It's déjà vu all over again, in the words of the late Yogi Berra. Once more, investors are afraid of European banks -- or is it more accurate to say that the fear never went away and is re-surfacing now?
Back in 2010, the eurozone debt crisis started with investors' fears that banks in Europe held too many toxic assets on their books, including sovereign bonds issued by members of the single currency area with less than solid budgets, such as Greece, Italy, Ireland, Portugal and Spain.
Things slowly improved, with bailout programs for Ireland and Portugal apparently having good results, Spain managing to reach some sort of escape velocity, and Italy slowly digging itself out. Greece seemed to remain the only outlier -- dragging Cyprus down with it too. The European Central Bank's bond-buying operations that started last year greatly helped, and the crisis seemed to be over.
But now it seems to be flaring up again. As is the case whenever there is stress in U.S. stock markets, investors also take a look at Europe, and they usually get even more scared.
As Real Money's Carleton English wrote the other day, "Forget the U.S., European Banks Are Ailing." Perhaps forgetting the U.S. is too big a task -- after all, there is a lot of stressed debt in U.S. companies, especially in the energy sector, as our Stressed Out index shows (if you want to read more about it and check out all the content that's normally under a paywall, take advantage of Real Money's Open House offer, which lets you read everything for free for a few days).
Certainly, although the ECB's president Mario Draghi keeps the printing presses humming along, all is not well in the European banking system. The STOXX Europe 600 Banks index, which contains the continent's biggest banks, is down more than 20% year to date, having lost almost 5% in the past week alone.
Carleton also wrote about Deutsche Bank (DB) and how its hybrid debt/equity instruments are showing signs of stress. Italian banks have investors in Europe even more worried.
Alberto Gallo, the head of global macro credit research at RBS, noted in a report earlier this month that Italian banks were not initially affected by the bursting of the real estate bubble in 2008 in Europe to the same extent as banks in other countries in the eurozone. "But this initial resilience turned into complacency, when Spain and Ireland implemented an extensive consolidation of their banking systems, while Italy didn't," he said.
As a result, loans are now turning sour, as his chart shows:
Source: RBS Macro Credit Research
Investor jitters increased towards the end of last year, when four small Italian banks needed to be bailed out. Besides, data from the ECB showing non-performing loans at around 337 billion euros ($375 billion) or about 17% of Italy's gross domestic product, are not reassuring.
It's true that at the end of January Italy reached a deal with the European Union that allows the government to offer a guarantee to banks that sell their bad loans on the private market. This, it is hoped, will help them offload the bad debt, or most of it, at least, and start afresh.
However, things aren't as easy as they sound. For one, the guarantee falls short of initial plans to create a "bad bank" where the government could dump all the toxic loans, which would have dealt more quickly with the situation.
Secondly, the state guarantee will only apply to investment-grade loans, which, for obvious reasons, are the least likely to need it.
And thirdly, the process itself is very cumbersome -- the banks are supposed to package the loans into tranches and then buy a government guarantee to go with each package, which is hoped would sweeten the deal for potential investors in these tranches.
If this sounds like a typically European kind of fudge, it's because it is. But does this mean that Italy will end up a bigger mess than Greece, like some pessimists have been warning? Anything is possible, but personally I doubt that things will get that far, unless we get hit by another huge crisis -- in which case, not just Italy will suffer.
What is more likely to happen, in my opinion, is that this issue will continue to weigh on the markets, which will have good days and bad days, and the ECB will continue to prop up the European banking sector by doing "whatever it takes" to keep the show on the road.
Standard & Poor's credit rating agency said in a report after Italy's deal with the EU was announced at the end of last month that it expects the economic recovery in the country to gain pace this year, and this will benefit the Italian banking system.
The agency added that the measures launched by the Italian government will take time to work, and that it expects to see "a wave of consolidation" among regional and local banks that would create banks with stronger pricing power and significant cost savings.
If the S&P scenario comes true, this looks more like an opportunity than a reason to be afraid of European banks. But then, a lot of cleaning up must still be done before these banks truly become investment opportunities. Investors would be better off on the sidelines until that is done.