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. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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  1. Gottfried Bach | October 10, 2011

    Keith, can you please help with PUT Options on Dexia, BNP, SocGen?
    I can't find any. Thanks.
    /gottfried

  2. alan | October 10, 2011

    1how to get options on pink sheets (Societe Generale SA (PINK: SCGLY))
    2which is the third bank?(( 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.))
    3 why note give the stock trading symbol for all your suggestions?

  3. LORNE | October 10, 2011

    CAN YOU PLEASE PROVIDE SYMBOLS AND EXCHANGES FOR THE TWO BANKS MENTIONED…THANKS

  4. Franz | October 10, 2011

    Your newsletters against the European banks are always very biased and not neutral. They are about as misleading as Bush was concerning the Iraque having atom bombs!

    Fact is, that the Credit Default Swaps of the main American Banks are much worse than those of Europen banks (data per 7.10.11):

    425 for Morgan Stanley
    395 for Bank of America
    362 for Goldman Sachs
    291 for Citigroup

    vs.

    358 for Royal Bank of Scotland
    328 for Société Générale
    248 for Crédit Agricole
    239 for BNP
    200 for UBS
    160 for Crédit Suisse

    I hope that your information is in the future less biased and more matter-of-fact.

    Greetings from Switzerland

    • Neil Morrison | October 10, 2011

      Franz i like a man that puts the the actual facts directly upfront for all to see i have been shorting BANK of America and Morgan Stanley based on the figures you have shown for a few weeks.cashed in and am now waiting for the smalll rally to fissile out before i continue, its amazing yes that the US Banks are in worse shape than the The European Banks with bigger credit default swaps and the gap is getting bigger the figures speak for themselves
      Thanks

    • Ron Parks | October 10, 2011

      Franz, I can't speak to the rest of the Money Morning writers, but Mr. Fitz-Gerald has always been very matter of fact about the disgusting state of American banks and the risks they pose to everybody while acknowledging that there are good European, Asian and even South American banks. He is very clear on this and has been since this entire mess started.

  5. LEMOYN WOLFE | October 10, 2011

    Hi my name Is LeMoyn .I was the subscriber who wrote in about the 19% .Not sure how it came through as Leon w but my real name is LeMoyn W .I know ive got a very different name and am not offended in any way if it gets mispelled .It has been butchered so many times i have got used to it. Bill and team You folks are the only ones i follow on a daily basis.I now know a few weeks in that you Truly do have our best investing interests at heart and are not out to grab a quick buck like the other talking head newsletters do. Having taken a real bath in the 90s on stocks i always felt in my heart that a group of individuals were out there somewhere and so i am Deeply Thankful for both myself and my wife that you are helping us prosper from your vast experience Prosperous Regards LeMoyn W

  6. R. Squier Ball | October 10, 2011

    The EU "movement" started in earnest in the middle 1920s. One heart of the movement was in Luxembourg:
    ARBED(Acieries Reunies de Burbach-Eich-Dudelange). The countries in this steel organization were: France, Germany, Belgium, Luxembourg, the Sarre teritory, Austria, Hungary and Czechoslovakia(cf. p.461, Biographie Nationale du Luxembourg). Leaving out the last three, these countries(or areas) became the European "Common Market" later on. This information comes from my doctoral thesis: RILKE EN FRANCE,
    accepted by Middlebury College in 1969.

  7. mwn560@aol.com | October 10, 2011

    Everytime I think I know what's going on, Bernakie says QE something. Won't a Euro QE timed with a US QE ruin this trade? What do you think the next plan is? Well it is QE3 here and something very simular in Europe.

  8. Neil Morrison | October 10, 2011

    Hi i do love your the way you clearly spell out your predictions and i do agree with your forcasts on these Banks but please explain how you intend to SHORT THEM when there is a BAN on shorting most EUROPEAN banks i was going to short Society General 3 weeks ago and the day i decided to do it the ban came in Please explain how you intend to get around it ?

  9. Calbert Malone | October 11, 2011

    When there is no stability in currencies and inernational monetary policies, banks are the worst hit.

  10. Eddie Murphy | October 12, 2011

    Very biased and prejudiced view. Actually what are you suggesting here is something everyone knows. Or perhaps you think only you know what is going on. Mainstream media is talking it all day long.

    Obvious trades touted as a premium advice. Nah. You guys gonna get burned.

  11. Luba | October 13, 2011

    Hi , guys i think its a bit biased towards EU banks…but have a look at Max Keizer reports, where the things are said clearly..;-)

    Thanks.

  12. LEMOYN WOLFE | October 13, 2011

    Just wanted to say Thanks and give appreciation for the recomendation on Omni Vision .Im already up 10% just since Tuesday this week and still climbing. Your team has instilled in me the confidence that i lost in the 90;s to invest in stocks. Its such a great and satisfying to see your stock recomendations end up most each day in the green as opposed to the red LeMoyn

  13. Robert Gifford | October 16, 2011

    A lot of exicement from Fool and party is a new product that
    will take the place of credit cards, a NFC technology in a I-phone
    that will read your bill at check-out and record your action.
    It will take the place of all credic cards. Do you know anything about this?
    Thanks Bob.

  14. Wieland | October 17, 2011

    I'd like to suggest to be careful with comparing Societe Generale or BNP with Lehman Bros. 2012 is election year in France, and Sarkozy will do everything to be reelected. That includes keeping SocGen and BNP from
    going down.

  15. Nash W | October 17, 2011

    Yahoo Finance shows no Options available for both Banks. How do we short them?

  16. NDbadger | October 25, 2011

    Nice try, but there are restrictions against shorting the European Banks.

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