At European banks, the fire sale continues by Megan Barnett @FortuneMagazine December 9, 2011, 4:41 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons By Cyrus Sanati, contributor FORTUNE — Even as European leaders convened this week an emergency summit to save the euro, European banks were busy trying to offload trillions of euros worth of assets in a bid to slim down. But while the banks may appear desperate to sell in order to fortify their balance sheets and comply with new capital restrictions, they don’t seem willing to take a bath on their performing assets just yet, frustrating willing buyers hunting for an easy deal. Nevertheless, bankers do seem willing to play ball when it comes to their impaired assets. Hedge funds and other investment firms here in the U.S. stand to make some sweet returns buying up those impaired assets at distressed prices – if they are willing to absorb the risk. In Brussels, European leaders are hashing out their differences in order to stabilize their crippled banking sector and sputtering debt market. Last night, Germany agreed to drop a provision that would have forced investors to take large haircuts on their sovereign debt holdings if the country that issued the debt is bailed out by the eurozone, something known as private-sector involvement, or PSI. This appears to be a gift to the European banking sector, which includes some of the largest holders of sovereign debt. The top 10 European banks held around 226 billion euros of the stuff at the end of last year. The banks will now only be required to mark down their holdings to levels previously agreed to with the International Monetary Fund in its bailouts of Greece, Portugal and Ireland. This has allowed the Europeans to move up the time-table to launch their 500 billion euro bailout fund, which they hope will bring stability to the debt markets. But while the banks have won a victory here, they still have a long way to go if they want to see their fortunes turn around. Large with leverage European banks spent much of the last decade acquiring assets in an attempt to become massive, full-service global banks. Some got bigger by merging with other European banks, while others plumped up by snapping up banks in foreign countries, far from the eurozone. The banks also issued and bought billions of dollars worth of securitized investment products, like residential mortgage-backed securities, RMBS, many of which turned toxic in 2008 and never recovered. It now looks like they went a bit overboard as they levered up to buy assets all over the world. The eurozone banking system currently holds about 30 trillion euros worth of assets. That’s roughly two-and-a-half times larger than the entire U.S. banking system, which stands at around $16 trillion (12 trillion euro). Such a large gap may make sense if the eurozone’s economy was much larger than that of the U.S., but it isn’t. The eurozone’s GDP is actually smaller, at around 9.5 trillion euros, where the U.S. GDP is around 11 trillion euros ($14.5 billion). Europe has itself to blame for bank sell-off It won’t be an easy task to bail out a banking system with assets three times the size of the currency region’s entire economic output. The European Banking Authority, the eurozone’s banking regulator, has been pushing the banks to build their capital buffer so that they could absorb future losses derived from their spending spree. Yesterday, the EBA announced that the system had to raise 114.7 billion euros to quickly comply with new stringent capital rules — 8 billion euros more than they had estimated back in October. The number grew as the value of the banks’ assets deteriorated due to the current eurozone crisis. The big banks have finally realized that being bigger isn’t necessarily better, especially when that largesse came by levering up. The European Central Bank has aggressively moved to shore up its banking system to prevent any liquidity event such as a Lehman-like collapse. While the structural issues with the euro remain, the ECB’s actions have stabilized the continent’s banking sector — or at least bought it enough time to slim down. The ECB could ostensibly fund the European banks indefinitely, but it doesn’t seem willing to do so. This has put pressure on the banks to reduce their balance sheets. The banks have in total pledged to shed around 5 trillion euros worth of assets in the coming years to comply with new, more stringent capital standards as demanded by the EBA and the Basel committee. Who’s buying Banks have wasted no time slimming down. But the sale of 5 trillion euros worth of assets is going to take time and will need buyers with very deep pockets — global banks and investment firms, like hedge funds. But the selling banks don’t appear to be in panic mode just yet. That’s because the ECB has effectively absorbed the banks’ liquidity risk, which means that they won’t be collapsing overnight. This has given the banks some breathing room, allowing them to negotiate some strong deals for some of their assets. Given the stress in the eurozone, the assets that are the most in demand are the banks’ foreign assets. The majority of those assets seem to be coming from the big banks. “We are seeing billions of assets for sale from the European banking system from many banks in multiple different countries,” Bruce Richards, the co-managing partner and chief executive of Marathon Asset Management, a $10 billion hedge fund, told Fortune last week. “From the 27 countries in the EU, the banks in 10 countries represent over 90% of the asset disposition.” S&P to ECB: Pony up The Europeans are first offloading their foreign holdings to banks and investment firms where those assets live. They are also looking to spin off subsidiaries in foreign countries to local bank and investment firms. Performing assets seem to be selling at or near par value, Richards says. The banks appear unwilling to let those go at steep discounts, frustrating some buyers hoping to make a quick buck. But the banks do seem willing to cut a deal on those assets that aren’t doing so well. Hedge fund managers tell Fortune that they have been approached by several European banks looking to offload large multi-billion euro loan packages, which have been stuffed with a hodge-podge of dodgy securitized assets, like commercial and residential mortgage backed securities. Marathon has been a buyer and managed to snap up one of those packages from an undisclosed European bank for 60 cents on the dollar. Richards expects the firm to make a return at least in the mid-teens on that investment. Each of these loan packages are bespoke, so banks and fund managers are doing a lot of due diligence on what’s inside of them. Richards says Marathon just bid 20 cents on the dollar on another package of securitized products that were of lesser quality than the firm bought earlier. It is unclear if the banks are willing to go down that low, but it seems that they are willing to entertain such offers that could help them offload all those risky assets. The banks can continue to take their time as long as the ECB has their back. But if European leaders fail to fix the structural problems plaguing the eurozone, not even the ECB can save the banks from the deluge of defaults that could come from a broken euro.