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Invest in a European bank? It's not too mad... - Outside View by MoneyWeek

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Invest in a European bank? It's not too mad...
Nov 30, 2011

Many of Europe's banks are in big trouble.

They've lent far too much money to the wrong European governments. As the eurozone crisis worsens, the value of those loans is dropping fast. In turn, this is damaging the banks, as we explain below.

Bank shareholders are hurting too - and not just because share prices have plunged. Banks used to be a good source of decent dividend income. Not any more.

However, one European country was savvy enough to sort out its banks well before the current crop of calamities. And yet its banking sector has been punished along with the rest.

That means there may still be an opportunity here for more adventurous investors...

European banks are in a mess

The eurozone's woes just keep getting worse. Now it's Italy's turn to feel the heat, as John Stepek explained yesterday: What does Italy's crisis mean for your money?

As he points out, "Italy is the third biggest bond market in the world. Banks across Europe have significant exposure to the country's debt. To draw an analogy to the 2008 crisis, if Greece was Bear Stearns, then Italy is Europe's Lehman Brothers".

How has this happened? Italy has racked up a mammoth pile of debt over the years. The current ratio of national debt (what the country owes) to GDP is about 120%. Italy has funded this by selling its bonds to investors, including banks.

Until the last few months, the markets had somehow assumed that this debt pile wasn't such a huge problem. If push came to shove, or so the thinking went, Germany would pick up the final tab.

But markets are now having a major rethink. The Germans show no desire to shell out ever-increasing sums on bailing out the likes of Italy. In turn, that means the risks of holding Italian sovereign debt are climbing fast.

And as the yield on Italian bonds rises fast, their value drops (the coupon, or payout, on these bonds is fixed, so when yields rise, it's because prices are falling).

So big holders, which include many eurozone banks, will have to write down the value of these assets. That will create gaping holes in lenders' balance sheets. So the region's banks will need to raise vast sums of new capital.

In the meantime, bank dividends are being axed. Take French giant Societe Generale. It was - in theory - paying a 10% yield. But this week the board axed the next dividend payment.

Net result: shareholders are sitting on a stock that's plunged in value by two-thirds within the last nine months. And they aren't likely to receive any income from their investment for another year and a half.

In short, we're looking at a banking horror story.

The eurozone should have learned from Sweden

It's a real shame the eurozone hasn't dealt with its banks the way they've done it further north - in Sweden.

Sweden got its act together on its banks at the start of 2009. Seeing that there were potential problems ahead, it recapitalised lenders via a mix of private money and state support.

Further, the government made sure of something else early on. Any Swedish bank that joined the state-organised scheme had to stop paying bonuses and freeze top management's pay.

Of course, it helped that Sweden has past form on bank bail-outs. The government was able to draw on how it had handled a huge problem in the sector in the 1990s.

Back then, a mix of bad regulation, short-term economic policy and a burst property bubble had left the country's banks almost bust. But instead of bending over backwards to keep the banks happy in the hope that the boom days would somehow rematerialise, the Swedish government took decisive action.

The government (ie the taxpayers) didn't just take over financial firms' bad debts. They also forced through big asset write-downs, which meant that shareholders had to take losses on the chin.

Rules on lending were toughened to ensure that banks had to become much more responsible.

And the banks were also made to issue stock to the government. So when the recovery came, and the banks were able to sell off their toxic assets, taxpayers got the benefit. And the government made more money later by selling its bank shares too.

Sweden's banks have slid along with the rest

Armed with this experience, the Swedish bank rescue model that restarted two years ago had a better-than-average chance of success. And so it has proved. "Sweden's commitment to enforcing rigorous standards has paid off", says Johan Carlstrom on Bloomberg.

The country's banks are better capitalised than most of their European and US rivals, and have better access to funding markets and a lower risk of default. "Tougher controls enacted during the Swedish banking crisis of the 1990s also protected the state budget, which will be in surplus this year."

In other words, Sweden's banks aren't a drain on the public purse. Unlike the UK, which turned a blind eye to bank lending excesses until too late, and the eurozone, which is in the hole we talked about above.

What's more, Swedish banks are able to do what banks are supposed to do - lend money. That's good news for both bank shareholders and the Swedish economy.

Small wonder that "investors have come to view [Swedish banks] as a relative haven during the sovereign debt crisis", says Espen Furnes, at Storebrand Asset Management.

Yet Swedish bank shares have still been dragged down by the overall turmoil. Nordea Bank (SS: NDA) is still 13.5% owned by the government, which had been hoping to sell its stake. That plan has since been shelved as Nordea's price has dropped by 20% since the start of August.

But that has left Nordea on a current year p/e of just nine, and with a prospective yield of 5%, forecast to rise to 5.7% in 2012. For a bank these days, that's a very decent dividend.

This article is authored by MoneyWeek, the UKs best selling financial magazine. MoneyWeek offers intelligent, easy-to-read analysis of the financial news, with practical investment advice.

Disclaimer:

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