The Portuguese crisis over Banco Espirito Santo should be a reality check for European markets. Espirito Santo is just the excuse — real problems lie far deeper.
The European Central Bank has been playing with fire, with junk bonds ultimately funded by German taxpayers. Investors are waking up and smelling smoke, and at some point they will get singed.
Three companies are involved in the Espirito Santo mess. Banco Espirito Santo is the largest publicly traded commercial bank in Portugal. Its controlling shareholder, Espirito Santo Financial Group, owns 25 percent of its shares. The privately held parent company, Espirito Santo International, owns 49 percent of Espirito Santo Financial Group (and therefore part of Banco Espirito Santo). It is this parent company that is likely to default on its payments. Even if Espirito Santo International defaulted, Banco Espirito Santo does not necessarily have to go under, but it might.
The problem is that Banco Espirito Santo is a weak institution irrespective of its parent holding companies, dabbling in risky assets in emerging markets that saner banks would not touch. Its risk management department needs a major shakeup.
For instance, the bank has invested in Angola, setting up a subsidiary known as Banco Espirito Santo Angola (BESA). BESA has relied on Banco Espirito Santo for its funding, with loans in Angola amounting to 220 percent of deposits. Bad loans have exploded in Angola in recent years, rising by 84 percent from 2010 to 2013. BESA’s assets include 6 billion euros’ worth of loans payable, and Banco Espirito Santo has a 55 percent stake in the bank.
The government of Angola, a former Portuguese colony, has given the bank a “personal guarantee” amounting to 70 percent of the bank’s loans. There is doubt about whether the bank can retain solvency in the event of a crisis, even with the guarantee. An anti-corruption organization in the country, Maka Angola, has claimed that the reason for the guarantee was several hundred million dollars’ worth of loans given to powerful figures in the Angolan regime. However, the authenticity of these claims is unclear.
There is also trouble closer to home for Banco Espirito Santo: It has lent over 1 billion euros to its various parent companies. Should Espirito Santo International default, Banco Espirito Santo will fall below the capital ratio mandates set by Basel III at the same time that the European Central Bank prepares to do stress tests.
Shares in Banco Espirito Santo were suspended from trading yesterday by the Portuguese government after they fell 17 percent. Prior to that, Espirito Santo Financial Group pulled its own shares from trading due to “ongoing material difficulties” at Espirito Santo International.
The catalyst for the sell-off appears to have occurred July 9 when Espirito Santo International delayed repayment on short-term debt owed to customers of its Swiss bank. That was not the first time Espirito Santo International has been in trouble. In December, it sold 6 billion euros of debt to Espirito Santo Financial Group, exposing investors to even more losses should the company fail, in what the Wall Street Journal called “financial gymnastics.” In May, Espirito Santo Financial Group released an audit of Espirito Santo International, revealing that there were several irregularities on its balance sheet, making its outlook more negative that previously thought.
The debt of Banco Espirito Santo is government-guaranteed, leading to good ratings but also potential moral hazards. Given the size of the conglomerate, it is possible that one or more of the companies will require a bailout if things deteriorate. The Bank of Portugal has said it believes Banco Espirito Santo is not at risk, despite the problems at its parent companies. It also said explicitly that it had 6 billion euros on hand to rescue the banking sector if necessary.
Moody’s on Wednesday downgraded the debt of Espirito Santo Financial Group. The company’s bonds have tumbled in recent weeks from 100.2 cents on the euro last month to 10.1 cents today, reflecting waning confidence in the company’s ability to pay back its debt.
The troubles at Espirito Santo are a wake-up call for investors. It is not just that Portuguese stocks have taken a hit, with a major index of Portuguese companies (the PSI 20) falling 4.2 percent yesterday. Stocks fell across Europe to a lesser degree. Banco Popular Espanol, a major Spanish bank, postponed a 750 million euro bond issue, citing conditions in the market. The Greek government issued a three-year bond, but only placed half of the 3 billion euros it had intended. In the U.S., the Dow Jones Industrial Average plummeted, though pared losses late in the day.
Why the extreme reaction to a minor Portuguese bank that has been taking undue risks all along? Investors are taking a closer look at Europe, where Banco Espirito is a reminder of how weak the Portuguese economy is and how large the losses on its banks’ balance sheets are. Coincidentally, or not, industrial production is weakening across Europe, including Italy, France and Germany. As I wrote earlier this month, the Bank for International Settlements in its annual report noted that global markets have become disconnected from underlying fundamentals.
American Enterprise Institute fellow Desmond Lachman, formerly managing director and chief emerging market economic strategist at Salomon Smith Barney, told me: “I think that the markets are now beginning to ask whether the Eurocrisis is really over and whether Portugal is an isolated case. However, with the Fed still printing money and underwriting a big party in the markets, it is not clear whether the markets will make the big adjustment that I am still expecting to occur once U.S. interest rates start normalizing.”
As an example of this disconnect, during the first week of July, 10-year bond yields in Spain were lower than in the U.K. That is not because it is safer to invest in Spain, but because investors expect the European Central Bank to continue to buy the junk bonds of debt-ridden countries such as Greece, Spain and Italy, with Germany continuing to cover the ECB’s losses. On Tuesday, the pattern reversed itself, with U.K. yields falling and Spanish yields rising.
Extreme investor reactions to small events occur when central banks paper over their problems with monetary accommodation. At some point, German taxpayers will tire of underwriting weaker countries’ junk bonds. Real problems call for real solutions. Europe needs to reform its tax system and its convoluted labor regulations to spur economic growth, rather than its futile attempt to depreciate the euro to prosperity.
Diana Furchtgott-Roth is Director of Economics21 at the Manhattan Institute for Policy Research. She is also a contributor to the Wall Street Journal’s Market Watch. This article was originally published in Market Watch on July 11, 2014.
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