We’ve analysed quite a few European banks over the past 12 months. As yet, none have made it into the International Fund's portfolio, though the hunt continues.
The most compelling opportunities we've found are just too small and illiquid, even for us (trading in the hundreds of euros per day). Others are unusual cooperative/for-profit hybrids and we aren't quite sure where the profit penny (or euro cent) drops.
Others, the subject of this post, have fairly obvious landmines on their balance sheet. Most obvious are the Western European banks with significant Eastern European operations.
We spent quite a bit of time mid-last year trying to get comfortable with a few of these. They look cheap, trading at price earnings multiples of 5-10 times and less than book value, despite decent growth prospects. But they deserve to be cheap.
The key landmine is foreign currency loans. Of course, these banks deal in at least as many currencies as they have international operations. That’s not the issue, rather it’s the gigantic mismatch – within each national operation – between the currency of the bank’s assets and liabilities.
You see, many Eastern European borrowers like the idea of borrowing in Swiss francs or Euros, because the nominal interest rate is currently drastically lower than what they’d pay on a local currency loan. Some of this activity is legitimately sensible—say a Polish firm borrowing Euros to set up a distribution centre just across the border in Germany. But most of it is shopping around for a lower interest rate, by both businesses and mortgagees, currency risk be damned.
Pre-crisis, the banks were silly enough to acquiesce. Most of them cite ‘competitive reasons’ as a justification for doing so (lemming behaviour). Most investor relations departments say that their bank is now running down the foreign currency loan book, but the numbers haven’t shifted much since 2008, so don’t necessarily believe them.
That leaves the liabilities (deposits) of each Eastern European subsidiary mostly in local currency, while a big proportion of the assets (loan book) is in Euro or francs. Austrian bank Raiffeisen Bank International (WBAG:RBI) has operations in more than 10 Eastern European countries that don’t use the Euro currency. In those 10+ subsidiaries of the bank, the percentage of its loan book denominated in Euros or francs ranges between 40-75%.
This is a giant, unhedgeable risk for a bank. Management may even claim to hedge their foreign currency exposure (at great expense). But forget about the bank being hedged. The chief risk is the currency risk taken on by the borrower. From the bank’s point of view, this is chiefly an issue of default risk rather than currency risk.
Should the currency of one of these Eastern European countries depreciate significantly against the Euro or franc, roughly half the bank’s customers will find their borrowings balloon uncontrollably in comparison with their own assets and earnings. Many borrowers will default. For a bank, many customers defaulting at once is a death sentence. And should all or most of these countries experience currency devaluation at the same time (they’re surely rather correlated), some of these Western European banks will blow up in impressively short order.
The sad (insane, laughable, tragic?) part of all this is that these banks should have known better. It seems that every country needs to go through a foreign currency loan debacle once – it happened in Australia with Swiss franc loans just a few decades ago. The same thing happened in Western Europe at much the time. Some of these very same banks were throughly mauled by foreign currency mismatches in their home markets.
Corporate memory, it seems, tends to be about as short as management tenure.
Ready to invest?
Visit this page for more information on how to invest with Forager.
Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.