|Shares Out. (in M):||899||P/E||0.0x||0.0x|
|Market Cap (in $M):||34,620||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
Up until this week my assessment of the chances of euro currency failure (which I define as either break-up or granting ECB permission to print) had been 60-40 but I now feel it’s at least 80-20. For those of you who want to hedge a portfolio against the unknowns that come next, I suggest shorting DB, a liquid stock that has the potential to decline to $11-12, which I calculate by taking adjusted tangible equity assuming no further write downs and running a dilution scenario that would take the stock down to 10x leverage (i.e. government taking equity or equity-linked stakes just as in the U.S.). European banks are simply too leveraged. The catalysts are close in my view.
Inability to Coordinate an OK Down-to-Earth Plan
My 80-20 view isn’t based on any liquidity jitters, derivatives disasters, bank runs or scary balance sheet items. Rather, the thesis centers on the surprising lack of co-ordination and pre-planning at the most senior levels in the eurozone. When things are this bad and people repeatedly fail to learn the importance of working out the details, one must conclude that somewhere there is at least a partial lack of political will to make it all work.
Yesterday Prime Minister Papandreou announced it would subject the latest bail-out plan to a referendum, giving in to pressure from the opposition at the risk of losing support in his own party. Facing a no-confidence vote, he’s using this tactic for getting a better deal. But he didn’t even tell his finance minster about it. Merkel and Sarkozy are obviously livid and other leaders agree that this adds to instability, uncertainty and delays the implementation of the latest plan. This all might make sense politically for Papandreou but it surely is a unique sight to see how little unity exists in Europe a mere 5 days after the grandest bail-out plan.
From Dow Jones today:
“The announcement "has created substantial uncertainty in markets," Michael Kemmer, managing director of the German BdB bank lobby group, said. As a result, "important detail planning following the EU summit will now be delayed, or at worst, put on ice," Kemmer said in an emailed statement.
Another person familiar with the German banking industry said a Greek "No" would remove the "business foundation" for the entire bailout package, adding it isn't clear what a new plan would look like, as politicians had already reached their limits of what is feasible. “
When the Euro was created, countries took on the obligation to keep their deficit to 3%. It took *years* to discover that some had been cheating and/or were unable to sustain 3% in the long term. Only then did the members start talking to each other seriously; the EFSF was created in June 2010. Numerous analysts said at the time that it isn’t enough but politicians of course pressed on. It took *months* for liquidity issues to resurface and on July 21st of this year the Europeans put in place a ‘final’ plan to strengthen the eurozone, including private sector haircuts, with a goal of helping Greece while ring-fencing Italy and Spain. It took *weeks* for the market to make a total mockery of that plan and eventually a leveraged EFSF idea began to make headlines. In the early morning last Thursday, Europe announced a giant plan that was supposed to be the grand-daddy of them all but analysts, commentators and the markets have completely proven the weakness of that plan within *days*.
Years; months; weeks; days: it is getting exponentially harder for them to keep markets stable when measured in units of time. And it shouldn’t be surprising because the lack of communication is profound. On Saturday the 22nd when they sat down for a meeting, it turned into a shouting free-for-all which was described as an uncontrolled mess. Apparently it was the first time many of these leaders looked at the numbers. Four days later they still came out with a plan. How can did such a nice outcome come about? Because it’s only nice on the surface, it’s all talk. The shortcomings of the plan have been detailed everywhere so let’s just summarize them in point form:
- leveraged EFSF size of 1 trillion is smaller than the 2-3 trillion initially mentioned
- Over the past few days it has become clear that Chinese participation in the SPV portion will not come so easily
- For the insurance portion of the plan, sovereigns do not typically default with loss severity of only 20%. Usually the survival game is played long enough such that the loss is at least double.
- Insurance on new issues can create two-tiered market: old bonds and new bonds
- EFSF is pledge-based, money is not in the vehicle yet.
- Intra-European Deficit/Surplus issues of course not yet resolved
- Italy’s commitment to austerity questionable
- 50% haircut only for some bondholders, not all. More like 30% blended-average
- 50% haircut includes NPV adjustments
- Resultant Debt/GDP for Greece of 120% not low enough.
- Size of capital raises “forced” on banks smaller than all external estimates of what is required
- Banks reluctant to dilute equity plus it’s hard to raise capital now, they prefer selling off assets, this leads to credit tightening and more recessionary pressures.
- ISDA guidance that credit event will not be triggered leads to unintended consequences for CDS markets, CDS holders, CDS writers and gets bondholders who hedged more nervous
- ISDA guidance is not yet an official vote, potential for lawsuits, political pressure etc.
- Other countries will learn the drive hard for a haircut and even Greece itself now having the referendum to play such games
- Circular nature of scheme makes it not-so-useful
Market Reaction So Far
So we know that co-ordination so far is not impressive. How does the market feel about this? Through the rally of October, Italian bond yields rose and continue to rise. And this week even the now-supposedly-unreliable sovereign CDS are violently rising in price. Bank stocks are crashing. This is a dramatic repudiation of Thursday’s plan.
The situation could easily get worse. No one knows what Italy will do. They’re the only country that is both in the G8 and the PIIGS. France and Germany give it little respect and the Italians aren’t happy. Berlusconi, Merkel and Sarkozi have all said this is the Euro’s last chance and that Italy must do the “right thing” but they don’t all have the same plan in mind. Italy is close enough to a situation where liquidity problems can translate into a solvency problem; every risk aversion episode gets people nervous about the solvency. There have been a few such episodes over the past few months and they each subsided but what has not subsided is the yield on Italian bonds, which can rise further. The last time Italy’s debt/GDP was at current levels is 1996; the country was paying a blended average of almost 10% in interest at the time.
A rebound from the current panic won’t come soon in my view, the reason being that (i) no one knows what will happen in Greece if the government falls or a referendum ‘no’ vote wins. (ii) we just had a huge plan and is becoming clearer that the next plan, whatever it is, will have to include the ECB printing money. Germany opposes money printing and although they could change their mind, with the miscommunication and mistrust so large and populations so angry, they won’t agree unless we first have a Lehman-type event with post-Lehman type consequences. My guess: significant stock/bond price declines + at least one financial institution going down in a relatively shocking way. One might guess the most likely victim will be a large French bank.
How to Play This
If one knew for sure that Germany will allow the ECB to print, shorting the Euro would be an easy way to play this. However, we need to find a solution that works in both the printing and non-printing cases. Bank equity is the best short because it’s the equity piece of institutions directly exposed to the Euro economy (which by the way is on the cusp of recession), are invested in PIIGS debt, are participants in derivatives markets and hated by the populations who all need to make sacrifices for the Euro to survive. In the long run political pain will be channeled towards bank equity.
In their last quarter, DB wrote down Greek debt to market (46 cents) but (i) according to many people it deserves to go down more (ii) DB didn’t write down other assets enough (iii) like most big banks they have a record of not seeing economic downturns ahead of time (iv) they are leveraged in much the same way that U.S. banks were leveraged in 2007. So their balance sheet will go through more stress.
A bank should not have 34x leverage. For such a bank, a liquidity crisis can become a solvency crisis very quickly and force the company to delever one way or another. Popular perception is that because Deutsche is not a Spanish Caja and is diversified they’ll be ok. That doesn’t mean anything as seen with banks like Citigroup.
We shall give very generous credit to DB regarding asset marking, assume no derivatives disaster and take the firm’s adjusted assets figure which, among other things, assumes derivatives netting. Then we assume it’ll have to adjust leverage to 10x via injections of equity or equity-linked capital.
Goodwill and intangibles
Adjusted assets (latest investor presentation)
Adjusted tangible leverage ratio
|Diluted shares outstanding||932mm|
|Tangible equity per share||$40.45|
|Tangible equity per share diluted by factor of 3.4 : 1||$11.77|
And so my target is DB’s adjusted tangible per-share book of $11-12 once leverage has come down to a normal level. Any other deterioration, either of the economy or of PIIGS debt, is gravy.
- If Greek government survives no-confidence vote, referendum planned, bail-out possibly rejected. If not, new government formation process delays beginning of bail-out.
- Italian debt declines further and other countries see declines in bond/asset prices
- Unintended consequences of the CDS legal situation
- Credit rating downgrades of anything European
- Liquidity/bank funding issues
- Italy plays games
- Political pressure on banks
- New plan to bail out banks in return for government equity in them, or some sort of debt-for-equity swaps