A strong foundation of assets is key to making big profits for big banks and the largest international banks hold trillions in assets across a variety of units. So with having large amounts of assets being key to producing profits, why did European banks Commerzbank AG (NASDAQOTH:CRZBY), Bank of Ireland (NASDAQOTH:IREBY), and National Bank of Greece (UNKNOWN:NBG.DL) shed a combined 2 trillion euros in assets last year with more assets sales expected this year?
Like American banks that saw the recession hit loan books hard, European banks were left with lots of assets that were once good but became sour after borrowers couldn't repay. Commerzbank AG, a bank that has seen a more the 90% drop in its share price, has seen first hand the power of souring loans on bank share prices. Prior to the financial crisis, Commerzbank moved heavily into making loans to ocean shipping companies. Unfortunately for the bank, these shipping companies were hit hard by the crisis with many going bankrupt and others becoming non investment grade.
Ireland's banks experienced a similar rise in toxic assets after the Irish real estate market went belly up during the recession. Even Ireland's strongest bank, Bank of Ireland, sold largest amounts of its toxic assets to the nation's National Asset Management Agency (NAMA), a state-sponsored bad bank designed to take toxic assets off bank books.
A similar problem hit Greek banks as well. The economic crisis in Greece destroyed real estate values, and homeowners were increasingly without the funds to pay their bills. National Bank of Greece has been looking to clean up its balance sheet by finding a way to deal with non-performing loans, but the problem is an ongoing one as Greece's economy remains shaky.
A stressful time
European banks have been in a particular rush to sell these toxic assets due to the upcoming stress tests that impact all major European banks. Of particular concern for the banks is the expectation that this round of stress tests will be tougher and more through than the tests conducted in past years.
The risks of failing the stress tests are significant. At a minimum, it would mean cutting back or restricting dividends, but could turn into share sales bringing even more dilution to bank shareholders. In a worst case scenario, failing banks would require more government cash triggering harsh penalties for private investors.
Obviously, big banks want to avoid these forms of capital raising and would rather raise capital by selling off non-core and toxic assets. Commerzbank has been lining up assets sales for some time and reports progress on this key figure alongside earnings. National Bank of Greece has also been focused on selling non-core assets but is running a share and debt offering to plug most of its current capital gap.
Cleaning up the banks
Even after these sales, European banks still hold billions in non-performing loans and toxic assets with billions more in non-core operations that banks are looking to sell to raise capital and reorganize.
As stress tests approach in 2014, expect more asset sales throughout the year as banks work to raise the capital they need to prevent dividend reduction or share dilution.
Alexander MacLennan owns shares of Bank of Ireland (Irish listed) and Commerzbank AG (German listed). He also has the following options: long January 2015 $7 calls on National Bank of Greece (ADR) and long December 2017 National Bank of Greece warrants. 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 has no position in any of the stocks mentioned. 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.