A busy summer for both the banks and for the Badger of Broad Street!

This is supposed to be the quiet contemplative part of the English summer – a time for nice long lunches and treating the office to ice cream. Unfortunately, it’s pretty darn noisy in terms of news flow.

Gaza, Russia, US GDP expansion, and the Fed warning about rates. But, perhaps the most interesting current tale is Portuguese banking. I have nothing against England’s oldest allies in Europe, but I’m wondering what we can learn from them that could be repeated across the rest of the European banking sector…

After our shock and surprise when we discovered the UK’s hallowed ethical Co-op Bank was being chaired by an entirely unqualified and cocaine addled churchman with a penchant for young men of the night, do we really have any right to comment if the Portuguese family who retained leadership of Banco Espirito Santo were effectively using it as their personal piggy bank?

We are shocked, shocked and shocked again that such things are still going on. As we watched the stock and bonds of BES bounce like a manic rubber ball on particularly strong drugs, I was wondering what possible pharmaceutical enhancements buyers were on as we saw many speculative and ungrounded investments made into what was so obviously a conflicted and twisted name. 

And, it’s all happened so very close to the ECB taking full responsibility for regulating the most important European banks. As Portugal’s number two, BES was one of the banks that would have fallen under their Aegis. It was subject to repeated stress tests and would have been subject to the new Asset Quality Review.

Yet, it appears the bank has been hiding systemic mismanagement and massaging its books for years.

Since the BES crisis erupted in June following dodgy dealings around its rights issue, we’ve been amazed at the sheer lack of information and absence of transparency as to its true position.

Now it turns out the bank has lost far more money that it originally thought. It had to wipe out its subordinated debt holders, and take a Euro 4.9 billion capital contribution from EU banking resolution funds. It would appear it’s lending to the founding family of the bank has been spectacularly squandered. Among the losers are partner banks like Credit Agricole.

A further Euro 3.3 billion looks to be lost lending in Angola through a banking subsidiary that has just been effectively nationalized.

Nice. I don’t suppose that money is likely to be returned with a polite thank you note. Bad lenders lending money to bad borrowers – an unlikely recipe for success. And an uncomfortable lesson for the shareholders and subordinated debt holders who find themselves unhappy investors in the new BES bad bank. We suspect any recoveries will be… “modest”.

But, what the sorry saga does serve is a salutary lesson about what investors should be thinking about.

Do you trust the investment promises made by the bank, or do your own homework and conclude it was a hollow shell that had been hiding losses? How can you ensure and trust the information you receive? Surely bank regulators have said too much about banking transparency – yet we really don’t know what assets are still marked by banks on their banking books. And then go figure how many of Europe’s other banks are essentially rotten?

And if the banks are rotten, what does that say about European economies?

We’re all aware lending has tumbled and bad debts escalated across crisis Europe. Corporates can’t borrow to expand because banks are prepared to take risks – especially if the east trade is to keep buying European government bonds on the basis the ECB will honour the Draghi promise to do whatever it takes. It’s a dangerous addiction the markets have acquired.

I’ve read more than one respected bank analyst say BES is a one off. So was Co-op in the UK. So was Hypo Alpe Adria in Austria, a bank that has just bailed in its debt holders following years of unwise lending by the bank’s politically appointed leadership, or SNS, a Dutch bank that also bailed in subordinated debt holders following escalating losses in mortgage and commercial lending.

The bottom line is that across Europe there are still banks that are seeing their Non-Performing Loan ratios rise, their local management trying to maintain their relevance, asset portfolios that are massively skewed towards government bonds – which since the Euro was introduced are little more than dodgy credit risk.

I really can’t get excited about banks. But on the basis the coming stress tests and asset quality review won’t rock the wobbly and leaking boat, perhaps this week’s trade isn’t to go short banks, but simply stay neutral on the basis… Draghi will make it all better!?

Badger