Greece has been in the news for several years in a rather negative context: bailouts, austerity, “grexit” and debt haircuts are too often associated with the Greek saga. But each downturn eventually ends and gives way to a recovery. We are indeed at the stage of the cycle, where various important reforms have been put in place, the economy is showing signs of life while banks have been generously recapitalized. The dust is slowly settling and after the depression-like collapse in growth, there are signs of stabilization and even green shoots.
After three bailouts and a near 30% drop in nominal GDP, Greece is a poorer country but many of the underlying problems are recognized and are being addressed. The collapsing economy created a hole in the balance sheets of Greek banks, as non-performing loans (NPLs) rose to 35% of outstanding loans, wiping out equity capital in the banking system. However banks have undergone three separate recapitalizations (equity injections) and now – even accounting for non performing assets – have a solid capital buffer. They are in all likelihood over-capitalized in an environment of improving economy, and favorable bad debt dynamics. Crucially, the legal and judicial framework for dealing with NPLs, mortgages and collateral has been revised, allowing banks to recover significant amounts and reduce NPLs in line with ECB/SSM targets.
After the tremendous pain of the recent years, the stage is set for gradual improvement, which judging by economic data has just begun. The biggest worry might be the unsustainable government debt, however there is a silver lining here too. Only a relatively small share of the debt is owed to the private sector. The majority is owed to the troika (European Commission, European Central Bank and the IMF) and debt relief of that portion can reasonably be expected. Such debt relief would have no negative implications for Greek banks, on the contrary it would ensure sovereign debt sustainability. Greek bank equities are cheap and are discounting a dire future. It’s time to buy as the risk-return ratio is favorable.
1. A short history of the Greek Sovereign Crisis
The Greek debt crises is almost entirely due to the country’s government finances. The private sector hasn’t overborrowed, and banks were collateral damage – not the main culprits – of the sovereign’s problems. The origins of the crisis go back to the late 90’s when Greece was preparing to join the European Monetary Union (EMU). The EMU required joining member countries to fulfill certain debt and fiscal criteria, ie to maintain government debt to GDP below 60% and budget deficits <3% in a given year (the original 1992 Maastricht treaty rules). Unfortunately the Greek government at the time decided to blatantly lie, and through a series of financial transactions concealed the true level of debt and budget deficits. Surprisingly, the cheat was not discovered until much later and the country joined the European Union (EU) and the Eurozone in January 2001.
These lies went largely unnoticed until after the Global Financial Crises (GFC) when risk premia exploded and the cost of borrowing for peripheral European issuers such as Greece rose considerably. In late 2009, a newly-elected government announced that the deficit for that year was estimated to be 12.7% instead of 6%. The European Commission was outraged, but it was just the beginning as it really took a few more years to clean up the Greek statistics agency and establish a true picture of the sovereign’s liabilities (including debt issued by state-owned companies). In the light of these revelations the price of Greek bonds fell sharply (yields and spreads vs Germany exploded), and soon put at risk the government’s refinancing (or rolling over) of its debt.
As the Greek government was not able to borrow new funds, in March 2010 the first bailout package of €110bn was agreed with the troika, in exchange for a demanding austerity program and deficit reduction in Greece. Tax evasion, uncovering of further state liabilities as well as collapse of growth due to austerity have made it quickly clear that a another bailout would be required. In February 2012 the second bailout for €130bn was agreed between the troika and the Greek government. At this stage, a haircut on Greek bonds was negotiated (this is when Greece effectively defaulted). Certain privately held bonds were swapped for much longer maturities, effectively reducing the face value of these bonds by 50%, while the real value (due to maturity extension) was reduced by three quarters. However the official sector (in particular bonds held by the ECB and IMF or 44% of the total debt) were excluded from this exchange. As a result the impact on the overall debt load, was much more limited than the 50% reduction in face value would imply. Furthermore, the Greek banking system, which participated in the bond swap, took large losses on their holdings, and needed recapitalization to the tune of €22bn. As a result, a nominal haircut of 50% on €200bn of bonds, only effectively reduced the outstanding debt by €85bn, or 23.9% of the outstanding debt.  Not quite enough as it turned out.
One reason why a further third bailout was necessary, were the regrettable events of 2015. In January Syriza won 149 out of 300 seats in the parliament on an anti-austerity program, heavily criticizing previous bailouts and the troika. Investors were becoming increasingly worried about a upcoming confrontation between the government of Alexis Tsipras and the troika, and deposit outflows accelerated in the first half of 2015 after a relative stable period in 2013-2014. This further increased the dependency of the banking system on financing from the European Central Bank (ECB). The government was still running deficits and was going to struggle to refinance upcoming debt maturities in this environment. After a lot of truly Greek drama in June-July and a referendum, the third Greek bailout of €86bn was finally backed by the Greek parliament on August 14th 2015. It was another severe austerity package and required a number of reforms: streamlining VAT, safeguarding independence of the statistical agency, automatic public spending cuts, reform the labor market, privatize state assets and (yet again, for the third time) recapitalize the banks. Alexis Tsiparas ad Syriza are still in power today and have mostly been overseeing the implementation of this bailout. While the troika continues to oversee the reform program, the Greek government has largely aligned itself with the European agenda, as can be seen in a recent quote by the prime minister on state television: “We inherited unemployment at 27 percent, we will hand it over at 17 percent. We inherited a country that was on the edge of a cliff, we will deliver a country that is at the core of Europe… and an economy that will be growing, with social justice, which we did not even see when the economy was growing” (ERT-3 on the week of 11-Dec-2017). Note the reference to Greece being at the “core of Europe”. Admittedly parts of the ruling Syriza party are not wholeheartedly supporting some of the reforms, but as far as this author is aware no mainstream party advocates a break with Europe anymore.
2. Greek bank fundamentals
NB: A lot of our analysis will focus on the four largest and systemically important Greek banks (Alpha Bank, Piraeus Bank, Eurobank Ergasias and National Bank of Greece), the “Greek4”. These four institutions represent two-thirds of the assets of the banking system (€260bn vs €391bn) and are all listed on the Athens Stock Exchange (with some also listed in the US). We will occasionally also use data reported by the Bank of Greece for the entire banking system or Monetary Financial Institutions (MFIs). For further information on these stocks, you may follow Jan Willem Barnhoorn on Seeking Alpha, who provides updates and great commentary.
The banking system got hit by the crisis in two ways: directly, by the one-off losses from haircuts on sovereign bonds (the blip in 2012 on the chart above is the result of the “haircut” or Greek debt restructuring), and more importantly, indirectly by an explosion in non-performing loans due to the collapse of the economy as GDP cratered, while fiscal expenditure was cut. NPLs account for around 36% of outstanding loans as of Q2 2017.
Non-performing Loans are the elephant in the room
There is no doubt, that it is the huge pile of NPLs that will represent the biggest challenge to the Greek banks in the coming years. This problem does have the attention it deserves and progress is being made in this space. Since 2016 the ECB via its so called Single Supervisory Mechanism (SSM) has been working with the Bank of Greece and the Hellenic Bank Association on a plan to reduce non-performing loans and non-performing exposure – NPE being a slightly broader measure of impaired loans. A detailed NPL reduction trajectory has been agreed, and appears to be broadly on track as can be seen in the table below.
As of September 2017 the Greek banks were on track with NPEs falling to €99.1bn (vs €99.9bn target), while NPLs fell to €70.2bn. And these are still early days, as the targets are back-loaded, with the biggest reductions to occur in 2018 and 2019 bringing down the NPL ratio to 21.1% from the current 35.1%. There are three main ways for banks to reduce their bad loans: liquidations, sale of loans and write-offs (each contributing about €10bn reduction over the next 2-3 years according to the ECB/SSM targets).
There has been encouraging newsflow on this front at a micro level. In October Eurobank sold a pool of €1.5bn unsecured consumer loans to Sweden’s Intrum. Admittedly the loans were sold at only 3% of face value (+fees) but unsecured consumer loans are the most troubled category (residential and corporate fairing relatively better). During recent Q3 result conference calls, Alpha Bank and Piraeus Bank both mentioned accelerated NPL reductions in the near term, while Eurobank assured investors about their ability to meet targets set with supervising authorities. Furthermore, over the past 12 months a number of important legal changes have been made while more are planned, to improve non-performing loan recovery. These legislative efforts show that the government (admittedly with some pressure from the creditors) is making a significant effort to tackle the NPL problem. Some of these are difficult politically (repossessing properties to pay the banks does not get many votes in Greece apparently), but considerable progress has been made regardless.
The progress on the legal front is so important, because the old framework was particularly inefficient at recovering bad debts. As a result many borrowers in Greece decided to default on their debts even though they would able to continue servicing them. This group has been branded “strategic defaulters”. A Bank of Greece study found that as many as one in six companies were not servicing their debts despite having the ability or selectively defaulting, hoping to reach a settlement or having their debts forgiven. This certainly raises hope that recovery rates on at least part of the outstanding NPLs will be high.
Legislative changes to unclog the NPL pipeline
There are many examples of how the pre-2016 legal framework was inadequate and made recovering bad loans slow and costly. The General Bankruptcy Code allowed the liquidation process to last for up to ten years, which is obviously hugely inefficient for the creditors and the whole system. Over-indebted individuals could game the system by almost continuously reapplying for debt relief leaving limited time for creditors to enforce their rights, between applications. Repossessions of properties have been extremely limited in recent years. The legal framework was inefficient in the best of times and when the tsunami of NPLs hit the banks in 2010-2015, it was in clear need of overhaul. A number of changes, recommended by Greece’s creditors and the Hellenic Financial Stability Fund (HFSF), have already been implemented and several more are forthcoming. Many more steps are taken to improve the operating environment for lenders – let us highlight four main initiatives below.
Out-of-Court Debt Workout Out-of-Court Debt Workout has gone into effect on the 3rd of August 2017 and will allow voluntary debt restructurings. 300’000 companies, who have outstanding bank loans or arrears to the state, are eligible. The framework allows viable companies who have a hard time meeting their financial obligations to settle their debts based on their real financial situation and after conducting a full assessment of their assets. 7’550 initiated the process as of end of October.
Code of Civil Procedure amendments The Code of Civil Procedure has been amended in 2015 to streamline procedures before civil courts as shown above. Further changes planned for early 2018 will allow banks to claim 100% of owed loans from bankrupt businesses (as opposed to 65% currently) after property taxes and six months of backpay to employees. A clear step to boosting the recoveries (and value) of NPLs.
E-auctions: Since the crisis began repossessions have been kept to a minimum – mostly by politicians, but more recently due to disruptions of public auctions. Seeing little risk and urgency of foreclosure, strategic defaulters who had the capacity to continue paying back their loan, decided to suspend payments. A non-payment culture fostered. This dynamic contributed to the very high level of NPLs today as the backlog hasn’t been cleared in years. The good news is that, change is already happening. Legislative changes in Q2 2017 lay the ground for banks to sell property off via online electronic auctions, a step that would finally start clearing the backlog. After delays of several months, the website was launched and first e-auctions have taken place in early December and it looks like they will accelerate in 2018, with the target being about 1’000 properties/month in mid-2018.
Auctions could also trigger another positive side-effect for banks, and the banking system in general by encouraging strategic defaulters to come forward and start meeting their loan repayments to prevent their property being sold at well below its market value.
Politically, the government appears to be walking a fine line though, as Alexis Tsipras originally campaigned using the slogan “no homes in the hands of bankers”. However as long as the Greek government is committed to working with its European partners, it may have little choice but to follow their recommendations. Properties of low-income families are protected from repossessions and being auctioned off, if the owed amount is below €200k or the property is valued at less than €280k.
Credit Bureau: An independent agency will be created in early 2018. It will track tax, social security and bank loan arrears for individuals and companies. It will surely be helpful in identifying people who are “gaming” the system and surveying credit quality of borrowers in general.
These reforms go a long way in fixing the inadequate legal framework and address the “non-payment culture”. It should allow banks to effectively deal with the huge NPL overhang and make the NPL/NPE reduction targets agreed with the ECB achievable.
The balance sheets of the banks are in rude health. As can be seen below, the equity capital has been replenished (after a long series of write-offs and losses) and today at over €33bn is higher than the pre-crisis peak (while assets are somewhat lower than previous peaks). Commo Equity Tier 1 ratio (CET1) is at 17.1%, while the Capital Adequacy Ratio (CAR) is at 17.2% (both higher than year ago levels).
Liquidity has similarly been improving. For several years, and particularly during and after 2015, the banking system became dependent on emergency liquidity assistance (ELA) from the ECB/Bank of Greece, which is an expensive type of funding. Use of ELA funding has been declining. Eurobank, National Bank of Greece and Piraeus Bank all raised funds through covered bonds over the past three months. Finally deposits have been rising modestly over the course of the year. Confidence is building, the crisis is over – this is slowly being reflected in the cost of credit.
Banks do not typically have a “revenue” line. Instead, the top line in the income statement is called Net Interest Income or NIM. It represents the spread between interest received (on loans and other assets) and interests paid (or cost of funds). The NIM of Greek banks is a healthy 2.6%, whereas many European banks only have a NIM of about half that amount.
Let us briefly consider bank accounting for expected losses on lending. Provisions are a charge against anticipated losses from lending in the income statement of the bank. They are taken on a quarterly basis. Provisions have moderated over the last few quarters after a final spike after the referendum and panic in 2015. Given the improved economic prospects (discussed below), provisions are likely to remain contained. As net interest income is consistently strong, low provisions will directly feed through to higher profits and over time build up higher levels of (book) equity.
Accumulated provisions become (loan loss) reserves (on the balance sheet). In recent years, significant reserves have been set aside by the banks to cover losses from NPLs. Indeed, the NPL coverage ratio (reserves divided by NPLs) amount to around 60% and have been on a rising trend.
One would be correct to point out that 40% of the NPL book is not covered by reserves. However the other missing element in this analysis is loan collateral (and ultimately NPL recoveries). The vast majority of loans given by banks has collateral, and as explained above, this collateral will be increasingly recoverable thanks to the legislative changes. According to calculations by Jan Barnhoorn, the coverage ratio including collateral values for the Greek4 banks was between 111% and 125% as of December 2016. Thus, the NPL stock is currently well covered by reserves and collateral. Going forward, reserves may not have to rise any further, if, as we anticipate, NPLs stop rising. This will be helped by an economic recovery.
How much upside is there?
The share prices of Greek banks are down over 90% (in some cases 99%) from the highs in 2007. It has lead some investors to assume that in a recovery scenario the upside might be in the 10-100 times range. That is in all likelihood wrong. The market value of the equity of the Greek4 banks has fallen from €50bn to €10bn, while their market value as a share of GDP has fallen from 25% to 4%. Thus a more realistic upside target in a full recovery scenario would be 6 times or 600% – an exciting prospect. The difference between the drop in the share prices of over 90% and the drop in market value of 80% is of course accounted for by the discounted rights issues and three capital increases at Greek lenders. There is upside in the Greek bank trade, but it’s in the 3x-6x range (not 10x-100x – it is not bitcoin after all).
Another approach would be to consider the multiple of market value (or price) to tangible book value (per share) for banks in Greece. This measure is currently very depressed (below 0.4x) and could potentially rise towards the Eurostoxx Bank average (which is itself very depressed historically) of almost 1.0x in a recovery scenario. That would suggest expected returns of around 3x for Greek lenders.
3. The Greek Economy
The Greek economy is by no means in a boom, and neither are we forecasting one. The positive view on bank equities is predicated on economic stabilization with modest growth going forward. Bank of Greece expects growth of 2.4%-2.5% in 2018 and 2019 – it might not seem like much, but it would in fact be the highest rate of growth since early 2008. For almost ten years companies and consumers have been extremely thrifty and cautious. The return of confidence will make a huge difference.
Apart from being a financial crisis, the Greek saga has been a real social tragedy for the Greeks. Thus, the most important economic indicator for the Greek people and politicians must be the unemployment rate. Although still high, it is down over seven percentage points from the peak, which translates to almost 400’000 less unemployed.
The number of people quitting their jobs – usually in order to take up a better job – was frequently cited as Janet Yellen’s favorite indicator of market tightness (the famous “quits rate”) – there appears to be good news in Greece as the number of voluntary quits has risen.
Greece has not benefited from a currency devaluation (as it remains in the Eurozone), and there was no real export boom. Although imports did collapse during the crisis, bringing the current account into balance.
Tourism has contributed to balancing the current account and has been one important source of growth in recent years as tourist arrivals are set to breach 23 million this year. Greece is an attractive destination with its 6’000 islands, thousands of kilometers of coastline, Mediterranean climate and good food. In addition, by most accounts it remains an affordable destination. As per a recent BoG release, travel receipts in January-October 2017 rose 14.2% year-on-year.
After years of living thriftily, there is probably some pent-up demand for cars. Before 2008 an average of 40 thousand cars would get registered on average per month, and this measure fell to below 15 thousand between 2011 and 2017. Surely the age of the average vehicle has risen and the replacement cycle will kick in, once confidence returns.
In terms of housing prices, we can only speak of stabilization after a fall of 40% peak to trough, however construction permits are showing timid signs of life.
Further “green shoots” in the construction sector can be seen in demand for cement.
It’s early days, but construction activity should progressively normalize as banks become healthier. Construction activity is running at very low levels and the trend is higher.
Finally, leading economic indicators are encouraging. The Purchasing Managers’ Index recently came out at levels rarely seen since 2008. The leading New Orders component is also on the way up.
To summarize the economic situation we will borrow a paragraph from a recent Bank of Greece report.
The positive course of the economy is reflected not only in GDP figures, but also in several key indicators of economic activity, such as industrial production, retail sales, private sector employment flows, exports of goods and services, and foreign direct investment, as well as soft data such as the manufacturing PMI and the economic sentiment indicator. Improvements are also visible in the financial sector: bank deposits of the non-financial private sector have increased, the decline in bank credit to non-financial corporations has slowed, and banks’ dependence on central bank financing has gradually decreased.
After going through hell over the last eight years, Greece is finally turning the corner and Greek banks, which are cheap and over-capitalized will benefit from the recovery. The legal framework is being put in place to deal with the NPL overhang, while better growth will also be favorable for NPL formations and collateral values. The top four lenders in Greece will be reporting healthy profits, as provisions remain contained. Equity values will continue to grow and before the end of the decade some will start paying dividends again – of course, at that stage share prices will be much higher.
A word of caution
To be sure, many problems remain in Greece: the government still has too much debt, demographics and long-term growth prospects are uninspiring, non-payment culture is alive and well, while unions have too much power. Greek politics will remain volatile and although odds favor a recovery bank stocks, there is never such a thing as certainty. This trade is for seasoned investors who are able to take a loss should one occur – widows and orphans stay away.
The main risk of this trade is related to Greek politics. Although no major political party advocates a break with Europe, that could change. Recently, forces to the left of Syriza organized campaigns and demonstrations during repossessions of properties and in front of courthouses during auctions. A split in the ruling Syriza can also not be ruled out. But as long as Greece remains in the Euro and owes considerable sums to the troika, it will have to follow the path of reforms. It would be a huge waste to abandon it now, that so much has been achieved.