French Banks, European Debt, and Turmoil: Synonymous in 2011

Societe Generale, BNP Paribas, and Credit Agricole are three of the largest global banks in existence. As the European debt crisis worsened over the last several weeks, all three banks witnessed fleeing investors and surmounting doubt by the general public. In fact, Societe Generale's CEO Frederic Oudea scheduled multiple appearances on television and other media to convince the public of his company's solvency.

Like many of their American counterparts, French banks got a little too greedy. Underwriting massive amounts of debt and taking risky bets with shareholders' money did not serve any bank well over the last few years. Societe Generale, unfortunately, has been at the forefront of the French banking decline.

In early 2008, SocGen announced that one of its proprietary traders incurred losses of approximately $7.2 billion. The futures trader, Jerome Kerviel, was a junior employee who fraudulently set up transactions without the knowledge of his superiors. Given the volatile markets in 2007 and 2008, the trader fell victim to the invisible hand. The same day of the announcement, Fitch and Moody's downgraded the bank's long term debt.

SocGen suffered further in 2008 when one of its clients did not pay for 15 tons of gold based on a consignment agreement. The Turkish company claimed the deal was for only 3.3 tons. SocGen took the matter to court, and the bank never received its money back. In fact, by the end of the ordeal, the Turkish company filed a counter-suit alleging defamation of its reputation. While this situation is not a reflection of Societe Generale's operations or capabilities, it still materially affected the firm's capitalization by over $500 million.

Societe Generale made big bets during the 2008-2009 financial crisis that ended up paying off in the end. One such transaction involved credit default swaps with AIG AIG. SocGen invested nearly $11 billion in the securities with AIG, and if the company was not bailed out by the government, SocGen would have suffered extreme losses. The transaction ultimately worked out for the French bank, but the principle is the same. Banks should not be overly greedy.

Extreme leverage and excessive risk-taking did not serve many institutions well during the last financial crisis. Lehman Brothers, Bear Stearns, and Merrill Lynch all suffered significantly while numerous hedge funds and private equity vehicles became insolvent. While French banks had luck on their side, one wrong turn of events could have triggered even worse consequences.

In the current economic climate, European debt in various countries is deteriorating in value and trustworthiness rapidly. Italian debt is highly troublesome; China, however, pledged to purchase the country's debt if it is recognized by the European Union as a market economy. A market economy is one in which the goods and services available are priced based on supply and demand. Currently, China has a Socialist market economy, in which supply and demand play large roles but asset ownership is determined by government.

Even if China purchases Italian bonds, the underlying problem will not be solved. The country has to solve its spending and revenue-generating dynamic. China purchased a $505 million worth of Spanish bonds in 2010 as well. Greece, on the other hand, is not in a similar position as Spain and Italy. While all three countries are facing significant infrastructural problems, Greece is having the most trouble trying to stabilize itself. Over the last several months, the Greek government has been selling assets like the state-owned mining and telecommunications companies, airplanes, land on islands, and casinos.

Greek bonds, as expected, have not been performing well in the debt capital markets. No entity outside the European Union has considered purchasing the bonds. Further, the French Banks that are Europe's "too big to fail" institutions are suffering from over-exposure to Greek debt. Recessionary fears are rising all over Europe and the world, but is there any way to prevent significant damage? One strategy that would avert another 2008-2009 crisis is to prevent banks from failing. Given the sheer size of BNP Paribas, Societe Generale, and Credit Agricole, some may think that capital injections are the only way to prevent their failure. However, given the equity markets' turmoil, that notion is simply not true.

In a recent article published by Bloomberg, SocGen may be facing the risk of acquisition. At a time when its equity value is significantly lower than many other banks, SocGen may be purchased for an attractive price. Although its CEO denied rumors and stated that a merger would not solve the bank's underlying problems, when push comes to shove, a merger would be better than bankruptcy and insolvency.

Societe Generale's problems are far from resolved. Over the last few months, SocGen has been selling billions of dollars of assets in order to free up liquidity. As with Bank of America BAC, the CEO has been attempting to convince the public that his company is fine when liquidity is become an issue. Within the last week, Oudea stated that asset sales, cost cuts, and staff reductions to free up nearly $4 billion in capital. Some critics have said this attempt will be tough to accomplish by 2013. BNP Paribas also followed suit recently, claiming that it will be liquidating $96 billion of its assets by the end of 2012.

To make matters worse for Credit Agricole and SocGen, Moody's cut their long-term debt by one level, to Aa1 and Aa2, respectively. Confidence has not been lower in a long time for the banks, and we are in a time when institutions cannot afford to spook investors. Despite the inherent riskiness involved with the firms, their leadership teams will have to find ways to appease the markets. They will have to work with government bodies and even other private-sector companies to pull through the crisis.

Too big to fail is a phrase ingrained in all of our brains due to 2008. Banks have made mistakes in the past, and while it is not possible to reverse them now, there are various measures that they can take to mitigate the damage. Although times look grim for French banks in particular, efforts must be taken. The fate of the global economy requires it.