Swedish banks have been the life and soul of the Baltic boom over the past few years; now they are suffering from a severe hangover as Latvia, Lithuania and Estonia plunge into recession.

Swedbank and SEB, which dominate the region’s tiny banking markets, earned big profits as they fuelled the economic boom that followed EU accession in 2004; now they are counting the cost as their loan losses mount and their credit ratings drop.


Swedbank’s Baltic loan losses more than doubled in the fourth quarter compared with the third, while SEB’s almost quadrupled. Analysts predict these losses will plunge both banks into the red this year or next.

The Baltic economic crisis could not come at a worse time for the two big Swedish banks, because their home market has also entered recession and their other foreign operations – notably Swedbank’s subsidiary in Ukraine – are in trouble. Swedbank’s shares have plunged 78% since the onset of the credit crisis last October, while SEB’s have fallen 43%.

Swedbank’s share valuation is now 0.4 times tangible book value, according to Citigroup, while SEB’s is 0.7 times book. This compares with 1.0 times book for Nordea and 1.3 times book for Handelsbanken, the other two big Swedish banks, which have less exposure to struggling central and eastern Europe.

The Baltic economic crisis has also affected both banks’ credit ratings. Standard & Poor’s cut SEB’s rating to A in February and changed the outlook to negative in March. Moody’s cut Swedbank to A1 in February and downgraded SEB two notches to A1 in April and has both banks on negative outlook. In April, Fitch cut Swedbank to A.

Swedbank, which has to pay the highest premiums for deposits and loans, has taken advantage of the Swedish government’s offer to guarantee bank borrowing; SEB has indicated that it might follow.


The root of the problem

Things looked very different 10 years ago when SEB and Swedbank entered Vilniaus Bankas in Lithuania and Hansabank in Estonia, respectively, and made the Baltic states their second home market.

Through organic growth and acquisition, both banks expanded across the three Baltic countries to achieve higher market shares than they hold at home. SEB is now number one in Lithuania, the second largest bank in Estonia and is just third behind Parex Banka and Swedbank in Latvia. Swedbank is number one in Estonia and Latvia and is in second place in Lithuania. It now has more clients in the Baltics than it has in Sweden.

After EU accession, the two banks poured in funds to expand lending at a dizzying rate – particularly for mortgages – as they sought to profit from higher margins and faster growing volumes than in their mature home market. In 2006, total bank lending in Estonia soared by 75%, while Latvia and Lithuania racked up increases of 53% each.

Banks competed to offer mortgage loans worth more than 100% of the house value – if supplementary loans for furnishing were included – and interest rates fell as competition between lenders forced margins down. Banks also extended loans to finance housing development and the construction of shopping malls to serve pent-up demand.

The lending boom helped the Baltic economies grow by double-digit rates and fuelled housing and consumption booms as Balts made up for lost time under the Communist rule of the Soviet Union. House price inflation in Riga, the Latvian capital, peaked at nearly 60% during 2006.

Business became so good that, despite their size, the three countries became a significant proportion of the banks’ assets and profits. For Swedbank, last year the Baltic states represented 17% of lending and 25% of operating profit, while the respective figures for SEB were 11% and 12%.

However, the banks’ growing credit exposure in the Baltic states – and their even greater dependence on that market for profits – began to make analysts, shareholders and regulators jittery as signs of overheating became evident. At the end of 2006, SEB began to tighten lending but local banks and new entrants such as Nordea and Danske Bank stepped in to keep the Baltic economies on the boil. SEB’s new loans in the Baltics grew by just 7% last year and Swedbank’s by 14%, but Nordea’s still rose by 32%.

“We took an early decision that things were not moving in the right direction,” says Anders Arozin, head of Baltic banking for SEB. “We have lost quite a lot of market share over the past two years.”


Credit squeeze starts early

When other banks finally reacted to the deteriorating domestic and global environment at the end of 2007 by braking credit growth, it pricked the housing bubble, flattened the real-estate sector and pushed the economies into a sharp downturn. This accelerated after the global credit crunch last autumn as the Baltics’ main export markets in the eurozone and Russia followed it into the downturn.

The crisis deepened at the end of 2008 when the Latvian government had to take over Parex, which had suffered a run on deposits. Latvia was forced to turn to the IMF for help, and an international consortium – including the Swedish government – agreed to lend it €7.5bn on condition that spending cuts were implemented.

The three Baltic economies are now forecast to contract by 10% or more this year and not to recover before 2011. All three governments are now scrambling to cut budget deficits in order to defend their fixed exchange rates. Lithuania is widely expected to follow Latvia and seek IMF aid later this year if the credit crunch continues to prevent it issuing a Eurobond.

SEB and Swedbank’s Baltic operations are now in full retreat. Tighter lending conditions – including a virtual freeze on loans for real estate development – and falling loan demand have cut the loan stock in the three economies since the start of 2009.

“The speed of the reduction in the loan stock is our worry,” says Erkki Raasuke, chief financial officer for Swedbank. “We’re asking ourselves if it is happening too fast.”


Damage limitation

But the bigger worry for banks is the size of loan losses. This has become such a sensitive issue that both Swedbank and SEB have stopped issuing forecasts. Swedbank booked SKr977m (€87.5m) of Baltic loan losses in the fourth quarter – almost two-thirds of the group’s total – representing 1.9% of its Baltic loan book. SEB’s figures are little better: it booked SKr898m of Baltic loan losses, representing 1.3% of its loans there.

However, things will only get worse. Citigroup forecasts that Swedbank’s Baltic provisions will be 3.5% this year, another 5.7% next year and 3.9% in 2011.

Both banks have prepared for this by setting up special-purpose vehicles to hold seized collateral and repossessed property, although no assets have been placed there yet. The banks will hold onto this real estate because prices are so depressed and selling now would accelerate the downward spiral. It could also delay the recovery of the market, according to a senior banker at SEB.

Moreover, there remains a danger that Latvia might yet be forced to devalue, with a knock-on effect on Lithuania and possibly Estonia. This would lead to massive losses because much of the lending in the Baltics has been in foreign currencies, typically the euro. In Estonia and Latvia, foreign currency lending represents 82% and 87%, respectively, of all loans, while in Lithuania it is 62%.

Devaluations would increase the debt burden of mortgage holders and companies, triggering more defaults and putting enormous pressure on the untested insolvency system. “If the Latvian peg goes, loan losses could go through the roof,” says one analyst.

Even in such a nightmare scenario, analysts believe Swedbank and SEB are strong enough to weather the storm – though further injections of capital by shareholders and perhaps the Swedish state might be required to steady the ship. Both banks have already raised equity and are now well capitalised compared with their European peers. Swedbank has a Tier 1 capital ratio of 11.1%, while SEB has 12.1%.

UBS estimates that Swedbank’s Baltic loan losses would have to reach 11% of loans before the bank’s profits and its recent SKr12.4bn rights issue were wiped out.

“We expect total loan losses to have a very limited impact on equity,” says Louise Lundberg of ratings agency Standard & Poor’s. “If the Baltics were to devalue – which is not our base case – loan losses could have an impact, but still a limited one.”