Reuters | Sat Jul 24, 2010 | 11:31am IST
Valuations on Europe’s banking sector may look cheap on paper but don’t expect U.S.-based portfolio managers to scoop them up even after stress tests showed a vast majority have sufficient capital. The results of Friday’s assessment, criticized for not being tough enough, found that just seven out of 91 European banks would need to bolster their balance sheets by a total of 3.5 billion euros ($4.5 billion) to withstand another recession. "To us the bank stress test results came out as a non-event. When you look at the results they didn’t look very stressful," said Scott Snyder, portfolio manager of the ICON Advisers Europe fund. The method of the stress test has drawn scrutiny particularly because of the way the tests treated European government debt. Even so, U.S. investors had already shown distaste for the European banking sector as data reveal the massive net selling that has occurred over the last two years.
U.S. mutual funds cut their holdings of publicly traded European banks identified in the tests to just $12.1 billion from $29.8 billion, a whopping 59.2 percent decline in the last two years through May, according to Lipper, a Thomson Reuters company. The bulk of the sell-off was between 2008 and 2009. However even after the U.S. government conducted its own stress tests in May of last year — widely believed to have put a floor underneath U.S. financial shares — holdings in Europe’s banks continued to decline. "It stands to reason the most visible banks in Europe are the most scorned, perhaps because we know more about them. The holdings of ING, Bank of Ireland, Commerzbank, and Royal Bank of Scotland used to account for $4.4 billion in account assets. Now they are less than $800 million," said Jeff Tjornehoj, U.S. and Canada research manager at Lipper. By comparison, U.S. bank shares, as measured by Standard & Poor’s financial index, have risen 13.57 percent since the U.S. government announced its stress test results on May 7, 2009, through Thursday.
Credit default swaps (CDS) on European banks improved after the results were released on Friday although the region’s stock markets were already closed. According to data from Markit, credit default swap spreads available on 61 out of the 91 banks that underwent the stress tests showed three-quarters of them improved after the results. CDS act like insurance against defaults or credit restructurings. Eric Fine, portfolio manager for Van Eck Global’s G175 Strategies, said he did not believe the tests were very credible as they did not focus on entire balance sheets. The evaluations took into account potential losses only on government bonds the banks trade, rather than those they are holding to maturity. Examples include bonds issued by Greece, whose debt obligations investors fear, might not be repaid. Greece faces about 300 billion euros in debt. "Given the policies that sovereigns have pursued so far, they have no choice but to guarantee their entire banking systems," said Fine. "So having a stress test when ultimately the capital is going to come from the sovereign, which is the source of the problem, is not really the point," he said.
David Marcus, chief investment officer at Evermore Global Advisors, said the stress tests are like an X-ray, showing where work needs to be done on the fractures in European banking. "They are moving in the right direction rather than pretending there are no problems. So we see it as a net positive," said Marcus, who specializes in European assets. However, Marcus said better values can be found elsewhere, although he likes Lloyds Banking Group Plc, where certain tranches of its debt yield more than 12.5 percent. ICON’s Snyder also sees pockets of value in Europe’s banking sector and believes Europe overall needs to rise by 34 percent in order to reach fair value. "In BNP Paribas we see a more than 80 percent upside to fair value, but bargains are there for a reason as they indicate shakiness to the market," Snyder points out, saying he would need to see confirmation of a broader upturn before committing more cash to the banking sector.
Snyder says his fund is underweight the sector as of June 30, with 13 percent in European financial stocks versus a 22 percent weighting in its benchmark, the MSCI Europe fund. Charles de Vaulx, a portfolio manager at International Value Advisers LLC who closely watches European assets in its $8 billion portfolio, said the stress tests would not change the firm’s outlook on the banking sector in Europe. "We find the European banks still undercapitalized," de Vaulx said. "The lack of a test for sovereign risk means the test was too soft and not credible."