Statistical adjustments caught-up with Greece as the ‘money tap’ started to run dry when the GFC unfolded and the financial institutions started to look at how they can shrink their balance sheets. The Greek government declared that it was running fiscal deficits closer to 10% vs. 3% (as per Maastricht criteria), and approached the EU to ask for a programme and help to put Greek back on sound financial footing. The first EU-IMF-ECB (popularly known as Troika) bailout programme was introduced with an austerity plan requiring expenditure and revenue measures. At the same time, ‘non-Greek’ banks were trying to pull-out from Greece, aggravating the impact of austerity measures (revenue side suffered) as corporate Greece was faced to liquidity squeeze.
A Brief History – how did it get here?
Prior to this change in environment as described above, the Greek economy was afflicted with a very different type of ‘Dutch Disease’: this was not a result of a boon flowing into the economy due to discovery and exploitation of resource endowment, this was ‘cheap money’. With Greece scraping through the criteria (statistical ‘adjustments’) and joining the Euro, it gained access to ‘cheap’ money and the interest rates collapsed (from 16-17% in Drachma which was subject to perpetual devaluation to keep pace with deteriorating terms of trade), Greek populace gained access to mid-to-low single digit interest rates as well as ‘credibility status’ of belonging to a club where monetary policy is well managed. European banks rushed to lend to price hungry Greeks and the Greeks were quite willing to borrow for ventures or activities which they would never dream of. Banks continued to roll debt to the community without any fear or a need to be repaid (after all, it is the Euro).
The government failed miserably on the reform front (politics, oligarchy, self-interest….). Going ‘cold turkey’ is not easy, especially when the pain has to be borne more by those who did not benefit during the heydays. It was quite a sensitive time (2012) and the thought that Greece might have to ‘give-up’ the Euro (the term Grexit was coined) opened doors for other countries to potentially leave the Euro (such as Portugal, Spain and Italy) With a large number of European banks with significant cross-country exposures, the break-up of the Euro was a bridge too far to cross. With the collapse of the government in Greece (under the pressure of austerity measures), elections were held and the newly elected government signed up to the second bailout programme with stricter reform criteria, a more frequent and intrusive review process and a large sum of money. This was a time when Grexit could have led to the collapse of the European project.
Reforms were slow and austerity became too painful for the coalition government to keep majority, and as such, another election was called where a populist party (anti-austerity rhetoric) came to power and asked for the second bailout programme to be re-negotiated. With Europe now on better footing and the contagion effect from Grexit manageable, Europe called the bluff and was prepared to allow Greece to exit from the Euro. To cut a long story short, the anti-austerity government after a few antiques (referendum, elections), folded and grudgingly signed up to the third bailout programme which encompasses all the reforms that the previous government failed to deliver on, and some more.
It is the first review that is being contemplated to be completed in the current period (April/May) as there are negotiations remaining over a few agenda items (it’s the scale of adjustment, and not the content that’s in dispute) and the question of the ‘right size’ of the austerity that is needed to meet debt sustainability targets. The ECB came to the rescue of the financial system (not individual banks, but the system) by pumping liquidity to avert financial crisis to result in a prolonged economic depression. During this period of austerity, Greek GDP has been shrinking in real (and nominal terms) by more than 25%, while unemployment level has more than doubled and unit labour costs and unit productivity costs have declined to levels which have once more made Greece competitive relative to its trading partners in Europe.
Impact on the Banking Sector:
In a word, it got decimated. Under-reporting of income, poor tax collections, bloated public sector, inefficient bureaucracy, ‘guildhall’ like closed professions, labour unions, generous pension packages, when these segments face austerity, not only affordability, but behavioural problems also come to the fore.
The result was capital flight (pronounced effects were visible with every election), liquidity squeeze in the system (public sector payment deferrals leading to corporate payment deferrals), increase in unemployment, non-payment of populace for utilities, taxes, other services lead to unprecedented growth in NPL. A weak legal system did not help the situation in as much that as we look at the sector today, roughly 38-40% of the gross loan book of the 4 systemically important banks is non-performing.
Capital flight has required the banking system as a whole to borrow from the Euro-system under different programmes (given that Greek Government Bonds, do not qualify as collateral as 1st review completion is necessary for it to become so), borrowing from the ECB is quite expensive (155bp + cost of guarantee for pillar II bonds which is adds about 50-100bp) which affects the banking sectors ability to generate margins to ‘pay for’ the cost of risk. As it stands today, the banking sector in Greece has borrowed about Eur71bn (down from peak just before capital controlsof Eur84bn) under various liquidity programs.
The banking sector has gone through three capital raising exercises during the three bailout programs, the first capital raise being Eur45bn (with private sector participation of Eur4-5bn), followed by the second round of capital raising which was done pre-emptively prior to the AQR and stress test in 2014 (all systemically important European banks were subjected to this). The banks raised about Eur8-9bn, all from the private sector and the third and final round which took place in December 2015 where the banking sector was asked to raise cEur14bn (raised through a combination of private sector subscription, debt to equity swap and HSFS subscription) with private sector participation (debt to equity swap & cash subscription) of Eur8.2bn.
As at December 31, 2015 the gross loan book stood at Eur234bn, NPL stood at Eur85bn, cash provisioning against the NPL stood at Eur58bn, total provision (cash + collateral) stood at Eur95bn, total CET1 stood at Eur28bn and Common Equity CET1 Ratio Stood at 15.3% (all in CET1 at 18.4%). Essentially, the Greek banking sector has the highest capitalisation ratio and one of the highest levels of cash coverage of NPL within the European context.
A snapshot of where the system (which to us is no more than aggregation of the four banks) tells us a lot about what the recent picture looks like.
Over the last 5 quarters (reported so far), the overall level of Gross loan has stood very stable at around Eur 234-38bn and the overall NPL has increased from Eur83bn at the end of 4Q14 to Eur85bn at the end of 4Q15). What we can also see is that the NPL coverage for the system has significantly increased from 58% to 68%.
To us, there is evidence suggesting that the negative development has reached its peak and we believe that, barring a complete failure of the review, NPL is more likely than not to peak in by the 3rd quarter of this year.
As it can be seen from the above chart, the NPL formation on a quarterly basis has followed a declining trend from mid-2013 – two punctuating events in 1Q15 and 3Q15 are explained by Syriza winning the elections and asking the Trioka to suspend previous programme and not seriously discussing a bailout (1Q15) and the second one being an introduction of capital controls (3Q15).
With c36% NPL for the 4 banks, to us it seems plausible that anyone and everyone who has suffered in the economic crisis in Greece and is not able to service its debt is in the NPL. Also, those who believe that they do not need to service debt (i.e. the business is closed and their owners believe that they will not need to have a banking relationship for at least the next 5 years) and all those who can get away with not servicing their debts are already in the NPL category. The potential flow that can come now for 2016 are most likely those who are likely to suffer due to economic conditions in 2016. Our view (and that of the troika) is that the worst for the economy has already passed (and by the way, it delivered better than what was expected by the troika).
Without going into boring details of changing laws on NPL etc., it is sufficient to say that the credibility of the ‘stick’ in terms of ‘touching’ the collateral has improved significantly and the promises of politicians on ‘debt forgiveness’ are nearly dead and buried, and in all likelihood we will see NPL flow to decline to null in the 4th quarter.
Our core underlying basis for the Greek banking sector exposure is based on the premise that there is an end to ‘abnormality’ of deterioration and the banking system is likely to start to function normally from the latter part of this year.
Our forecasts and Valuations:
Our forecasts are based on our understanding of how the underlying profits of the business will start to work with some form of trend or return to normalcy and our understanding of NPL recovery plans and business goals of the management. What we have considered to be our base case scenario incorporates the following simple assumptions:
For our central/base case, we have assumed that the banks deliver only 50% of their implied targets by 2018 whereby roughly 25% of the NPL reduction is achieved through 100% write-off (i.e. Provisions are consumed), roughly 25-33%is achieved through liquidation mode where the banks only collect 10-15% of the loan value and the remainder is cured through restructuring (interest holiday/reduction, elongation of maturity and other such products).In summary, this is what the results look like to us:
The banking sector on an aggregate basis trades at below 2X earnings multiple on 2017 estimates and price to tangible book below 0.25x 2017 estimates. Even considering the sector without the benefit of the NPL strategy, only a return to normalcy puts the banking sector at P/E of 4.3x and P/TBV of 0.3X 2017 estimates.
Put it simply, the banking sector, with a tangible book of Eur28bn operating in a normal scenario would start to trade at 1x (i.e. at least 3x the current levels). If we were to incorporate that the banks’ management are able to deliver 50% of their implied targets, tangible book would increase by Eur7.5bn, to a total of Eur 35.5bn, making it 4 times the current aggregate market cap, therefore we could see share prices quadruple from current levels in the next couple of years.