Goldman Sachs Turns Bullish on Stocks in European Banks Bond Market Shuns

Goldman Sachs Group Inc. is telling investors to buy European bank stocks for the first time in more than 16 months. Bond buyers are taking the opposite view on concern that policy makers will fail to staunch the debt crisis.

Banks in Spain, Italy and Greece have led the Bloomberg Europe Banks and Financial Services Index 16 percent higher since November. While shares of Spain’s Banco Santander SA rallied 23 percent and Italy’s UniCredit SpA jumped 25 percent, both lenders had to offer investors record premiums over government debt when they sold covered bonds in the same period.

Equity investors are betting political leaders will bridge their differences over the mandate of the European Financial Stability Facility and stop the region’s debt crisis from spreading. Bond buyers are skeptical that the talks will succeed and concerned banks may be forced to accept losses on the more than $2 trillion of loans and other assets they have in Greece, Ireland, Italy, Portugal and Spain. Analysts say that while equity investors may be right in the short term, they risk ignoring a jump in funding costs that will erode future profit.

“The fundamental split here is about whether policy measures in Spain and the rest of Europe are going to work in halting the crisis -- or not,” said Huw van Steenis, a banking analyst at Morgan Stanley in London.

‘Especially Attractive’

Goldman Sachs equity strategists, including Peter Oppenheimer and Sharon Bell, turned bullish on European lenders last week, saying anxiety about the debt crisis will ease, driving down banks’ funding costs. The analysts, citing a “narrowing of sovereign spreads in the peripheral eurozone,” said in a Feb. 3 note that bank stocks were among the cheapest and the “trade-off between their growth prospects and earnings in the next few years looks especially attractive.”

UBS AG, Switzerland’s biggest bank, today posted a 7 percent increase in fourth-quarter profit. Deutsche Bank AG last week reiterated its target to double pretax profit at its operating units to 10 billion euros ($13.6 billion) this year from 2009 levels as the Frankfurt-based company posted a gain in fourth-quarter earnings at its investment bank. Santander, Spain’s biggest bank, reported fourth-quarter profit on Feb. 3 that beat analysts’ estimates. Chairman Emilio Botin told reporters that “the worst of the crisis is behind us.”

Bank stocks are benefiting as investors ride the “positive earnings story” for short-term gains, said Suki Mann, senior credit strategist at Societe Generale SA in London. “Funding levels are still very high for the banks,” he said. “Credit’s where the smart money is.”

‘More Uncertainty’

That point was echoed by Alexander Plenk, a Munich-based analyst at UniCredit.

“Equity investors are typically more focused on the short term than credit investors, and the really horrible news seems to have ended,” Plenk said. “Credit investors tend to take more of a medium to long-term view, where there is much more uncertainty.”

European banks have more at stake in Spain than in Greece and Ireland combined, with total claims exceeding $716 billion at the end of September, according to the Bank for International Settlements. Europe’s lenders hold more than $902 billion of loans and other assets in Italy, including sovereign debt, and $216 billion in Portugal, according to BIS data.

Financial firms in southern Europe are paying some of the highest costs ever to borrow relative to government debt. An increase in funding costs erodes bank profit by narrowing the net interest margin, or the difference between what a bank earns from lending and pays for funding.

Covered Bonds

Lenders in Spain and Italy are offering record amounts of covered bonds because investors are wary of buying unsecured debt that could be subject to so-called bail-ins being discussed by regulators that would convert it into equity when triggers are breached. Investors are forcing banks to pay more in interest on the securities, which are typically backed by mortgages or public-sector loans, are getting costlier for banks to sell as supply outstrips demand.

Santander, which hasn’t sold a senior unsecured bond this year, issued 1 billion euros of five-year covered bonds on Jan. 5 at a spread of 287 basis points, almost three times what it paid in March last year. UniCredit, Italy’s largest lender, sold 1.25 billion euros of 12-year covered debt on Feb. 1 at a record spread of 210 basis points. Four months ago, the Milan-based bank sold seven-year covered notes at 154 basis points. A basis point is one-hundredth of a percent.

Intesa, BBVA

Intesa Sanpaolo SpA, Italy’s second-biggest bank, based in Turin, paid a record spread of 208 basis points to sell 10-year covered bonds on Jan. 14, compared with a spread of 148 basis points at a five-year debt sale less than three months earlier. Banco Bilbao Vizcaya Argentaria SA, Spain’s No. 2 lender, sold 1.5 billion euros of three-year covered notes on Jan. 4 at a record spread of 310 basis points.

U.S. banks by contrast are selling debt from three-year floating-rate notes to 30-year bonds as the cost to protect the securities from default declines amid signs the economy is improving. Borrowing costs for U.S. lenders are near the lowest in nine months relative to the debt of industrial companies.

No banks in Portugal, Italy, Ireland, Greece or Spain have sold debt in dollars since September. German, Swiss and British lenders, including Deutsche Bank and London-based HSBC Holdings Plc, aren’t paying as much to borrow as southern European banks and are finding overseas investors willing to buy their debt.

Credit Suisse Group AG, Switzerland’s second-biggest lender, raised $2.18 billion this year in the U.S., including a sale of three-year notes that paid a spread of 128 basis points over Treasuries. HSBC, Europe’s biggest bank, sold 750 million euros of four-year notes at a spread of 127 basis points on Jan. 24, two weeks after a $4 billion offering, Bloomberg data show.

‘Pretty Dire’

Funding costs for Banco Santander, Intesa, UniCredit and BBVA have declined from record highs this month, helped by a wider rally in bank bonds. Spreads on senior euro-denominated bank debt narrowed 32 basis points to 169 basis points last week since reaching a six-month peak on Jan. 11, Barclays Capital’s Euro Aggregate Banking Senior Index shows. BBVA raised 2 billion euros in a five-year covered note sale on Feb. 2 at a spread of 242 basis points. That’s still more than three times as much as the lender paid about a year ago to sell similar securities.

“Nothing material has changed over the past two or three weeks, even though there has been improved sentiment in the stock markets,” said John Anderson, who manages about 500 million pounds ($805 million) in European bonds as head of credit at Gartmore Investment Management Ltd. in London. “The macro situation is still pretty dire in countries like Spain, and if they can’t grow, they can’t reduce their deficit.”

Capital Rules

European Union officials are trying to bolster confidence in the 27-nation bloc’s financial industry by forcing banks to hold more capital in reserve against future losses and to undergo stress tests to show they can withstand a recession.

Group of 20 leaders in November endorsed rules drawn up by the Basel Committee on Banking Supervision that will more than triple the highest-quality capital, such as shareholders’ equity, that lenders must hold to cushion against losses. European regulators, preparing a second round of stress tests in the first half of this year, have pledged to toughen the exams.

The cost of protecting European senior financial debt from default has surged 32 percent in the past four months. The Markit iTraxx Financial Index of 25 banks and insurers increased 39 basis points to 162.5 basis points, which means it costs 162,500 euros annually to insure 10 million euros of the debt for five years, according to data provider CMA.

Prices for credit-default swaps linked to the bonds of New York investment banks, including Goldman Sachs and Morgan Stanley, traded at levels that approached those of junk bonds in March 2007, before the global financial crisis and as shares in those firms were rallying.

Unlimited Cash

European banks are also charging more to lend to each other. The rate at which European firms say they will lend euros to other banks for three months, known as Euribor, reached a 19- month high on Feb. 4 on concern that the European Central Bank may withdraw emergency cash supplies to lenders in April.

The ECB said in December it would lend unlimited cash at its weekly, monthly and three-month refinancing operations until April to alleviate banks’ funding pressures and spur lending. The ECB offers the unlimited cash at 1 percent, the same as its benchmark, record-low interest rate. European banks are still dependent on the emergency funding: 371 lenders sought 213.7 billion euros in seven-day funds on Feb. 2, the most this year, according to the ECB.

‘Comprehensive’ Package

EU leaders meeting in Brussels Feb. 4 reiterated a March 25 deadline to reach what German Chancellor Angela Merkel called a “comprehensive” package to address the crisis. The measures may include stiffer sanctions against budget deficits higher than 3 percent of gross domestic product, lower interest rates on loans and allowing the 440 billion-euro stability fund to buy debt directly from member states.

Merkel, forced into underwriting a 110 billion-euro rescue of Greece last year, has toned down her insistence that government bondholders accept losses in future bailouts. In November, as the EU and International Monetary Fund bailed out Ireland, she called the euro’s condition “exceptionally serious.” Two months later, she said she’d back “whatever is needed to support the euro.”

That’s helped Europe’s benchmark Stoxx 50 index gain 9 percent this year. Credit-default swaps tied to Spanish government bonds fell about 36 percent since Jan. 10, CMA prices show, indicating an improvement in the perception of credit quality. The swaps are at 230 basis points. Contracts on Italy fell about 33 percent to 172 basis points, CMA prices show.

“Some of the frantic activity we have seen in the last few weeks has died down,” said Julian Chillingworth, who helps manage about 15 billion pounds of shares at Rathbone Brothers Plc in London. “Whether or not the European debt crisis is over is debatable. There’s still a long way to go.”

To contact the reporters on this story: Gavin Finch in London at gfinch@bloomberg.net; Bryan Keogh in London at bkeogh4@bloomberg.net; Charles Penty in Madrid at cpenty@bloomberg.net

To contact the editors responsible for this story: Edward Evans at eevans3@bloomberg.net; Paul Armstrong at parmstrong10@bloomberg.net

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