20 May 2010

Why you should not be long European banks

I have indicated for a couple of months that I would not be long financial stocks despite the fact that banks borrow at close to nil cost and invest in sovereign bonds which provided a nice "riskless" spread. Holding Government debt is also advantageous with respect to regulatory capital ratios, allowing more leverage.

Well, riskless? No, risky instead!

The graph below explains a lot about the vows of the banking sector across Europe, particularly when compared to the US: more than 35% of outstanding Government debt is held by banks (mainly European) vs. 15% of US Treasuries. The current crisis outlines how risky this was and explain the panic mode of European leaders that conducted to the EUR 750 billion rescue plan (still waiting for the detail of its implementation ...): the objective was to save the European banking sector from collapse more than saving Greece; the green light given to the ECB to buy European sovereign debt in the secondary market was not only to reduce borrowing cost for PIIGS countries but also to lower the pressure on banks by improving prices in the secondary market.