Argonauts return to Greece

The Argonauts have returned to Greece, making our first investments in the country since 2006. Having lost €38bn from Greek government debt restructuring, the Greek banking sector has largely been recapitalised with new equity of €40bn¹. This has also resulted in unprecedented large scale consolidation, with the four largest banks (Piraeus, Alpha, Eurobank and National Bank of Greece) now having a market share of 96%² (compared to 55% pre-crisis)³. Not only do we think that there is an adequate margin of safety in terms of existing loss absorbing capital to any further deterioration in asset quality but we also think the equity valuations of the leading banks are modest given the likely level of profitability in a post-recession macro environment.

Currently around a third of all loans in the Greek banking system are in default⁴. This ratio is still increasing and is unlikely to peak until 2014 or possibly 2015 (12-18 months after Greece emerges from recession). The Greek banks have set aside provision charges on their balance sheets amounting to over half of the loans in default (which given 90% of loans have some form of collateral backing is not obviously imprudent). The two biggest banks, Piraeus and Alpha, also have regulatory capital well in excess of the 9% Basel Tier 1 ratio requirement, whilst National Bank has plans to raise further capital through asset disposals (including selling a minority stake in Turkish bank Finansbank)⁵. Our analysis suggests that Piraeus and Alpha have enough capital to withstand an increase in NPL ratio from 31% today to 50% in an adverse scenario, whilst National Bank could withstand an increase in NPL ratio from 22% today to 41% in an adverse scenario (see Table 1). We believe that this gives us an adequate margin of safety on bank capital and would expect the forthcoming Blackrock II review to officially confirm this.⁶

Table 1: Greek Bank Regulatory Capital, Asset Quality and Solvency⁷

But not being bust does not in itself make for a compelling equity investment – for this we need a recovery in corporate profitability. There are three dynamics that give cause for optimism here: falling provision charges, cheaper funding and synergies from the consolidation process. Although asset quality continues to deteriorate in aggregate, the pace of defaults is slowing. Assuming stable coverage ratios, this means that P&L charges for bad loans have peaked and that bank profits will see a significant delta from a return to a more normal cost of risk. This is an obvious example of a less bad economic environment being good for shareholders. If the Greek economy were to experience a more robust economic recovery longer-term, a “blue-sky” scenario whereby write-backs of the massive loan loss provisions from the balance sheet to the P&L would be possible (see Table 2).

Table 2: Greek Bank Capital Structure and Valuations⁸

Deposit flight from Greece together with lack of access to market or ECB funding has seen sky-high funding costs for Greek banks, with term depositors being paid generous rates of interest (500bps⁹ as opposed to the EU average of 180bps) and penal central bank funding through the ELA (at 225bps rather than 50bps at the ECB¹⁰). The Greek banks regained access to the ECB earlier this year, whilst the end of any domestic uncertainty over Greek membership of the Euro has seen deposits slowly return to Greece. This is resulting in a steady re-pricing of funding costs toward the Eurozone average and a significant recovery in net interest income. Whilst the sector consolidation has been beneficial in the re-pricing of term deposits, it also offers the banks significant cost saving opportunities through the rationalisation of branch networks. For instance, market leader Piraeus plans to half its network from 1,300 branches to 650 over the next three years¹¹.  It can achieve this without customer attrition as all four major banks are engaged in the same process. This should lead to mid to high teen sector ROE by 2015 which should more than justify the modest price to tangible book values of the domestic banks¹² (see Table 2).

The best time to invest in a country is often when its economy is emerging from recession and all of the bad news is in the rear view mirror. We have previously highlighted the European banking sector as the most obvious stock market beneficiary from a European economic recovery (see Europe’s economy: the last great recovery trade). It should therefore come as no surprise that the Greek banks are the most geared equity investments to the “GRECOVERY” and in our opinion offer some compelling investment opportunities.

Barry Norris
Argonaut Capital
December 2013