near their tangible book value. Their latest multibillion-dollar loss due to a rogue trader bolsters my opinion that UBS should hive off its investment banking activity. That monster is a hybrid offspring of numerous acquisitions, which collectively has never inspired confidence in its ability to manage risk. Sell the investment banking unit, and management will be free to focus their energies on the three very profitable remaining businesses: private wealth management, asset management, and Swiss banking. Those businesses ought to command a real premium over book value.

Be warned
I want to give readers fair warning: Unless you're experienced, knowledgeable, and dedicated, stock picking is best left to the professionals. That is doubly true when it comes to picking bank stocks. And whether professional or amateur, investors can't know every detail of a bank's loan or securities portfolio, or the risk and severity of a potential liquidity crisis. As such, investors venturing into this arena need to be familiar with the notion of "risk capital," and comfortable with stomach-churning volatility.

Greater volatility and greater opportunity
We have not seen the worst of this crisis. Things will get worse for the banks in the eye of the storm. However, outside the eurozone, the opportunities to buy profitable, well-capitalized institutions will only become more attractive. There is no need to rush in, but I do recommend that experienced investors begin tracking banks like UBS by adding them to your Watchlist.

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Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 21, 2011, at 5:13 PM, SisyphusRocks wrote:

    I suspect the reason that the French and German banks have lower price to book value is that they are thought to have much higher exposure to Greek bonds than the Spanish banks, e.g. Santander. I think the French banks have disclosed their approximate Greek debt holdings.

    The Spanish banks are of course heavily exposed to Spanish sovereign debt, but that seems to be less risky than Greek, Portuguese, Irish, and Italian debt these days.

  • Report this Comment On September 21, 2011, at 5:49 PM, xetn wrote:

    I found this article very informative as regards the EU, EMU and a possible break.

    http://lewrockwell.com/north/north1037.html

  • Report this Comment On September 22, 2011, at 8:07 AM, iceemaster wrote:

    I would add DnB NOR ASA a Norwegian bank. It is also outside the eurozone, has a roe of 14.11, a dividend of 7% and a p/b of .83. It trades in the us under the ticker DNBHF.PK......although very low volume.

  • Report this Comment On September 22, 2011, at 8:23 AM, malcolmcochran wrote:

    Youe caution at the end is good. It really is impossible to know what's what. That's been ultra-true of any bank, as most of us know to our cost, directly or indirectly.

    Bank metrics are like the Titanic's iceberg.

    About ten years ago, or less, I thought Danskebank. Yup, I'm in. Non-Euro, but near-Euro, &% dividend, sane advances into Poland.

    First, my 7% was taxed at 35% at source, then (greedy) US investment houses (I listened to the conference call) thought they weren't expanding fast enough and wouldn't show ROI after taking over a Finnish bank.

    So big sell off.

    Wonder how Danske bank has fared? Either way,

    I agree you gotta be cautious.

  • Report this Comment On September 22, 2011, at 9:48 AM, ihtfp92 wrote:

    How about a hedge? Given the enormous volatility of these stocks a portfolio that was insensitive to the overall European banking crisis could be built as follows:

    Long:

    DB

    UBS

    Short:

    BBVA

    STD

    If both higher and lower quality stocks are being equally hammered then the long term outlook for such a construct should be much less volatile and significantly positive.

  • Report this Comment On September 22, 2011, at 11:58 AM, pastreet wrote:

    Cheap stocks! What I don't understand is why people are panicking and selling shares of already cheap (American) companies. Looks like a good old fashioned fire sale. Be greedy when others are fearful.

    Pat

    www.compoundingreturns.com

  • Report this Comment On September 22, 2011, at 12:17 PM, joaquingrech wrote:

    Note: I'm from Spain

    Spanish banks do not have major investments on greek's debt and are considered among the safest in the european union. I'm talking the 2 biggest banks: BBVA and Santander.

    Then you have "cajas" which are something like a community bank, which are horrible, but they are not linked to BBVA or Santander.

    Both of the major banks were top ranked on the stress test, above german's and french's banks. Also these two banks have close to 50% of their customer base outside europe: latin america. So... that's why they are considered safer than the others.

    Keep in mind that just because companies are based on a country (spain) it does not mean that their economics is linked to them. Nowdays everything is international, so don't assume that geographic location = economic location.

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