No sooner do we stop worrying a banking meltdown in one EU country,then were toldto start fretting about another. In September, traders were sweating over Deutsche Bank in Germany. Today, its the Italian banking sector.Steve Eisman, the Wall Street trader who foresaw the 2008 financial crash (as brilliantly depictedin The Big Short), is now shouting out fresh warnings about an Italian banking crash. Banking disasters rarely restrict themselves to one country so how worried should investors in Lloyds Banking Group (LSE: LLOY) be?
The Italian job
There are good reasons to fearthe Italian banking system, given that the IMF classified nearly one in five loans with a total value of 360bnas troubled at the end of last year. This represents roughly 40% of all bad loans within the eurozone. Eismanhas warned that Italian banks are stuffed with non-performing loans (NPLs),written down as worth about 45% to 50% of their original value.
The problem is, he reckons, they arent worth anywhere near that much, as they sellfor around 20% of the original price. If they were recognised at their full value, the banks holding them would go bust overnight, Eismansays. Italys third largest bank, Banca Monte dei Paschi di Siena, emerged as the weakest of 51 major European banks, according to stress tests in July.
Long and short of it
Eisman was the angry one in The Big Short, outraged at banks sellingsub-prime mortgages rated triple-A that wereactually junk, but he remainedcool enough to nethimself more than $1bn by betting against them. However, he praises the Federal Reserve today, saying that USbanks have been enormously deleveraged and de-risked, while warning thatEuropean regulators have been much more lenient. As he puts it: Europe is screwed.
So what about Britain? Im not really worried about Englands banks, Eisman says. They are in better shape than most in Europe. That may sound like damning with faint praise, but investors will breathe a sigh of relief. Lloyds has steadily repaired its core tier 1 ratio, which measures a bankscoreequitycapitalagainst total risk-weighted assets, whichstood at 10.2% in 2010 but hit 14.1% in September, pre-dividend. This is higher than both Barclays at 11.6% and HSBC Holdings at 13.9%.Lloydstotal capital ratio is 22.1%. Bad loans are increasing, but remain low as a percentage of itsoverall portfolio.
Tiers arent enough
Lloyds has further protection because of its reduced exposure to investment banking, as it focuses on domestic retail and small businessbanking. However, if Eisman is correct and Italy plunges into crisis, theres no way UK banks can escape unscathed. Evena hard Brexit wouldnt protect us from the contagion of a liquidity crunch.
Thats the risk you take when you invest in Lloyds, or any bank. It partly explains why the stocktrades at the discounted rate of just 6.95 times earnings, with ayield at 3.8% and growing. That dividendis covered a generous 3.8 times and the yield is forecast tohit 6.2% by the end of next year. Theseare good reasons to invest in Lloyds, but youshould also understand the risks. Keep an eye on Italy.
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Harvey Jones has no position in any shares mentioned. The Motley Fool UK has recommended Barclays and HSBC Holdings. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
