European Bank Sovereign Debt Exposure

Written by Chris Porteous

Analysts have been increasingly bearish on sovereign debt and banks within the European Union. While
the ECB has been ‘successfully’ monetizing debt through liquidity programs, this has not stopped
interest rates and credit default swap spreads from rising throughout many countries. This has put
major French and German banks at greater risk as they are heavily exposed to the government debt and
banks of many EU sovereign nations, despite the fact that these ‘risks’ have not been recognized in the
recent stress test results.

French banks were unable to ride the recent strength of the Euro, as they have been actively shorting it
during this remarkable melt up of the currency. BNP Paribas even went as far as forecasting euro-dollar
parity in 2011. Similar to the U.S., EU banks are very intertwined. The contagion effect spreading across
the entire EU, largely due to the existing inter country claims, will only speed up the process in dragging
down the value of sovereign debt.

In this piece, I will be looking at a combination of French and German Banks: BNP Paribas, Societe
Generale, Deutsche Bank, and Commerzbank. These four banks have extremely large exposure to
European debt and are highly levered. Looking at U.S. banks, it’s relatively easy to see how this is going
to end.

At the end of 2009, German and French banks had PIIGS exposure worth USD 690B and USD 781B
respectively. This represents great risks to the stability and solvency of the European financial system.
These two countries have total exposure to 1.47T to PIIGS. While both countries made it seem
(politically) that an ECB/EU/IMF bailout of Greece was out of the question, they did little to stop the $1
trillion dollar bailout. This data was based on the April 2010 IMF Country Report.

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 German Banks
(Foreign Claims on International Banks)

United States, 599

Rest of the World,
1,139

Euro Area (Excluding

PIIGS), 712

Central & Eastern

Europe, 208

Emerging Markets,
PIIGS Countries, 690
114

French Banks
(Foreign Claims on International Banks)

United States, 617

Rest of the World,
1024

Central & Eastern

Europe, 164

Emerging Markets,
339 Euro Area (Excluding
PIIGS), 1523

PIIGS Countries, 781

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While Germany 2010 GDP forecast was cut from 1.5% to 1.2%, and 2011 from 1.9% to 1.7%, the IMF
notes:

"Simulation exercises suggest that German banks could suffer significant losses
from commercial real estate investments in the U.S. and Spain, and more generally
from exposures to Southern Europe. The simulations also suggest that a reassessment
of risks associated with claims on Southern Europe could have a large impact on capital
flows within Europe, as German banks would significantly reduce their foreign claims to
restore capital ratios."

Based on this argument, France should be next on the chopping block.

Looking specifically at exposure to PIIGS, both countries have significant exposure to Italy and Spain and
moderate exposure to Greece, Portugal and Spain relative to total claims. The two countries have over
USD 100B in exposure to Greek debt, this may lead to a wipe-out in shareholder’s equity for many banks
if Greece were to restructure.

Exposure to PIIGS Debt

500
450
400
Exposure (USD Billions)

350
300
250
French Banks
200
German Banks
150
100
50
0
Greece Ireland Italy Portugal Spain
Country

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Conducting the Analysis
To determine the impact of losses that may arise with write-downs on the extensive sovereign debt
holdings by the major French and German banks, I conducted a sensitivity analysis on sovereign debt
holdings of PIIGS nations as well as the rest of EU. Standard & Poor’s assigns an estimated recovery
rating based on the spread between libor and borrowing rate. In the case of Greece, the spread is
currently 728bps which gives it a recovery rating of 3, 50% - 70% recovery expectation in the event of
restructuring debt. Here’s a chart provided by S&P:

Applying the S&P loan recovery data to the EU countries in question, I used the following to conduct
sensitivity analysis:

Country Spread (bps) Recovery Rate Base Case Adverse Case Optimistic Case
Greece 728 3 40% 50% 30%
Ireland 220 2 20% 30% 10%
Italy 137 1 5% 10% 0%
Portugal 230 2 20% 30% 10%
Spain 185 2 20% 30% 10%
France 64 1 5% 10% 0%
Germany 37 1 5% 10% 0%

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The Banks
As mentioned in the intro, we will be looking at 4 banks: BNP Paribas, Societe Generale, Deutsche Bank,
and Commerzbank. Gathering data related to sovereign debt holdings at each of the banks will be
estimated, as many of these banks don’t issue or release this data.

BNP Paribas
The bank is in much better shape than it was last year. With the help of excess stimulus provided by the
central banks and governments worldwide, the firm was able to take advantage of increased asset
prices across the board. It was able to reduce its leverage ratio from 35.20x in 2008 to 25.61x as a result
of issuing more equity and through retained earnings. On May 6th, the bank announced it had €5B (USD
6.5B) in Greek sovereign debt exposure. BNP Paribas held half of France’s gross exposure to Italian
sovereign debt, amounting to approximately €23.2B. Only €1.4 of this is on its trading books, the other
€21.8 is not required to be marked to market. Based on estimates, the bank has approximately €158B in
total sovereign debt. These numbers were derived using extrapolation, Bloomberg, and general
consensus amongst analysts.

Societe Generale
The bank had significant exposure to the real estate market in 2007 and took substantial losses in
unhedged CDO’s and CMBS within the United States and residential real estate in Spain and the United
Kingdom. They were leveraged 31.30x in 2008, now operating at 24.52x as a result of increased retained
earnings. However, the bank still has €2.5B in unhedged CDO’s tied to the US residential mortgage
sector and €7.0B in commercial mortgage backed securities. It currently holds €3.1B in Greek sovereign
debt, and is exposed to a total of €13 in PIIGS (Portugal, Ireland, Italy, Greece, and Spain) debt. Most of
this is ‘held-to-maturity’, they are not required to mark this down on their balance sheet.

Deutsche Bank
Deutsche Bank appeared to weather the credit crisis much better than most of its peers. They marked
down a total of €10.8B in debt, this compares to €54.5B for BoA and €35.0B for UBS. It was able to avoid
billion dollar losses from the start, remaining relatively healthy. As Greece was falling into insolvency,
the bank disclosed that it has negligible exposure to Greek government debt, but provided no disclosure
about the sovereign debt exposure to other PIIGS. As a result of this, I estimated the sovereign debt
exposure of these countries. Deutsche Bank had approximately €12B in exposure to PIIGS sovereign

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debt, and another €28B between France and Germany sovereign debt. It had total exposure of
approximately €46.0.

Commerzbank
The bank had negligible exposure to the U.S. real estate market between 2006-2008. As a result, they
avoided the large losses that other banks realized. However, the firm has substantial exposure to
European sovereign debt. According to its 2009 10-K, it had total exposure of approximately €129B in
public debt globally. They have €3.1B in exposure to Greece sovereign debt and €24B between the rest
of the PIIGS countries.

Bank Exposure to EU Sovereign Debt

BNP Paribas Societe Generale Deutsche Bank Commerzbank

Greece 5.0 3.1 0 3.1
Ireland 3.0 2.5 2 5.85
Italy 23.2 2.5 4.8 5.85
Portugal 2.5 2.5 3 5.85
Spain 3.0 2.5 2.1 5.85
Germany 45.0 15 24.6 14.2
France 55.0 13.7 3.5 14.2
Other Western Europe 55.0 5 3 14.2
Central & Eastern Europe 9.4 12.3 3 14.2
Total EU Sovereign Debt 201.1 59.1 46.0 83.3

Results
As a result of a sovereign debt crisis, BNP Paribas and Commerzbank would see a collapse in
shareholders’ equity. Under a base case scenario, BNP Paribas would see losses of approximately
€22.7B, resulting in a 28% loss in equity. This would lead to a leverage ratio of 45.3x. Commerzbank
currently has too much exposure to sovereign debt, under the base case scenario, the bank would see
46% of its equity disappear, bringing its leverage ratio to 58.4x. While many may believe the
governments will step in, in the event of a crisis, there’s not much they can do in the event of a
sovereign crisis.

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 Sovereign Debt Losses
40.0

35.0

30.0

25.0
€ Billions

20.0

15.0

10.0

5.0

0.0
Base

Base

Base

Base
Adverse

Optimistic

Adverse

Optimistic

Adverse

Optimistic

Adverse

Optimistic
BNP Paribas Societe Generale Deutsche Bank Commerzbank

There are several ways to play this current crisis. Timing is very important; the current EUR melt-up
based on a liquidity squeeze shows how volatile the markets currently are. While I believe that this
trend will continue for the next few weeks, the market is running out of steam based on volume and
outflows. While the long-term fundamentals of physical gold are very attractive, short term margin
liquidations are putting a squeeze on gold prices.

Here are my recommendations:

 Long non-levered stakes in gold equities, such as New Gold (NGD) and Westdome (WDO)
 Long the Swiss Franc relative to the EUR, money continues to flow into Switzerland. The Swiss
Central Bank will begin offloading their EUR positions shortly.
 Long the Canadian Dollar relative to the EUR, Canada currently has one of the lowest debt levels
in the developed world
 Short those with exposure to sovereign debt, such as BNP Paribas and Commerzbank.

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Sovereign Debt Losses and Valuation

BNP Paribas Societe Generale Deutsche Bank Commerzbank

Adverse Base Optimistic Adverse Base Optimistic Adverse Base Optimistic Adverse Base Optimistic
Greece 2.5 2.0 1.5 1.6 1.2 0.9 0.0 0.0 0.0 1.6 1.2 0.9
Ireland 0.9 0.6 0.3 0.8 0.5 0.3 0.6 0.4 0.2 1.8 1.2 0.6
Italy 2.3 1.2 0.0 0.3 0.1 0.0 0.5 0.2 0.0 0.6 0.3 0.0
Portugal 0.8 0.5 0.3 0.8 0.5 0.3 0.9 0.6 0.3 1.8 1.2 0.6
Spain 0.9 0.6 0.3 0.8 0.5 0.3 0.6 0.4 0.2 1.8 1.2 0.6
Germany 4.5 2.3 0.0 1.5 0.8 0.0 2.5 1.2 0.0 1.4 0.7 0.0
France 5.5 2.8 0.0 1.4 0.7 0.0 0.4 0.2 0.0 1.4 0.7 0.0
Other Western Europe 16.5 11.0 5.5 1.5 1.0 0.5 0.9 0.6 0.3 4.3 2.8 1.4
Central & Eastern Europe 2.8 1.9 0.9 3.7 2.5 1.2 0.9 0.6 0.3 4.3 2.8 1.4
Total EU Sovereign Debt 36.7 22.7 8.8 12.1 7.8 3.4 7.2 4.3 1.3 18.8 12.1 5.5
Shareholder`s Equity 80.34 80.34 80.34 42.2 42.2 42.2 36.6 36.6 36.6 26.6 26.6 26.6
New Shareholder`s Equity 43.6 57.6 71.5 30.1 34.4 38.8 29.4 32.3 35.3 7.8 14.5 21.1
% Change in S/E -46% -28% -11% -29% -18% -8% -20% -12% -4% -71% -46% -21%
Assets 1977 1977 1977 1024 1024 1024 1500 1500 1500 844 844 844
Sovereign Debt as a % of Assets 1.9% 1.2% 0.4% 1.2% 0.8% 0.3% 0.5% 0.3% 0.1% 2.2% 1.4% 0.7%
Current Leverage Ratio 24.6 24.6 24.6 24.3 24.3 24.3 41.0 41.0 41.0 31.7 31.7 31.7
New Leverage Ratio 45.3 34.3 27.6 34.0 29.7 26.4 51.0 46.4 42.5 107.7 58.4 40.0

The issues in Europe are structural, with the absence of a political union and highly indebted nations on
the brink of bankruptcy. There are currently three possible outcomes: large write-downs in Eurozone
debt, large debt monetization from the ECB which will debase the currency, or a breakup of the currency
altogether.

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