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This week all
eyes are on Greece and Italy, which is reasonable since they're likely to be
pretty entertaining. But as incredible as it sounds, PIIGS country sovereign
debt might not be the biggest banking-system threat on the immediate horizon.
It turns out that the largest European banks have held onto -- and apparently
failed to mark down -- a mountain of crappy paper from the housing bubble.
From today's Wall Street Journal:
Old Debts Dog Europe's Banks
European
banks are sitting on heaps of exotic mortgage products and other risky assets
that predate the financial crisis, adding to pressure on lenders that also
are holding large quantities of euro-zone government debt.
Four years
after instruments like "collateralized debt obligations" and
"leveraged loans" became dirty words because of the massive losses
they inflicted on holders, European banks still own tens of billions of euros
of such assets. They also have sizable portfolios of U.S. commercial real-estate
loans and subprime mortgages that could remain under pressure until the
global economy recovers.
While the
assets largely originated in the U.S. financial system, top American banks
have moved faster than their European counterparts to rid themselves of the
majority of such detritus.
Sixteen top
European banks are holding a total of about €386 billion ($532 billion)
of potentially suspect credit-market and real-estate assets, according to a
recent report by Credit Suisse analysts. That's more than the €339
billion of Greek, Irish, Italian, Portuguese and Spanish government debt that
those same banks were holding at the end of last year, according to European
"stress test" data.
Many are
holding tens of billions of euros of bonds issued by financially shaky
countries. They are holding hundreds of billions more in loans to customers
in those same countries, which are likely to go bad at an increasing clip if
Europe's economy continues to struggle.
The large
amount of structured-credit assets still on European banks' books
"clearly heightens the importance of capital that banks need," said
Kian Abouhossein, head of
European banks research at J.P. Morgan. Until now, "they just haven't
taken the hits."
Banks in the
U.K., France and Germany are the biggest holders of such assets, even after
chipping away at their exposures. The four biggest British banks reduced
their holdings by more than half since 2007, while four French banks trimmed
theirs by less than 30%.
Barclays PLC,
for example, is sitting on about £17.9 billion as of Sept. 30, down
from £23.9 billion at the start of the year. The assets, which landed
on the giant U.K. bank's books before mid-2007, include collateralized debt
obligations, composed of securities backed by assets like mortgages,
commercial real-estate loans and leveraged loans that helped finance boom-era
corporate buyout deals. Barclays executives say they
have made good progress reducing their portfolio by selling assets or letting
them mature.
At roughly
€28 billion, Crédit Agricole SA has the biggest portfolio of such assets
among French banks, according to Credit Suisse. The bank's June 30 financial
report includes €8.6 billion of CDOs backed by U.S. residential
mortgages.
On top of
that, Crédit Agricole
also has at least €1 billion of U.S. mortgage-backed securities, some
composed of subprime loans. With the U.S. real-estate market still hurting,
further losses are possible in all these securities.
A Crédit Agricole
spokeswoman declined to comment.
Legacy assets
are also haunting Deutsche Bank AG. The Frankfurt-based bank is holding
€2.9 billion in U.S. residential mortgage assets, including subprime
loans. It has an additional €20.2 billion tied up in commercial
mortgages and whole loans. The bank says it has hedged nearly all of its residential
mortgage exposure.
Analysts at Mediobanca estimate that Deutsche's
exposure to such assets amounts to more than 150% of its tangible equity--a
key measure of its ability to absorb unexpected losses.
Some thoughts:
Here's the
crucial sentence: "Many [European banks] are holding tens of billions
of euros of bonds issued by financially shaky countries. They are holding
hundreds of billions more in loans to customers in those same countries,
which are likely to go bad at an increasing clip if Europe's economy
continues to struggle."
In other
words, these banks are on the hook not just for, say, Greek government debt,
but for securities built from Greek private sector real estate debt. So the
austerity measures now being imposed on the PIIGS countries might or might
not be good for public sector balance sheets, but will -- if they slow the
PIIGS economies -- be horrendous for local real estate projects. The fact
that the big European banks are actually more exposed to old-style toxic real
estate securities and their related derivatives means that even if the EU
miraculously solves the sovereign debt crisis, the balance sheets of these
banks could still implode -- as a result of the austerity plans.
Another
interesting sentence: "[Deutsche Bank] says it has hedged nearly all
of its residential mortgage exposure." It's amazing that banks still
present their credit default swaps as a valid type of insurance. The fact is
that they're actually a huge threat to the very investments they're designed
to protect, because asking the guarantor (i.e. the counterparty) to make good
on the policy risks bankrupting them, crashing the banking system and making
the crappy mortgaged-backed paper even less valuable. So no, Deutsche Bank,
you're not hedged and everyone who understands these markets knows you're
either delusional or dishonest.
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