They Haven't Been Praying Enough

According to press reports, Espirito Santo Financial Group, one of Portugal's largest financial groups and the biggest shareholder in Banco Espirito Santo (i.e., the Holy Spirit Bank, BES), is about to miss interest payments on some of its short term notes. The event prompted a sell-off in Portuguese government bonds as well. 10 year government bond yields have declined from more than 16% at the height of the sovereign debt crisis to about 3.25% at their recent lows, but have shot up by more than 60 basis points in recent weeks.

The chart of BES suggests that the troubles at the Holy Spirit Bank must have been on the minds of market participants for a while already. We have a feeling a costly scandal is brewing.

The Holy Spirit Bank inflicts some very unchristian pain on its shareholders – click to enlarge.

For BES shareholders it's presumably a bit like involuntarily taking a vow of poverty. Incidentally, the recent revelations about BES also led to shares of Portugal Telecom being taken out behind the shed and shot. Here are some additional details on the affair:

“Portuguese stocks and bonds dropped Wednesday, as continuing concerns over the financial health of lender Banco Espírito Santo rattled investors.

[…]

Shares in Banco Espírito Santo led declines after media reports that Espírito Santo International, which owns part of Espírito Santo Financial Group, which in turn owns a large stake in BES, had delayed coupon payments on some of its short-term debt.

"Last week some clients were asked to swap the commercial paper into equity," RBS credit strategist Alberto Gallo wrote in a note. He added that BES isn't directly responsible for the repayment of any ESI bonds, but "is subjected to reputational risks given its connection to the family."

Banco Espírito Santo didn't reply to a request for comment.

Moody's Investors Service on Wednesday downgraded its rating on Espírito Santo Financial Group to Caa2 from B2. "Moody's concerns regarding ESFG's creditworthiness are heightened by the lack of transparency around both the Espírito Santo Group's financial position and the extent of intra-group linkages," the ratings firm said.

Portugal Telecom shares dropped as much as 9% in response to criticism from Brazil's state development bank BNDES relating to an investment by the telecommunications company in debt issued by Espírito Santo International.

The impact was also felt in sovereign debt markets, with 10-year Portuguese government bond yields climbing to 3.82%, their highest in more than six weeks, before dropping back slightly. Yields rise as prices fall.

Traders said the uncertainty surrounding BES and declines in Portuguese stocks had caught investors off guard, given many had been betting on further gains for government debt at the start of the third quarter.

This is certainly not the first time that investors have been “caught off guard” by something like this, but “betting on further gains” in government debt may have been a foolish thing to do in any event. Portuguese bond yields have already declined enormously in an extremely short time period. Buying them at recent levels was asking for trouble.

Meanwhile, Banco Espirito Santo managers didn't have time to comment because they were actively seeking forgiveness for their financial sins. We have come across a photograph showing a procession of them. It is possible that the board of Portugal Telecom is also in the picture:

Managers of Espirito Santo Financial Group and Portugal Telecom are currently busy repenting.

(Photo credit: REUTERS / Erik De Castro)

Collateral Damage

The lack of transparency of the Santo Espirito group bemoaned by Moody's is evidently causing quite a bit of collateral damage. With the dealings of the ES group shrouded in a cloud of frankincense, investors can only guess how big the problem really is. We would however say that a group that cannot pay interest on its short term debt must really be in big trouble, considering that every corporate or sovereign Tom, Dick and Harry asking for debt financing happily unburdened by covenants or issuing bonds in junk-bond land gets funding these days at the drop of a hat.

The exposure of Portugal Telecom seems to be viewed as a serious problem by market participants as well, as the chart of its shares rather strongly suggests:

Shares of Portugal Tele-Splat in all their recent terribly glory – click to enlarge.

We recently noted that France's CAC-40 index looks like it may be leading a downside break in European stocks, but Portugal's PSI-20 index has lately also suffered noticeably from the burgeoning trouble at BES.

After bidding adios to its uptrend line some time ago already, the index has just violated an important lateral support level as well. In the course of this it has become a tad oversold and may therefore soon bounce, but the fact remains that the chart no longer looks very convincing.

As noted above, the government's debt securities have also come in for a spot of mauling, even though it is actually still a fairly small bounce in yields considering where Portuguese bond yields have been over the past few years. However, the fact that the recent bout of selling in the bond market has coincided with the market realizing that BES has a problem suggests that there is a degree of worry that the government may end up extending support to the troubled lender.

Lisbon's PSI-20 index: both trend line and lateral support (blue line) are gone – click to enlarge.

Portugal's 10 year government bond yield, daily. It has been rising since worries about BES have begun to percolate – click to enlarge.

Conclusion

Portugal is of course a small country, and the world will no doubt keep turning if in the worst case one of its bigger banks should so to speak cross the pearly gates and move on to the afterlife. We nevertheless find the event noteworthy, because we are on alert for debt-related troubles at the moment. To this it must be kept in mind that credit market problems almost always start in some obscure corner of the markets. What initially looks  like a seemingly unimportant event may in retrospect be recognized as one of the  first steps in a whole chain of events that are far greater significance. A fairly recent classical example was the bankruptcy of two small US sub-prime lenders in February of 2007, which was barely noticed. It is of course not possible to tell with certainty whether the recent problems in Portugal will turn out to have been one of those warning shots or not. But given the recent huge boom in debt securities, the system is no doubt vulnerable.

Lettuce pray for Holy Ghost Bank, its creditors and shareholders, as well as Portugal's tax cows, amen.

(Photo credit: klosterkirche.de)

Charts by: 4-traders.com, investing.com, BigCharts