What to Do About Banco Espirito Santo of Portugal

By GEORGE HAY and NEIL UNMACK JULY 10, 2014 1:34 PM

New York Times

Lisbon needs to sort out Banco  Espírito Santo – fast. Despite a recent successful rights issue, Portugal’s second-largest bank by value has a troubled major shareholder and a large exposure to shaky Angolan loans. With Portuguese bond yields up 40 basis points since July 7 and domestic bank shares tanking, a speedy restructuring is needed.
Banco  Espírito Santo’s market value has almost halved since May, when details emerged of “material irregularities” at its ultimate parent company, Espírito Santo International. This is the bank’s first big problem. E.S.I. and the chain of intermediate companies in the Espírito Santo group are funded with short-term debt, some of which was sold through the bank’s retail network.
E.S.I. and another group company, Rioforte, appear to be struggling to roll over their debt. Yet another entity, Espírito Santo Financial Group – the bank’s immediate parent – has been plugging the gap. It told the market on July 3 that its exposure to Rioforte and E.S.I. had nearly doubled in just six months to 2.4 billion euros “to support the reimbursement of (E.S.I. and Rioforte) commercial paper.” That caused Moody’s to downgrade E.S.F.G.’s debt by three notches on July 9. Its senior bonds are trading at just 60 percent of par.
That leaves Banco  Espírito Santo with a problem: it has lent over 1 billion euros to E.S.F.G. and Rioforte combined. With roughly 6 billion euros of core Tier 1 capital, default would hit its 9.8 percent Basel III core Tier 1 ratio just as the European Central Bank is stress testing euro zone banks. A  restructuring of Banco  Espírito Santo, as described in Portuguese media on July 9, would help – particularly if it can shield E.S.F.G., the bank’s largest direct exposure.
The snag is that the reported terms don’t sound that great for the holders of commercial paper. They would mean losses of up to 70 percent, according to Breakingviews calculations. A restructuring might create other problems. Holders of group commercial paper might sue Banco  Espírito Santo for selling them the debt.
Then there’s the bank’s Angola business.
The bank’s operations in the former Portuguese colony grew sharply after 2005, even during the Portuguese sovereign crisis in 2011-12. It relied on its parent for funding: the loan-to-deposit ratio hit 220 percent by 2013. That rapid growth is now backfiring. Bad loans in Angola soared 84 percent between 2010 and 2013, according to the accounting firm KPMG.
The Angolan government has given Banco Espírito Santo a fuzzy-sounding “personal guarantee,” but that covers only 70 percent of the 6 billion euro loan book, and expires in mid-2015. If B.E.S. Angola were to fail, Banco  Espírito Santo could have to write down the value of its stake – or even face losses on $2.7 billion of intra-group loans.
The Bank of Portugal, which regulates the bank, has started to do the right thing. It forced Banco Espírito Santo to appoint an outsider when family patriarch Ricardo Espírito Santo Salgado stepped down as executive chairman last month. It also has 6.5 billion euros remaining in its bank solvency support facility if the bank needs propping up.
Portuguese authorities need to do more. The problem is understanding how bad the losses really are. Citigroup reckons Banco Espírito Santo’s capital common equity Tier 1 ratio could fall to 3.1 percent in a worst-case scenario, but it may never come to that. B.E.S. should provide far better disclosure on the potential exposures it has to its parent companies; how much debt is secured; and what it is secured on. And it should disclose what its potential losses in Angola could be, and how much of the intra-group debt is secured. Once the bank’s position is clear, it will be able to raise more capital if needed, or seek support from the government.
Second, the government needs to manage as best it can the fallout from the Espírito Santo group companies, pushing through an orderly restructuring, and making sure it is equitable for creditors. It will be traumatic for lenders, particularly those who thought they owned safe commercial paper. One creditor, Portugal Telecom, has lost a third of its market value in the last month. Yet however painful, the restructuring should be manageable.
The Espírito Santo group has managed to create a national crisis out of a family drama. Dawdling could make an already big mess even bigger.
George Hay and Neil Unmack are columnists for Reuters Breakingviews. For more independent commentary and analysis, visit breakingviews.com.
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