Term Sheet

The latest on private equity, M&A, deals and movements — from Wall Street to Silicon Valley

Wall Street's hidden Europe risk

June 12, 2012: 6:00 AM ET

Big banks are betting that Europe's largest nations will avert crisis.

Goldman Sachs

Recently upped its exposure to Italy

Fortune - Wall Street firms have been trying to stay one step ahead of the European crisis. That might not be far enough.

Earlier this year, a number of U.S. banks disclosed that they had significantly cut their exposure to Europe's most troubled economies. That was welcome news at a time when the Euro crisis appeared to be heating up again. But what got little notice was that while Wall Street firms were cutting their exposure to Greece and Ireland and Portugal, they were increasing their lending and bond buying in Italy, France and other European nations that seemed more secure. At the time that might have seemed like prudent risk taking.

MORE: Bank bailout is no cure for Spain

Over the weekend, though, European nations were forced to bailout Spain's banks. That's raised fears that the larger European economies might be in more danger of default than earlier thought. And that might be a problem for U.S. banks as well.

Goldman Sachs (GS), for instance, bought $2.2 billion worth of bonds in Italy, which is widely seen as the next troubled nation after Spain, in the first three months of the year. Bank of America (BAC), too, added over $600 million of Italian government bonds to its portfolio in the first three months of the year. Morgan Stanley (MS) added $555 million in French government bonds, after largely betting against the nation's debt in the year before.

And that's just the bets we can see. While the banks now disclose more about their Europe bets than they used to. Most of the detail has to do with the countries that have been seen for the past year or so as the most troubled, like Greece, Ireland and Portugal. The financial statements of Goldman and Bank of America and JP Morgan Chase (JPM) still give no detail about those banks' lending and credit exposure in France. None of the U.S.'s largest banks disclose anything about how much much they stand to lose in say Germany, or Europe overall for that matter.

MORE: Four reasons why the euro will survive

It is likely that Wall Street firms and U.S. large banks have recently been upping their activities in Europe's largest economies. U.S. banks need more capital in order to meet new regulatory requirements. And they don't want to have to sell more shares to do so. The only other option is to increase your bottom line. But that's hard to do in a slow U.S. economy, still struggling with a housing downturn, and low interest rates. And so a number of U.S. banks are looking to Europe to expand and pick up business at a time when local banks are struggling. At a recent presentation for investors and analysts, Goldman's president Gary Cohn said that Goldman could benefit from Europe's financial troubles by picking up customers for weaker overseas rivals. But to do so, Goldman will have to up what it could loose in Europe as well.

How much are the big U.S. banks at risk in Europe? Wall Street seems mixed on this. Europe's troubles seem to be costing them business. European M&A, for example, and the advisory fees that U.S. banks get on those deals, is around an all-time low for number of deals. Compared to say how much the U.S. banks had riding on mortgage bonds or U.S. real estate, the European bets appear to be small. As long as their hedges work, and that is a big if, it looks unlikely that any U.S. bank would fail, or even come close, due to its exposures in Europe. The Kansas City Financial Stress Index, which ranks how much risk there is in the U.S. banking system, had a reading of -11 in May. Anything under zero means that the risk of having trouble at any of the U.S.'s largest banks is lower than usual.

That doesn't mean everyone thinks there is nothing to worry about. Veteran bank analyst Tom Brown recently told Bloomberg News that a director at one of the nation's largest banks told Brown that he is "scared to death." The director's main fear was that the counterparties that U.S. banks have placed their hedges with might not have the money to pay up if there were a default in Europe.

Bank analyst Christopher Whalen says there are a lot of people looking into currency risk. Goldman's Cohn said his firm has spent a lot of time looking into whether trading parties could eventually pay the firm in drachma or other currencies should they reemerge. Whalen says he is not particularly worried about Europe when it comes to the big banks, though he says we really don't know. "The new game on Wall Street is guessing where the European risk is," says Whalen. "We'll find out."

Join the Conversation
About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

Email | @stephengandel | RSS
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.