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10/04/2011 06:38 PM

Profit Warnings and Greek Debt

European Banks Show Signs of Ill Health

Germany's Deutsche Bank issued a profit warning on Tuesday anda Franco-Belgian bank wobbled signficantly as Greek debt begins to drag significantly on Europe's financial industry. The European Central Bank is expected to make emergency credit available this week for the first time since the Lehman collapse.

For months, financial experts have been warning that Europe needs to act quickly to shore up banks on the Continent due to their heavy exposure to Greek debt. This week, there are increasing signs that their dire prognostications may be correct.

Deutsche Bank on Tuesday said in a statement that the company's earnings targets for 2011 were no longer realistic and that third quarter results were well behind expectations. CEO Josef Ackermann, who is set to vacate his current post next May, had hoped to earn a record pre-tax profit of €10 billion ($13.27 billion) this year. But the bank was forced to write down €250 million in Greek debt in the third quarter after similar write downs of €155 million in the second.

In addition, share prices for stock in the Franco-Belgian bank Dexia plunged on Tuesday, the most recent symptom of its significant holdings of Greek debt. The stock dropped by as much as 38 percent on Tuesday as officials in Belgium and France struggled to come up with a plan to prevent it from collapsing altogether.

The news also led to a general fall in European bank share prices which dragged down European and global markets on Tuesday.

The problems at Dexia, and the profit warning from Deutsche Bank, come as a result of a private sector agreement to contribute to efforts to bail out Greece. As part of the new, €109 billion Greek bailout fund tentatively agreed to in July, private sector creditors agreed to a 21 percent debt discount. Dexia this year has already written down €338 million to cover that pledge.

Warnings from Ackermann

With the Greek economy stuck in recession, however, and the country's budget deficit not falling as rapidly as hoped, there are concerns that Athens will need much more than €109 billion. Consequently, European officials have floated the idea of revisiting the 21 percent private sector contribution -- with some having proposed raising it to as high as 50 percent.

Dexia, which holds some €3.8 billion worth of Greek sovereign bonds, would almost certainly be unable to survive such a writedown. Investors have fled the bank as a result.

Ackermann has been vociferous in warning against revisiting the 21 percent agreement, a position he reiterated again on Tuesday. "I personally am very convinced that any short-term restructuring of Greek debt could provoke a contagion which would need much higher ring-fencing ammunition for other countries," he said at a London conference.

He added that he thought Europe would ultimately be successful in overcoming the crisis, but that "it will take much longer than some people think, and that will have an impact on the real economy but also an impact on the financial markets."

In response to the increased pressure on European banks, the European Central Bank is expected on Thursday to boost the amount of emergency credit available to banks in need of financing. The last time the ECB made such a move was in 2008 in the immediate aftermath of the collapse of Lehman Brothers. Banks have become reluctant to lend to one another due to exposure to Greek debt. Should Greece become insolvent, banks fear they would never be repaid for loans to other banks.

The Search for a Solution

The European Financial Stability Facility, the expansion of which is currently being approved by euro-zone member-state parliaments, will be responsible for indirectly recapitalizing European banks once it becomes operational. There are grave doubts, however, as to whether the €440 billion the newly expanded fund will have at its disposal will be enough.

Indeed, European officials are already discussing ways to either boost the fund yet again or to leverage it, using the fund's assets as collateral to borrow up to €2 trillion. On Tuesday, Belgian Finance Minister, at a euro-zone meeting of finance ministers in Luxembourg to discuss the crisis, said that the euro-zone is likely to pursue ways to boost the fund.

That, though, is not a foregone conclusion. Germans in particular have been extremely wary of throwing additional billions at the debt crisis and a parliamentary vote last week to expand the EFSF to its current level already cost Chancellor Angela Merkel significant political capital. Several politicians from within her ruling coalition have said that further expansions are out of the question.

Her junior coalition partner, the business-friendly Free Democratic Party (FDP), has also swung toward skepticism in recent weeks. On Tuesday, the party decided to hold a poll among its 67,000 members on further measures to prop up the common currency. Should a majority reject further EFSF expansion, that will become the party's official position. And that in turn would significantly reduce Merkel's wiggle room in the search for a solution.

cgh -- with wire reports

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