Sunday, August 26, 2007

Merrill Lynch on European Banks Aug. 21

Conduits, LBOs etc should not sink the banks

In this report we have reviewed the downside risks for the banks from conduits, SIVs and upcoming LBO financing. Even on bearish assumptions, we estimate the combined impact of these factors would be to reduce the average Tier 1 ratio of the largest banks from 8.4% to 7.8%. This will not sink any banks covered in this report.

However, we do see some risks that share buy-back progammes could need to be curtailed at Deutsche, HBOS, UBS and CS. The impacts on valuation from these combined factors is also modest – equal on average to just a 2% downside risk to our estimated SoP valuations.

The real swing factor is the macro outlook

Our strategists point out that no asset bubble has ever corrected in an orderly manner. While we want to believe we are simply seeing a very bad case of the “jitters” in financial markets, the risks are clearly growing that the after-effects harm the real economy outlook for 2008.

We have modelled the estimated impacts of a normalising credit environment for the banks’ wholesale businesses. On average, this suggests a 10% downside risk to our forecasts – far outweighing the likely impacts of conduits etc. There is a wide dispersion around this average
figure – from a 2% risk to earnings at Intesa up to 20% at Deutsche and Natixis.

Valuations are not compelling given the risks

If we stress our SoP valuations for the potential bad news on conduits, LBOs and lower 2008 wholesale banking earnings, the upside in the sector declines from the base case 25% to 14%. The sector has on average traded 10% below our SoP valuations, so this figure of 14% is not compelling in our view, given the lack of disclosures on most banks’ subprime and CDO exposures. We think disclosure needs to improve significantly – hopefully with the Q3 results.

Clear stock calls – Buy Unicredit & Danske

No matter how we cut the numbers, Unicredit and Danske look to offer compelling upside potential of 20%+. By contrast Deutsche, HSBC and SEB look to offer the least attractive relative value given the potential downside risks....

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