Economics 27/7/10: Stress tests of Irish banks? Get real!

An excellent comment on AIB and BofI 'stress tests' results from Peter Mathews, worth a direct post (rather than 'just' a comment) on this blog. Read it here.

Economics 25/7/10: What lending markets tell us about EU policies

So the markets are not that enthused about the stress tests. After the initial bounce on the back of 'pass' grades, there are rising concerns about some 19 banks, including AIB, which were given 'all clear' with some serious stretch of assumptions.

But to see what is really going on behind the scenes, look no further than the actual interbank lending rates. In fact, the interbank lending markets provide a good reflection on the combined euroz one policies enacted since the beginning of the Greek debt crisis. Both euribor (the rate for uncollateralized lending across euro zone's prime banks) and eurepo (lending rates for collateralized loans between euro zone's prime banks) are significantly elevated on twin concerns about:

1. The quality of the borrowing banks (recall - these are prime banks); and
2. The quality of the collateral (with sovereign bonds being top tier quality, deterioration in sovereign debt ratings is hitting interbank markets hard).

Here are the usual, updated charts:

Chart 1Long maturities have been signalling extremely adverse effect of the Euro rescue package since its inception.

Medium-term maturities show severe deterioration since the euro rescue package. Steepest, and uninterrupted rise in 3 months euribor signals that the rescue package is faltering in delivering anything more than a buy-time for the euro… In other words, we have an expensive (€750 billion-sized) buy-in of short time.

The ECB claw back on longer term lending window did not help this process either. But the stress tests are doing nothing to stop the negative sentiment dynamics.

Chart 2Per chart 2 above, short-term maturities are showing that despite supplying underwriting to about a half of the full year worth of euro area bonds refinancing, the rescue package has achieved no moderation in the short-term risk perceptions of the market. In fact, the rise in euribor is more pronounced in the short term than in longer maturities, suggesting that short term risks of sovereign default remain unaddressed by the rescue package and are exerting a continuous pressure on interbank lending.

Introduction of the stress tests also did nothing to reduce overall cost of borrowing amongst the prime banks which were fully expected to pass the test even before the EU got on with setting test parameters.

In turn, all of this spells much higher costs of funding for the banks which have shorter term financing needs, such as the Irish banks. The implicit cost of taxpayers’ guarantee for Irish banks debt is therefore rising.

And panicked markets are not about to surrender their fears to the EU PR machine. With all the increases in the euribor, the volatility of the interbank lending rates also increased, across all maturities, as shown in charts 3 and 4 below.

Chart 3Chart 4As evident, in particular, from chart 4, in the longer term, credit markets are absolutely not buying the combination of the EU rescue package, ECB liquidity measures and the stress tests. Euribor trajectory for maturities of 6 months and higher firmly re-established and vastly exceeded volatility that preceded the pre-rescue panic. We are now worse off in terms of the cost of banks financing than we were before the Greek crisis blew up.


To remind you - eurepo is the rate at which one prime bank lends funds in euro to another prime bank if in exchange the former receives from the latter the best collateral in terms of rating and liquidity within the Eurepo basket. Eurepo rates have posted dramatic increases since mid-June 2010. The original effect of the June 2010 closure of the longer maturity (12 months) ECB discount lending was a temporary reduction in the rates, followed by a stratospheric rise two week later that has been sustained through the end of this week. This is especially true for shorter term maturities, suggesting that part of the adverse effect was due to the heightened uncertainty around the EU stress tests. Chart 5 below illustrates.

Chart 5Chart 6The u-shaped response in the interbank lending rates to ECB lending changes and to stress tests is even better reflected in the longer maturity eurepo rates, as highlighted in chart 6 above.

3-months and 12-months eurepo rates are now at the levels consistent with the height of the sovereign default crisis. There are significant differences in the rates by maturity group and vis-à-vis euribor due to the fact that the quality of collateral offered in the markets is now itself uncertain as sovereign credit quality continues to deteriorate both in terms of increasing probabilities of default and thus associated risk premia, but also due to the regulatory treatment of collateral that is being signalled by the stress tests.

As with euribor, eurepo rates are showing remarkable increases in volatility, for both shorter and longer term maturities.


Let us finally put the two rates side by side to compare evolution of euribor against eurepo, setting index for all at 100=January 4, 2010

Chart 7Chart 8
Some pretty dramatic stuff. To round off, recall that since the beginning of April 2010, the eurozone has undertaken the following measures to shore up its financial markets:

1. Set up a sovereign rescue fund worth more than €750 billion to underpin roughly 50% of the total borrowing requirement in the euro zone (which could have been expected to yeild an improvement in banks collateral and thus a reduction in overall systemic risks in the interbank markets as well);
2. Reduce maturity profile of ECB lending window (which was from the get-go equivalent to dumping more petrol on the forest fire);
3. Deploy aggressive quantitative easing by the ECB (again, this should have reduced uncertainty in the interbank markets as in theory improved pricing for sovereign bonds should have increased the quality of interbank collateral and improve banks own books);
4. Conduct an absolutely discredited stress test of the banks (designed to provide positive newsflow for the banks, especially for prime banks which should have seen their risk profiles reduced by a mere setting up of the test).

In short, none of the measures seem to be working, folks... May be, just may be, the real problem with EU banks is their unwillingness to come clean on loans losses and start honestly repairing their balancesheets?

Economics 22/7/10: EU stress tests - what do they tell us, really?

The EU stress tests of the banks confirm the worst fears of all analysts – including myself. The tests were simply a PR exercise, so poorly conducted that no one can have any credibility in their outcomes. Worse than that, the whole circus:

• The difficulty with which the EU member states appeared to be willing to release information about the tests;
• The way in which information is being released (via a drip feed – bit by bit over time, with massive leaks beforehand);
• The struggle through which member states have gone in order to even agree to carry out the tests in the first place;
• The rhetoric from the EU regulators assigning an almost heroic quality to its efforts to test the banks in the face of a clear shambolic nature of the whole exercise.
  

All of these things provide for a strong suspicion that the EU will not be able to undertake robust regulation and monitoring of the euro zone banking system in the future, plus a clear cut realization that the entire idea of the euro member states coming together to police their own fiscal behaviour will be even less honest, transparent or robust. In other words, how can we expect the EU to act as a functional policeman of its members fiscal policies if:

1. It failed to do so over years past, even armed with already robust and automatic regime of the Stability & Growth Pact, and
2. It failed to properly stress test its own banks?
   

In the nutshell: German banks, including Landesbanken, have already privately leaked the ‘news’ that they all had passed the test. Ditto for banks in France, Ireland and Italy. Only one German bank – already failed HRE – has failed the test from among 91 institutions.

In the case of AIB – the sick puppy was ‘passed’ by allowing to include into regulators’ calculations the €7.4 billion the bank plans to raise by the end of 2010. Good intentions count for hard evidence, then, per EU regulators. And Bank of Ireland passed - along with all the rest of the PIIGS banks is by the test excluding any possibility of twin shocks - simultaneous continued deterioration in quality of loans and a sovereign debt crisis. Now, in all likelihood, if the sovereign debt crisis continues to rage, does anyone in their right mind thinks that housing and other asset markets in the likes of Ireland and Spain are going to improve to alleviate the loans book pressures?

Farcical!

What the 91 tested banks did ‘pass’ was not a stress test, but a joke, concocted either by those with no understanding of banking (Eurocrats?) or created specifically with an ex ante intent of passing them all. The French and Greek banks privately said that the haircut applied to their holdings of Greek government debt were about 23%. Markets are factoring in 50-70% haircuts, so the EU stress test was less than half as severe as what is being priced already. Worse than that – the sovereign debt haircuts were applied only to bonds held in banks’ trading books. That accounts for just 10% of all Greek bonds held by the euro area banks, as 90% of Greek sovereign debt has been already moved to ‘held to maturity’ parts of banks assets portoflia, not reflected on trading books.

In other words, when it comes to Greek sovereign debt exposure, the EU tests were capturing no more than 5% of the total risk of such exposure for the banks. Like a doctor, looking at the brain activity chart of the patient and saying: ‘Look, there’s no activity at all. But 95% of all other vital signs are performing just fine. Indeed, no worries old man, the patient is still looking 95% alive then…’

And there's more. Per media reports, a memo from Germany's Financial regulator BaFin earlier this year said the real concern should be contagion from "collective difficulties" across the PIIGS, not an isolated default of Greece.

All of this did not prevent Irish stockbrokers from issuing upbeat reports about 'the good news' for BofI and AIB. What good news? The shares in two banks rallied today because someone, somewhere, allegedly decided that if Greece softly defaults, Irish banks will survive? Did that someone actually paused for a second to think, before placing a 'buy' order if Irish banks can survive their own home-made disasters? Or whether they can survive a meltdown of Greek debt default as priced by the markets? Or whether they can survive both happening at the same time?

Irish analysts, who issue these forecasts should be required to read Taleb's 'Fooled by randomness', though one wonders if they will understand much of what Taleb is saying for years now. Investors who chose to belive that AIB and BofI passing of the 'test' this week is some sort of a 'good news' are simply fooling themselves by ignoring a simple fact of life - misdiagnosing a patient with heart attack as being free of an Avian flu is not going to improving the patient's chances of survival. It actually reduces them.

Shamed by this absolutely incompetent, if not outright markets manipulating ‘testing’, you’d think the EU leaders would step back and start an earnest conversation between themselves as to what has gone wrong here. Nope. They are hell bent on creating more Napoleonic sounding, but utterly unrealistic and even disastrously risky plans. This time around – for fiscal harmonization. France and Germany – the two countries that have been clearly at odds with each other in responses to the current crisis have decided that a bout of amicable activism is long overdue. So behold the latest Franco-German alliance on a list of fiscal policy co-ordination proposals.

Per reports in today’s media: a French cabinet meeting took place with German presence, during which Sarkozy called for a complete harmonisation of European tax systems. ‘He did whaaat?!’ I hear you cry… yeah, he did call for that which was explicitly denied by him and the entire EU leadership core as ever having a chance of happening in the run up to the Lisbon II referendum in Ireland.

Now, don’t take me wrong here – this is not a voluntary call for individual states cooperative action – it is a call for an EU-wide ‘reform’. And if you don’t think so, the same meeting called, once again, for member states with excessive deficits to be punished by withdrawal of voting rights in the Council of Ministers, plus a fine and the compulsory imposition of an interest-bearing deposit for member states.

Eurointelligence blog has put it succinctly: “In other words, France and Germany [have called] to continue the same dysfunction regime, except that they strengthen those parts that have prove the most dysfunctional.”

Let me be a tad controversial here - wasn't all of this predicted to happen by Declan Ganley, Anthony Coughlan, Mary Ellen Synon and others who argue in favour of democratic reforms in the EU? Weren't they 'refuted' on exactly these predictions by the entire 'establishment' in Brussels and the all-knowing dons of the Upper Merrion Street? You don't have to agree with their points of view. You might as well agree that the idea of fiscal harmonization is a great thing. But what cannot be denied is that:

1. Any policies absent meaningful ability to honestly, transparently and effectively enforce them (and EU has shown none of these in its stress tests of the banks - the easiest area to deliver them in current political and economic environment) is destined to be nothing more than a bullying pit for some states to arbitrarily control others; and
2. Given grave doubts about EU's capabilities to provide for (a), the automatic default option of any new policies should be to scale opportunism and adopt pragmatic, cautious, incremental reforms approach - when in doubt, measure and caution must be the prevalent guide.
   

After all, if I were a person with the power to shape EU principles, I would adopt the milenia-old medical code of ethics, that is based on the fundamental axiom of morality: Primum non nocere, or First, do no harm.

Then again, adopting such a principle would have meant not conducting these 'stress tests'.

Economics 20/7/10: EU test - have a Pass grade before you turn up for a check...

Per Bloomberg report today: “Hypo Real Estate Holding AG, the commercial-property and public-finance lender taken over by the German government, failed a Europe-wide banking stress test, two people familiar with the results said.” Crucially, however, “the Munich-based lender is probably the only German bank to fail the test, one person said.”

Makes you wonder – what kind of test is that if out of 91 not exactly rude-health institutions, only one is expected to fail? At an expected 99% success rate, the EU stress test is clearly designed to put a PR spin on banking sector shares, bonds and interbank credit markets.

The only sticky part is that if any of the ‘passed’ banks fail in the near future, the investors should be able to sue the EU for any losses incurred. You see, the EU stress test is designed – at least in theory – to provide important markets-relevant information to investors. If so, someone should be liable for the quality of the test. Had the EU authorities given this a thought?

The test is farcical. And you don’t need to see the results to know this much. European banks are set minimum requirement of 6% Tier 1 capital ratio. This is the number being tested. But the US banks had this requirement 2 years ago, and since then have beefed up their capital ratios to well in excess of 9%. UK banks are now in excess of 10%. Where does this put the Eurozone with its banking system ‘tested’ to 6%? In a circus terminology – with the clowns, large shoes, red noses and curly wigs in place. So the EU regulators’ decision to put some more powder over their mugs wont be doing much good.

FT blogs' Tracy Alloway reported today on what the markets think. The article (linked here) reports that there has been a 50% or more rise in the short positions held against a number of Eurozone banks. Ireland’s sick puppies – BofI and AIB are actually most active on long investors’ lists with long positions up ca 20%. But the two are also amongst the most expensive securities to borrow. In other words, it does seem like shorts are heavily on the side of Ireland Inc’s grand dames.

Funny thing, relating to the stress tests, is that a number of public officials – from Greece, to Belgium to Ireland – have already been leaking heavily the ‘news’ that stress tests will clear their banks’ names. One wonders if there is anything else the EU can do to make the whole exercise even more farcical?