One of These Banks is Europe's Lehman Bros. – And We're Going to Profit From Its Collapse

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Back in July, I warned you that Europe probably had its own Lehman Bros. - an unstable financial institution on the brink of a collapse.

At the time, I didn't know exactly which institutions were most at risk.

Now I have a pretty good idea and want to share that with you.

One big firm, the Brussels-based Dexia SA, is already set to be dismantled.

And based on an analysis of 50 European banks with a combined $129 billion (92 billion euros) tied up in Greek sovereign debt, I've identified two other suspect institutions: BNP Paribas SA, and Societe Generale SA (PINK: SCGLY).

These banks have a high level of exposure to Greek sovereign debt and once they're forced to acknowledge the precariousness of their situation investors will stampede for the exits. That will have negative effects for both European and U.S. banks, as well as the overall markets. But there is a way to not only protect yourself, but turn a serious profit.

I will explain that to you shortly, but first, let me give you an idea of what it is we're dealing with.

Europe's Lehman Bros.

Basically, there are two ways to judge which banks are most at risk. You can look at how expensive the credit default swaps on these banks are compared to their peer group. And you can look at how quickly those credit default swaps have climbed.

Credit default swaps, in case you are not familiar with them, were originally created as "insurance" that protected the lender in case of a default. When they are purchased, the loan is turned into an "asset" and is then "swappable" for cash if the borrower defaults.

Generally speaking, the more expensive a credit default swap is and the faster its price has increased, the greater the risk there is associated with it.

As of Oct. 4 , the senior debt of the top 25 global banks with tradable CDS instruments was at 289 basis points. (A basis point is equal to 1/100 of a percentage point . They are commonly used to denote a rate change or, in this case, the difference or spread between two interest rates.)

However, the five-year senior credit default swaps for Societe Generale and BNP Paribas are considerably out of line with that figure - or at least they were as of Oct . 6. They've recovered since rumors of another rescue surfaced, but they're still dangerously high. Five-year senior credit default swaps were recently valued at about 386 points for Societe Generale and 287 basis points for BNP Paribas.

As for how fast the cost of insuring that debt has risen, the data is even more incriminating. Since 2009 Societe General's credit default swaps are up 294.17% and BNP Paribas credit default swaps have risen 199.60%.

This suggests two possibilities: 1) Traders are betting that the banks are substantially undercapitalized - meaning they may not have enough money to meet potential losses; or 2) They've got way too much exposure to Greek debt to withstand the country's failure.

This is no coincidence. BNP and Societe Generale are among the top foreign holders of Greek government bonds, according to the European Central Bank (ECB) and the Institute of International Finance (IIF).

Why regulators and central bankers cannot put two and two together is beyond me. To hear them tell it, BNP and Societe Generale have already written their Greek debt down 21%, so this shouldn't be an issue.

But other European banks wrote their Greek debt down by 51% on average. That means BNP and Societe may still have another 30% in write-downs that they don't want to pull from the closet like the skeleton everybody hopes isn't really there.

An additional 30% in write-downs for these suspect banks could result in more than $2 billion in extra losses, or roughly triple what's already been booked.

In BNP's case, the hit would be another $2.3 billion (1.7 billion euros). The bank calls that manageable, but I have my reservations. And Societe Generale would have to take an additional net loss of $135 million to $200 million (100 million to 150 million euros), according to Laetitia Maurel, a spokeswoman for the firm.

The Two Moves to Make

The word is that Europe is going to "handle it" (again).

Well call me crazy, but I don't believe it.

Aside from the fact that this is the seventh or eighth attempt at subduing this crisis, I simply don't believe that it can be done based on my experience in Japan over the past 20 years.

I lived through the financial crisis in that country and I recall very vividly what happened when Japanese banks were forced to take write-downs on bad debt. Many went bust and those that shorted the entire Japanese financial sector made a fortune.

That's what I see happening here.

So here's how you might play this if you're an aggressive trader.

Bear in mind, though, that what I am about to suggest will require some finesse - if only because the world's central bankers still believe they can save Europe's banking system.

That they will try I have little doubt. That they will ultimately fail, I have no doubt.

The key to this trade is sentiment. Stocks rose sharply towards the end of last week, lifted by the hope that the European authorities will succeed.

Good. The longer the illusion is maintained, the higher prices will be before we short them.

The timing signal I'm looking for is very simple: When Greece misses its first bond payment or news of break up talks hits the wires. That's going to cause a cascade of sales, forcing the value of all Greek bonds to immediately drop as traders make a mad dash for the exits. The three banks we're targeting will get hit the hardest, but U.S. banks will be adversely affected as well.

I don't think it would be out of line to get in the game a little early, but recognize that the trades may go against you before they ultimately perform as expected.

So here's what to do:

  • Short the banks I've mentioned - BNP Paribas SA, and Societe Generale SA. Be careful, though. These may rise dramatically in the short term before falling again in 2012 when the write-downs and declining earnings really come home to roost. Proper risk management is critical.
  • Buy long-dated put options on the individual banks, as well the broader Standard & Poor's 500 Index. Ideally, you want these to be dated 2012 or even 2013 when they become available. While your risk is limited to the amount of money you use to buy them, these puts will be volatile so only use capital you can afford to lose entirely.

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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He’s a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean.

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