Greek Banks: What are David Einhorn and John Paulson thinking? (Part 1)

With great interest I have read that David Einhorn and John Paulson have taken substantial positions in Greek banks Pireus (BPIRF:US) and Alpha (ALBKF:US). In Einhorn’s case it apparently amounts to a substantial position. The link can be found below:

http://www.valuewalk.com/2014/03/david-einhorn-alpha-bank

Both Banks have recently been recapitalized and Pireus, which will be the focus of this post, trades at 1.2 x book value based on the 2013 financials. In the first quarter the bank has completed a EUR 1.7 bn. equity offering which would bring the P/B ratio down to around 1. Regardless, the market, it seems, thinks that the worst is over in Greece, also evidenced by its recent return to the bond market. While I do think that certain progress has been made, simply because the government has run out of other people’s money (always a good thing) and as indicated by record tourist bookings, the market feels somewhat overextended.

When it comes to stock investing, I favour a value approach trying to focus on fundamentals rather than macro stories. This served me well in Greece in the past, as it led me to invest in two Greek stocks, engineering company Metka (OSQ: GR) state lottery operator Opap (Opap: GA), during the crisis, providing handsome returns. I still hold both stocks. So regardless of whether I personally think the Greek recovery story is largely overhyped or not, I will try to assess the attractiveness of Einhorn’s Investment in Pireus bank on a company specific “micro” level. The most recent financial report served as a basis for my quick analysis.

http://www.piraeusbankgroup.com/~/media/Com/Downloads/Investors/Annual-financial-report-2013en.pdf

I have reproduced the consolidated balance sheet on page 4 of the report in a somewhat stylized format below:

PireusBankBS

As can be seen Pireus bank expanded its balance sheet significantly in 2013. However, the growth has not been organic but is a result of several mergers/acquisitions. Pireus bank acquired the Greek operations of a Cypriot bank, Millenium Bank as well as parts of Agricultural bank of Greece in 2013. In view of this, it is quite tedious to figure out how the underlying business has developed. I will skip that for now and leave it for a further post.

The increase in total equity is largely the result of the already mentioned recapitalisation which accounted for EUR 8 bn. of the increase. Further, there was a profit of EUR 2.5 bn. in 2013. The high profitability comes as a result of the mergers and the “negative goodwill associated with them (details in my second post on the income statement). After deducting intangibles I arrive at a tangible book value of EUR 8.1 bn. So at first sight, the Bank seems under leveraged compared to European peers (TA/TE around 11.5 x), leaving room for strong growth. As already mentioned above, the equity has increased due to the equity offering at the end of Q1.

A quick look at the Balance Sheet

Book values are tricky, especially for banks and all the more for banks in Greece. In order to assess the quality of book value it is necessary to get a sense for the asset quality of the bank. I naturally start with the biggest item on the balance sheet: loans and advances. The bank provides a useful breakdown in its financial risk management section (page 33 of the financial statements, sorry for the bad resolution):

LoanBookPireus

Out of Gross loans of EUR 76 bn., EUR 23 bn. is deemed impaired leading to a NPL Ratio of 30 percent – reflecting the dire situation in Greece. Against these, provisions of EUR 14.5 bn. have been booked, resulting in the net loan amount of EUR 62 bn. The coverage ratios (Provision/NPL): 65% for the retail book and around 60% for the corporate book, respectively. At first glance this looks conservative, but keep in mind this is Greece: asset values have collapsed since the bulk of these loans have been granted, so it could well be that the provisioning level, albeit reasonable at first glance, is not enough. More detail is required until a final conclusion can be drawn on this one.

What really stands out however is the EUR 20 bn. of loans that are classified as “past due but not impaired”. This item amounts to 30% of net loans!!! These loans are do not need to be impaired according to IFRS only if the restructuring is done in a “NPV Neutral” way, i.e. if the interest rate foregone in the short-term is added in the future, or if the client has substantial collateral. I have examined enough loan books to know that in most cases assumptions in “NPV neutrality” make Facebook investors look conservative. Nowhere, however, have I seen such a large part of the portfolio classified this way. Further, from then notes we learn that there are EUR 5 bn. in loans forborne (i.e. restructured) that are neither impaired nor are they past due, i.e. they were restructured in time before they were past due. Now it gets interesting: depending on how you want to treat this information, the equity has to be adjusted substantially – clearly from a PV perspective these loans are not worth par. I will be generous: assuming that 25% of the past due loans are really “hidden” NPL and applying a coverage ratio of 50%, I arrive at an adjustment to book value of – EUR 2.5 bn.! Doesn’t look that well capitalised anymore!

Further we can see that public loans with Greek sovereign risk amount to EUR 2.1 bn. To this has to be added the book value of the Greek government bonds in Investment securities (EUR 1.2 bn.) and the EUR 300 Mio. Greek T-bills in the trading book and you get a Greek sovereign exposure of EUR 3.5 bn. If you happen to think – as I do – that Greece needs another haircut, you would want to adjust these values downward as well.

The rest of the investment securities book (EUR 14 bn.) consists of EFSF bonds, guaranteed by EU taxpayers. Although this worries me as an EU tax-cow, at least I do not have to adjust them for now.

Of course Einhorn and Paulson could reason that these loans will benefit disproportionately from the recovery and become money good again and think the book value alright. In this case the bank would be well capitalised and could start lending to Greek customers, presumably at attractive spreads.

Pireus Bank still heavily dependent on interbank (ECB) financing

But things are not that easy, growth needs to be not only supported by capital but has to be funded as well, so let’s turn to the liquidity situation of the bank: what jumps into the eye is the startling amount of interbank financing (due to credit institutions), which, although down from almost 50% of the balance sheet at the end of 2012 to 30% at the end of 2013, is still sizeable for a commercial bank. Of course most of these liabilities are liabilities to the ECB. By the way, if you’ve wondered why there have been no spectacular bank defaults in Greece despite a sovereign debt restructuring, deposit outflows and record unemployment – here is the answer! As a member of the Euro system Greek banks have been able to access Euro liquidity by the ECB, even on an unsecured basis (“ELA” loans). With that “competitive advantage” they could repay scared depositors and bondholders although they were lacking eligible collateral in the amounts required. If the ECB hadn’t loosened its collateral rules, this – and probably most Greek banks – would be long gone.

It is clear from the above stylized balance sheet that the bulk of the cash from the EUR 8 bn. capital increase has gone into repaying the ECB. This is understandable: repaying the ECB must be top priority for bank management and Greek regulators as well as the ECB. First, despite the fact that central bank intervention is considered normal nowadays, there is still negative stigma attached to your institution if you need ECB financing. Second, the sooner the ECB refinancing is gone the sooner the Greek government can get rid of the highly unpopular “Troika” and present themselves as reformers. It is safe to assume that any significant profit the bank is able to earn in the near future as well as liquidity coming in from bond offerings will flow into repaying the ECB rather than into new loans or dividends! Given these difficulties I do not see how Pireus Bank can grow without tapping new sources of funds. Certainly, the liquidty situation has improved after the most recent equity issuance. However, any tapping of external liquidity, be it equity or bonds will be costlier than the sweet, non-market based rates of the ECB facilites they currently have.  External funds would pressure the profitability of the bank.

It could be of course that the bank will be highly profitable after the restructuring and grow its way out of the problems. In the next post I will look at the income statement and the earning power of the bank.

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