Friday, July 30, 2010

European Stress Tests: The smoking gun

What is a (banking) stress test?

In theory, is an exercise where the bank revalues its assets under one or more adverse scenarios in order to find out whether or not it is adequately capitalized.

In simple words, "if things became worse than they are now, do we have enough money (capital) to absorb the losses?"

A prudent banker prepares for the actual stress (not the test) by either reducing the price of an asset (or creating a rainy day account) once collection becomes less than certain. Again, "I think US treasuries are 100% safe so I value their chance of default as zero (no rainy day account). Greece on the other hand, I am not so sure, so I either value the bonds below par or create a rainy day account." If someone doesn't pay, the bank doesn't take the full hit on the day of default since it has provisioned against the loss. Monitoring credits and saving for a rainy day is the very essence of banking.

In Europe, bankers were happily riding the gravy train of buying Greek, Spanish, or Portuguese debt and treating it like German debt (no chance of default). Since the Greek debt paid higher coupons but required no provisioning, this was great for returns as well as bonuses.

At some point early this year, someone realized that the Greek debt was not as safe as its German brethren. Even the rating agencies, never too aggressive to downgrade anything, currently rate Greek debt as junk.

Since most European banks are loaded with Greek debt, the policy makers faced a dilemma vis-à-vis the stress tests: If they used stress prices (current market prices minus a cushion) the banks would show the potential for steep losses. If they didn't perform the tests, the market would continue to distrust the European banks.

The solution? Allow the bankers to decide which portion of their balance sheets would be tested. How? By giving them the chance to book whatever they wanted in a so-called investment account. This would be akin to grade students on just the questions they are sure they know. They can still get a few wrong so, technically, it is still a test.

According to bloomberg :
"Lenders hold about 90 percent of their Greek government bonds in their banking book and 10 percent in their trading book, according to a survey by Morgan Stanley. They have to write down the value of bonds in their banking book only if there is serious doubt about a state’s ability to repay in full or make interest payments."
Yes, you read correctly. They booked 90 percent of the Greek debt in the banking book which means they can price everything at par. One can assume that the rest of the balance sheet was treated in the same way. This, of course, includes not only Spanish, Italian, Irish, and Portuguese debt, but, we may presume, Hungarian mortgages denominated in Euros as well as all sorts of loans to Eastern European companies.

Unfortunately, the first casualty of this blatant attempt to manipulate public perception of European banks will be confidence itself. Once lost, it will not be easily restored.

Spain "Austeridad (pero no mucha)" [Austerity (but not too much)]

I truly pity those who attempt to explain daily market moves. Last month, it was all about the PIIGS. This month, our manic-depressive portfolio managers, tired of waiting for another shoe to drop, have shifted their attention to the US economy.

Naturally, as they look at the US economy getting weaker, they had to do something, after all, what kind of a professional would you be if you didn't trade? So they sold the US dollar. Which of course means buying the Euro and the Yen.

So, for two weeks, we have heard that "the Euro is going up because Europe is stabilizing." Is it because of the stress tests? Well, not really, the tests had all the stress one can expect in the European continent in August. Not only did they ignore the true sovereign risk, but they made sure to render the results meaningless by allowing the banks to decide which risk would be tested while hiding the rest in investment accounts. I mean, would any buyer ignore any portion of a bank's assets on account that they promise to hold them to maturity?

In the meantime, the PIIGS are hard at work cutting their deficits for the benefit of the bondholders. Spain, for instance, has cancelled all sorts of public projects. Some of these, were only launched last year when the mantra was "Spend! Baby, spend!"

Canceling projects is relatively easy. After all, the construction workers are not the direct responsibility of the government. Public employment is another matter. As Spain announced today new record unemployment (click here if you can read numbers in Spanish) the report shows that the public sector continues to hire (click here if you can read charts in Spanish). According to this report, the "Autonomias" (regional authorities independent of the central government) have hired over 73,000 new employees in the last 12 months.

The conclusion is quite obvious. The markets focus on the big announcements by names they know like Trichet and Zapatero. If your competitors do the same, you can always say that you had all information available at the time. The reality on the ground, however, is quite different. In Catalonia, like in California, everyone the government fires/not hires is a voter. In the end, these are the people the politicians have to answer to, whether the bondholders like it or not.

Nobody has ever grown out of austerity without a devaluation. Although every situation is different, I suspect the reason is that the people on the ground, in the end, prefer bankruptcy to starvation.

I'll leave the moral judgment to the reader.

Disclosure: no stocks mentioned