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Swedish Banks Suffer Baltic Losses

Ballooning losses in the Baltic states are shaking Sweden’s financial system.

When the global economy was booming, the Baltic states became a hot destination for stag parties. The weekend before a wedding, groups of mostly British men would descend on the historic capitals of Estonia, Latvia and Lithuania for a couple of days of partying abandon before heading home to nurse hangovers.

These days it’s Sweden’s big banks that are paying the piper for their Baltic excesses. Swedbank, Skandinaviska Enskilda Banken and Nordea all crossed the Baltic Sea from their bases in Stockholm in the late 1990s to take advantage of the laissez-faire capitalism of the formerly Soviet Baltic states. With their capital, technology and brand names, they dominated the countries’ fledgling banking markets and fueled a credit boom that pushed the tiny economies into overdrive, with annual growth rates of 10 percent or more. But just as in so many other countries, boom has turned to bust in the Baltics. Ballooning losses linked mainly to real estate loans in the three countries are shaking Sweden’s financial system as severely as subprime mortgages and other risky asset-backed securities have undermined the banking industry in Western Europe and the U.S.

Swedbank and SEB plunged into the red in the first quarter of this year because of escalating Baltic losses. The deterioration is so sudden, says Erkki Raasuke, Swedbank’s CFO, that “we no longer provide guidance on expected loan losses in the Baltics.” SEB chief executive Annika Falkengren believes the worst is yet to come. “We will just have to sweat out a couple of very challenging years,” she says.

Economic problems in the Baltics would be manageable in normal times, but fears of mounting losses are driving up funding costs for the banks just as the global crisis is hitting Sweden’s economy with full force. “We have slowed down our activities in the Baltics,” says Nordea chairman Hans Dalborg. “But the real impact [of the crisis] will most probably come with loan losses in the Nordic countries, where we have the overwhelming majority of our business.”

The Swedes have moved decisively to contain the Baltic problems and the contagion at home. The government contributed €1 billion ($1.3 billion) to a €7.5 billion rescue package for Latvia that was put together in December by the International Monetary Fund. The package aims to prevent a devaluation that could spread through the Baltics, undermining confidence and leading to even bigger loan losses. In February the Swedish central bank, Sveriges Riksbank, agreed to a currency swap with Estonia worth $1.1 billion. Those moves complement a massive 1.5 trillion-kronor ($178 billion) government guarantee extended in October for debt issued by Swedish banks at home and abroad. And in recent months the three Swedish banks have launched rights issues to buttress their capital ratios.

These actions, although sizable, don’t guarantee success. With their economies in deep recession and social unrest rising, Baltic governments could be tempted to devalue their currencies to stimulate growth. “The risk of devaluation in the Baltics hasn’t dissipated,” notes Neil Shearing, an analyst at Capital Economics in London. The firm estimates that Baltic devaluations could boost credit losses to above 20 percent of the Swedish banks’ total lending in Central and Eastern Europe, causing their tier-1 capital ratios to plummet below the 4 percent regulatory minimum.

The three Swedish banks account for 87 percent of the Skr600 billion in loans extended to Baltic countries, an amount equivalent to almost 20 percent of Sweden’s gross domestic product. The leading player is Swedbank, a Swedish mortgage specialist that entered the Baltics by acquiring Tallinn-based Hansabanka in 1998 and today has 278 branches and 5.4 million customers there. The bank makes 44 percent of all bank loans made in Estonia, 27 percent in Latvia and 22 percent in Lithuania; it generated 29 percent of its Skr13.82 billion in group operating profits in the Baltics last year. SEB, which is controlled by the Wallenberg family vehicle Investor AB, operates 200 branches in the Baltics and serves 2.8 million customers. It accounts for 25 percent of all bank lending in Estonia, 28 percent in Latvia and 30 percent in Lithuania; those operations provided 14 percent of the group’s Skr12.47 billion in profits in 2008. Nordea, the biggest Scandinavian bank, has the smallest Baltic exposure, with 66 branches and a clientele of 250,000 in the region, accounting for less than 2 percent of the group’s operating profits in 2008.

The Baltics were the biggest growth driver for Swedbank and SEB from 2002 to 2007. Returns on Estonian, Latvian and Lithuanian assets were substantially higher than those on Swedish assets. Swedbank last year had net interest income of Skr6.45 billion on Baltic lending of Skr218 billion, a margin of 2.96 percentage points; its net interest margin on Swedish lending was 1.27 points.

Breakneck bank lending, in turn, helped foster the most dramatic economic revival in Central and Eastern Europe. In Latvia, where bank lending grew at a rate of more than 50 percent a year until recently, economic output expanded by 12.2 percent in 2006 and 10.3 percent in 2007. In Riga, the capital, housing prices shot up by 60 percent a year in 2005 and 2006, as older neighborhoods were gentrified and new suburbs sprouted. (By contrast, Swedish housing prices rose a total of 77 percent from 2000 to 2006.) Late-model BMWs and Mercedes choked the winding medieval streets of Riga, and upscale boutiques and bank branches dominated prime commercial space. “And all this in one of the poorest countries in the European Union,” says Morten Hansen, head of the economics department at the Riga branch of the Stockholm School of Economics. Last year, Latvia’s per capita income stood at $17,800 on a purchasing-power-parity basis, less than half of Sweden’s $37,500. Latvia’s neighbors were booming too. Estonia posted growth rates of 10.4 percent in 2006 and 6.3 percent in 2007; in Lithuania the figures were 7.7 percent and 8.8 percent.

The party came to an abrupt end, however, because of massive current-account deficits and rising inflation. The EU rejected Lithuania’s bid to adopt the euro in 2006 because the country’s inflation rate exceeded the ceiling laid down in the Maastricht Treaty by 0.1 percentage point. Considering that much of the Baltic boom was based on the belief that the countries would quickly adopt the euro, that near-miss triggered a wider crisis of confidence.

The global credit crisis exacerbated the pressure on the Baltic economies and their inflated housing markets last year. Swedish banks rely on wholesale markets for about 60 percent of their funding, a higher level than that of many of their European peers, which tend to have bigger retail deposit bases. As global liquidity tightened last year, Swedish banks experienced a sharp increase in funding costs and a shortening of maturities, which prompted them to squeeze their Baltic clients. “This double impact — the Baltic housing market boom and bust coupled with the global credit crunch — was followed by a decline in global trade and brought us to where we are today,” explains Swedbank’s Raasuke.

Today the Baltic states are in economic free fall. Latvia, the first and hardest hit, saw output contract by 4.6 percent in 2008, and the International Monetary Fund forecasts a plunge of 12 percent for this year. Estonia’s GDP fell by 3.6 percent last year and is projected to drop by 10 percent in 2009. Lithuania, which managed to grow by 3 percent in 2008, is also expected to decline by 10 percent this year.

The economic and political fallout of the crisis has been severe in Latvia. In December the government effectively nationalized the country’s largest local bank, Parex, and restricted withdrawals after the institution defaulted on €775 million of loans. In January street protests in Riga turned violent — more than 40 people were injured and a further 106 arrested — prompting the collapse of the Latvian government in February. In his first press conference at the end of that month, new center-right Prime Minister Valdis Dombrovskis warned that Latvia was “on the verge of bankruptcy” despite the IMF’s rescue package.

The economic pain is harsh because Latvia has for years fixed the value of its currency, the lat, to the euro in anticipation of adopting the EU unit. By contrast, many of its big trading partners — notably Poland and Russia — have allowed their currencies to depreciate sharply. Refusing to devalue and unable to enact a major fiscal stimulus, Latvia has pushed ahead with steep salary cuts in the public sector, and the effects are spilling over into the private sector, with unemployment doubling in the past year to more than 10 percent.

The economic deterioration has had an ugly impact on the banks’ bottom lines. Swedbank saw its operating profits in the Baltics decline by 16 percent in 2008, to Skr4.02 billion, before the bottom fell out of the market. The bank suffered Skr4.24 billion in Baltic loan losses in the first quarter of this year, leading it to post an operating loss of Skr2.88 billion in the region and an overall operating loss of Skr3.36 billion. In the same period a year earlier, operating profit was Skr1.17 billion in the Baltics and Skr3.72 billion overall. Fully 5.88 percent of Swedbank loans in the Baltics are nonperforming, up from just 0.47 percent at the end of 2007.

SEB’s Baltic operating profit declined by 63.6 percent in 2008, to Skr1.42 billion. The bank suffered Skr1.7 billion in loan losses in the region in the first quarter of this year and posted an operating loss there of Skr994 million, compared with a profit of Skr568 million in the same period a year earlier; 3.7 percent of the bank’s Baltic loans were nonperforming at the end of the first quarter, from 0.6 percent at the end of 2007. The Baltic losses caused SEB’s group net income to drop 44 percent in the first quarter, to Skr1.03 billion.

Nordea managed to boost its Baltic operating profits by 5.1 percent in 2008, to €59 million, but its NPL ratio almost tripled, to 1.41 percent, at the end of 2008 from 0.5 percent a year earlier. The bank’s operating profit in the region slipped 6 percent in the first quarter, to €16 million.

Back in Sweden the Baltic loan losses are hitting the banks’ credit spreads. The cost of insuring $10 million of Swedbank’s senior debt rose to 235 basis points, or €235,000 for €10 million of debt, in late April from 173 basis points six months earlier. Credit default swaps for SEB rose to 185 basis points from 115 over the same period, and Nordea’s CDSs rose to 125 basis points from 90.5.

Funding costs have risen too, particularly for Swedbank. Before 2008, Swedbank and Svenska Handelsbanken, the two largest issuers of mortgage bonds in Sweden, paid roughly the same rates on their bonds. By the end of 2008, however, Swedbank was paying 19 basis points more than its rival, or 3.73 percent for five-year bonds. In November 2008 a report by analysts at London-based brokerage firm Fox-Pitt, Kelton claimed that higher rates may have cost Swedbank Skr5 billion, or 23 percent of its net interest income, last year.

“All banks that have invested heavily in [the Baltics] have been punished at home in terms of funding costs,” says Swedbank’s Raasuke.

The rise in funding costs prompted the government to provide its loan guarantee scheme, which is similar to the federal guarantee extended to debt issued by major U.S. banks, in October. “The loan guarantee was mainly directed at Swedbank,” says Mats Odell, the minister for Local Governments and Financial Markets. In early November, Swedbank rushed to participate in the plan. It has so far issued Skr224 billion worth of debt carrying the government guarantee.

After unveiling its first-quarter earnings setback in April, SEB announced that it too would issue debt under the government guarantee program, which has been extended by six months to October. Nordea has shunned the program, however, as a sign of financial strength. “We didn’t want to be perceived as a bank in crisis,” explains chairman Dalborg. This way the bank can pay salary increases and bonuses to senior executives, something that banks using the guarantee are not allowed to do. Nordea has announced, however, that it will not raise salaries or pay any bonuses for the remainder of this year.

In February the government announced another support measure: It commited to buying as much as 70 percent of any new share issues, up to a total of Skr50 billion, if the banks decide to raise capital. Although no banks have applied for the program, bankers say it provides useful support in case they decide to tap the markets again.

All three banks have raised fresh equity since November. Swedbank did a Skr12.4 billion rights issue and scrapped Skr2.9 billion in dividends to increase its tier-1 capital ratio from 8.7 percent to 10.5 percent; Nordea pushed through a €2.5 billion share issue and cut dividend payments by €250 million to lift its tier-1 ratio from 8.2 percent to 10 percent; and SEB raised Skr15 billion with a rights issue and cut dividends by Skr4.5 billion to improve its tier-1 ratio from 10.1 percent to 12.1 percent.

The capital raisings have given support to the banks’ share prices. Late last month, Nordea’s shares were up 35 percent since the end of 2008, outperforming the DJ Stoxx banks index by 25 percentage points. The share prices of both SEB and Swedbank rose by 2 percent in the period, underperforming the DJ Stoxx index by 5 percent.

Notwithstanding the recovery of the share prices, the banks remain vulnerable to fresh deterioration in the Baltics. Moody’s Investors Service downgraded SEB’s long-term debt and deposit ratings last month by two notches, to A1 from Aa2, citing the risk of currency devaluations by the Baltic states. Two months earlier, Moody’s had downgraded Swedbank’s long-term debt rating by one notch, to A1 from Aa3.

The IMF rescue package for Latvia has reduced the risk of devaluation but not eliminated it. To keep its currency pegged to the euro, Latvia has had to accept a painful economic contraction and outright deflation. Wages have already dropped by an average of 10 percent since the beginning of the year, led by cuts in the public sector. Unemployment hit 10.4 percent in March, and with jobless rolls swelled by the ranks of returning expatriates who have lost their jobs in Western Europe, many analysts expect the rate to rise to 15 percent or more by the end of this year.

To resist devaluation “you need very flexible labor and product markets — and a tough government determined to withstand the inevitable popular backlash,” says Shearing, the Capital Economics analyst. The question is whether the government of Prime Minister Dombrovskis can stay the course in the face of growing discontent. Already it shows signs of weakening. It refused IMF demands for further budget cuts after the deficit soared to 11.7 percent of GDP in the first quarter, more than double the 5 percent ceiling set under the Fund’s loan program. The IMF responded last month by withholding a disbursement of €200 million from its rescue package.

The Baltic bust is readily visible in Riga, where one third of the country’s 2.2 million people live. Along Cˇaka Street, a once-thriving retail thoroughfare in the capital’s medieval center, every fifth storefront is vacant. The only apparently bustling retail center is on nearby Audeˉju Street, where 120 shops sprawl over the four-story, glass-enclosed Galerija Centrs, but the crowds are mostly window shopping.

At the Double Coffee, on the Galerija’s second floor, Katrina Prokopcˇuka and her fiancé, Eriks Briedis, both 24, nurse cups of cappuccino and explain why they have postponed their wedding plans. Recent university graduates — the first in their working-class families — they had hoped for employment in the marketing or loan departments of one of the city’s numerous bank branches but failed to land any sort of job. “So many people I know have lost their jobs — my sister, my aunt, my best friend,” says Prokopcˇuka. “And my father,” adds Briedis.

They both live in the barely middle-class, largely Russian-speaking Bolderaˉja district on the northwest outskirts of Riga, where three-story, Soviet-era apartment blocs were renovated in recent years with what turned out to be subprime housing loans. Briedis points out several empty, foreclosed residences on his street. Bolderaˉja apartment prices plummeted by 36 percent last year, according to the Riga City Council’s Housing Committee.

With the crisis growing in Sweden as well, the Baltic states may not be able to count on further generosity from either the Swedish government or the banks — whose rising funding costs make it hard enough to lend to less-risky Swedish clients, let alone the strapped Balts. Swedish government predictions in January that the economy would contract by only 1.3 percent in 2009 gave way to gloomier estimates in April of a 4.2 percent plunge in GDP. According to the government, unemployment, which climbed to 8 percent in February from 6 percent a year before, will likely hit 12 percent by 2011.

Blue-chip corporations, among the biggest clients of Swedish banks, are in dire straits. In April, Sony Ericsson, the mobile-phone manufacturer, announced that it would reduce its 12,000-strong workforce by one third by the middle of this year. The company posted a €293 million net loss in the first quarter of this year, compared with a profit of €121 million a year earlier, as sales plunged by 35.7 percent. Saab, the iconic Swedish auto producer, is near extinction after its troubled U.S. owner, General Motors Corp., said it would extend financial support only until the end of 2009.

“All economic forecasts in Sweden are pointing in one direction — downward,” notes Torbjörn Becker, director of the Stockholm Institute of Transition Economics, a think tank devoted to issues in the Baltics and other East European countries. “But public opinion still isn’t focusing on how the Baltics are linked to the economic situation in Sweden.”

That may soon change. “How much responsibility the Swedish banks bear is going to be a topic of growing debate in the coming years,” says Frida Willmansson, a Stockholm-based analyst for Danske Equities. Bankers themselves say it’s too early to heap blame — except in one respect. “In our Baltic business plans, we obviously did not consider that there could be more than a 10 percent contraction, and we didn’t test the resilience of our clients against that kind of decline,” allows Swedbank’s Raasuke.

But bankers insist they won’t quit the Baltics, and most other observers agree. “Don’t forget that for years this was a much more profitable market for the banks than Sweden,” says Hansen, the Riga-based economist. “They still believe there is an end to the tunnel — and maybe even light out there.”

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