Dissecting the Clues for the Upcoming Greek Bank Stress Test Results

There are some clues that are giving investors hints for what's to come next in the Greek banking saga.

Jan 27, 2014 at 3:48PM

Most investors in Greek banks understand their investments are risky. The true extent of this risk may become known as soon as the end of this month.

The release of the stress test results stand to produce a highly volatile event into Greek bank stocks. But there are clues about the tests already available, and they could provide insight for Greek bank investors.

The stress tests
Greece's banks have been hit hard as the economy shrinks and non-performing loans (NPLs) skyrocket. These factors have combined to wreak havoc on Greek banks, forcing them to accept 27.5 billion euros in recapitalization funds last year.

But as NPLs continue to rise and economic growth remains elusive, another set of stress tests has been ordered to examine the banks again. This set is being conducted by BlackRock (NYSE:BLK) and will give investors another look at the situations at Greek banks, as well as how much additional capital could be required.

Dilution risks
In general, large bank recapitalizations have been ugly events for shareholders. This is mostly because common shares are usually issued to plug the capital hole, and that results in massive share dilution. Even when the toughest times are over and the bank rebounds to a larger market capitalization, individual shares can remain well below pre-recapitalization levels because of the far greater number of shares outstanding.

An example of recapitalization and share dilution is Citigroup (NYSE:C). Adjusting for a reverse split, pre-recapitalization Citigroup traded for more than $500 per share, but today, those shares fetch about 90% less. The collapse of Citigroup shares during its recapitalization was severe and shows the large risk present in holding bank shares through stress tests.

Greek banks are at the center of these stress tests and have significant risk associated with them now. While there are four major banks remaining in Greece, only National Bank of Greece (NYSE:NBG) trades on a major exchange in the United States. NBG has seen its share price destroyed through the Greek collapse and previous recapitalization and is now set to face another set of stress test results.

Central bank clues
Right now, there is a lot of fear surrounding NBG -- and for good reason. If the stress test results show the bank does indeed need significant amounts of new capital, shares stand to see another wave of dilution.

What we know right now are only clues as to what could be required, but those clues could be helpful for investors, or potential investors. For instance, the governor of Greece's central bank has said Greek banks will likely need more capital. That's interesting, but it leaves two questions unanswered: First, which banks need more capital? It's already widely expected that Eurobank will need more capital. If it's the only one, the stress test results would be a positive for the other Greek banks.

The second important question is: How much capital will be required? Remember, the greater amount of capital required, the greater the dilution. The central bank governor said the funds remaining in Greece's bank recapitalization fund would be adequate to cover the capital requirements. With about 8 billion euros remaining in the fund, this recapitalization should be smaller than the last one. Still, full use of this fund would result in significant dilution, so the amount of capital required is still a critical question.

Protecting your investment
From what we know so far, a few things can be reasonably assumed from current information:

  1. Large recapitalizations almost certainly mean share dilution and a lower share price.
  2. There is a lot of uncertainty around these stress test results. Should there be little or no additional capital requirements resulting from the tests, that news could propel shares higher.
  3. At least one Greek bank (almost certainly Eurobank) needs additional capital. Other banks could also require capital.
  4. This recapitalization should be smaller than the one last year, but it could still produce significant dilution.

With all of this in mind, the upcoming stress test results release is a high-risk/high-potential-reward event. In my next article, I'll discuss one way to hedge the results at a reasonable cost while not capping your upside.

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Alexander MacLennan has the following options: long January 2015 $7 calls on National Bank of Greece, long January 2015 $40 calls on Citigroup, long January 2015 $45 calls on Citigroup, long National Bank of Greece warrants (Athens listed), long March 2014 $4 puts on National Bank of Greece, long March 2014 $5 puts on National Bank of Greece. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool recommends BlackRock and owns shares of Citigroup. 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.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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.

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