The stress tests conducted on 19 large American banks by the US Treasury in 2009 were an amazingly effective exercise in salesmanship and sleight of hand. Banking industry experts, including Bill Black, Chris Whalen, and Josh Rosner, dismissed the process as mere theatrics: too little staffing and not enough “stress” in the economic forecasts and loss assumptions (particularly on second mortgage). My pet peeve was that the banks ran the tests on their trading books using their own risk models, the very ones that had performed so well in preparing them for them in the runup to the crisis.
But the Treasury’s Tinkerbell strategy worked. If they could create enough confidence, if they could get enough people to applaud, the banks would live – at least for a while. The spectacle of daily coverage in the business press of the tests, including the howls-on-cue from the banksters, outraged by supposedly-unreasonable demands the Administration, created the impression that Something Was Being Done. And the Treasury did get one critical bit right: it had a credible process for making sure the banks would be able to plug any capital shortfall it identified, and that was by having able to have the government pony up the money to fill any shortfall they identified that the banks couldn’t fill on their own.
Imitation is the most sincere form of flattery. The ECB and European bank regulators are copying the US playbook for the stress tests, with results for 100 banks expected to be released around July 23. But the European authorities seem to have failed to understand why the US effort worked. The first was that Team Obama is particularly good at PR, and it used those skills to full advantage. Despite considerable evidence otherwise, it got the press to convey the message that the tests were tough, and the banks really were sound. Second, Geithner & Co. had a kitty they could draw on.
By contrast, the Europeans have been simply dreadful at the optics of their various rescue operations, with disarray and disagreements covered extensively by the media. Admittedly, this exercise is being conducted by bank regulators, so it is likely to be more cohesive, but “more cohesive”, with a process involving agencies in different countries, may not be cohesive enough. And “show me the money” is a major problem. The reason for this exercise is concern over possible sovereign debt losses. Who is going to back up the banks at risk? Um, sovereign states, admittedly ones not considered at risk of default (France and Germany), but whose ability to bail out their own banks is limited for practical and political reasons.
A story in today’s Financial Times provides confirmation of the skeptics’ concerns:
After another fast-moving news week, as it emerged that about 100 European institutions will be included in the tests – four times the size of the original group – some bankers are confident that the expanded programme will reveal that much of the banking sector is healthier than investors think…
But big questions remain about how rigorous the expanded tests will be, particularly with respect to the sector’s exposure to Greek, Spanish and other eurozone sovereign debt
Institutions will be asked to disclose their total sovereign debt holdings, and the tests will now include a loss rate or so-called haircut of about 3 per cent on all eurozone sovereign debt investments, according to several sources.
Let’s see how this all stands up. Eurobank exposure to Club Med sovereign debt is roughly $900 billion (note this excludes debt to eastern Europe, another possible source of tsuris). A 3% loss on that is $27 billion.
Ahem, let’s take a more skeptical view. Eurobank holdings of Greece’s government debt is $190 billion. Williem Buiter, now chief economist at Citigroup and a bit of an expert on sovereign default, estimated the haircut on a Greek restructuring at 20% to 25%. But S&P later downgraded Greece, and remarked:
At the same time, we assigned a recovery rating of ‘4’ to Greece’s debt issues, indicating our expectation of “average” (30%-50%) recovery for debtholders in the event of a debt restructuring or payment default. The ‘AAA’ transfer and convertibility assessment is unchanged.
Yves here. Do the math. Even if you assume the low end of Buiter’s now-charitable estimate, banks will take losses on Greece alone of $38 billion, 41% greater than the level provided for in the stress tests. If S&P is nearer to the mark, the losses will be $95 to $133 billion.
And the more Greece takes new loans before its debt is restructured (a restructuring or default looks inevitable; no country in the modern era has ever had this high a percentage of debt to GDP in a currency it does not control paid its creditors in full), the worse off the banks that hold debt now will be. The new loans will be senior to the current debt, which means the writedowns on the now-outstanding sovereign debt is likely to be high.
Analysts are discussing which banks will need to raise capital:
Friday’s edition of the Financial Times reported the expectation among bankers that the likes of Spain’s Banco Popular, and Monte dei Paschi and Banca Popolare di Milano in Italy were likely candidates for capital raisings.
All three said they had no capital-raising plans. Banco Popular said it was one of the best capitalised banks in Europe, with a core tier one capital ratio of 8.8 per cent.
BPM said its core tier one ratio was 7.9 per cent. Like tier one, core tier one ratio is a measure of capital strength.
At the same time, there were suggestions in Spain that policymakers were considering going further than counterparts elsewhere in Europe, increasing the required ratio for passing the tests in an effort to boost the confidence value of the exercise.
The FT took note of investor doubts:
News of the tests’ increased rigour has not fully eased concerns about transparency.
“The stress test idea is a shambles,” said one senior analyst in London.
“The whole thing is a complete joke.”
He said that the market’s expectations of securing meaningful disclosures through the tests were so low that any useful information would be a welcome surprise. “Ironically you might just get a boost if there are any decent disclosures at all,” he said.
Maybe the Europeans will pull a rabbit out of the hat, but the odds do not appear to favor them. John Gapper, in a comment on the stress tests, is doubtful:
Even some of those who in principle support the idea of banks being honest with investors are worried about the forthcoming European bank “stress tests” – successors to tests on US banks last year. “I have a horrible feeling that this will turn out to be an exercise in damaging confidence,” says one bank analyst….
The worst case is that southern European banks, loaded with bonds denominated in euros, will turn to governments for relief and trigger another sovereign debt crisis. Spain, which is trying to solve a crisis among its cajas – regional savings banks – is a potential victim….
he tests were certainly a turning point in confidence in Mr Geithner himself, who had suffered a rough few months in the job. Whether it turned the tide for banks is less clear; the US stimulus and other measures to restore consumer and business confidence were large factors.
In addition, European banks’ problems are more intractable and complex, and probably less amenable to a quick fix. For one thing, there was little question last year that the US could afford to rescue banks if it had to, whereas European governments are now heavily in debt.
Furthermore, European banks have inherent funding problems that their US and Asian counterparts lack – they are far more reliant on wholesale markets. US and Asian banks cover their loans with retail deposits, while Barclays Capital estimates the ratio of loans to deposits at European banks to be 120 per cent.
This leaves these banks vulnerable to a liquidity crisis…
Europeans do things in one way and Americans in another; Europe believes in discretion while the US likes openness even at the risk of embarrassment. We will soon find out if European banks can be salvaged by American methods and we had better hope so.
Precisely.
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Yves,
the good thing about your blog is that you usually go against consensus. In fact, you lead consensus.
The consensus on Greece and European debt may, well, have gone too far. Maybe we should check some fundamentals:
“(a restructuring or default looks inevitable; no country in the modern era has ever had this high a percentage of debt to GDP in a currency it does not control paid its creditors in full”
How many countries does your sample consist of? How many of them were in a political entity like the EU? The fates of how many were tied to the fates of the countries controlling the currency? The trade of how many was deeply intertwined to that of the countries controlling the currency? How many of them were modern democracies?
I think we are historically in uncharted waters. There is not much we can infer from past experiences. And I would be careful to select my investments based on the unjustified certainty of a Greek default.
I would rather doubt another consensus: namely, that the US cannot default on its debt because it can trash its currency. Easier said than done. When you start getting at 10% inflation, consensus will fade.
I don’t find the author at all convincing. He mostly cites pessimistic analysts. Why don’t the author discuss the recent central banking lending to European banks, which was much smaller than expected.
Too many of these blogs seek less the truth, than notoriety. They issue lots of strong opinions and 10% of the time they hit a home run. Maybe that is the Roubini/Nostradamus approach.
I was trained as a statistician, so I am well aware of the dangers of reaching conlusions based on small data sets.
I don’t think the data we have seen is enough to draw any firm conclusions.
Intellectual honesty requires us to admit that the world is highly uncertain these days.
I find your characterization of blogs more than a bit distorted. Read NC on the runup to the crisis, on Lehman, on the Administration’s posture to banks. NC was just about the first to call out how bank friendly they’d be, BEFORE Geither was sworn in. And there are other blogs, Willem Buiter before he went to Citigroup, Econbrowser, Calculated Risk, Mike Konczal and Steve Waldman, just for starters, who disprove your broadside.
I see Greece as the tip of a much larger problem that exists globally. The engine of this problem is the US Dollar. It’s a fiat currency as are the rest of the sovereign currencies. But the US Dollar has become the reserve currency in lieu of gold. In that role the US has exported its internal inflation to the world. You gotta love American ingenuity.
Now Greece may or may not default. It may be that default is a straw man, a deceit to hide the reality that living standards are going to come under severe pressure throughout Europe and the US. It is my view that one would do well to follow the rise of living standards in Asia relative to the fall of living standards in Eurpoe and the US.
EU Stress are, or will be, a copycat crime. I continue to be befuddled by the fact that some people believed that those that were done by the Fed were anuthing but a rigorous evaluation of the solvency of the examined institutions.
It’s a farce about to be undertaken out of a desperation founded in the full knowledge that more than a few institutions and countries are bankrupt.
What ‘internal inflation’ are you talking about? Inflation is about as tame as it can get in North America and Europe. There is more downside risk than upside risk.
I don’t see any stress on European standards of living in Scandinavia, Denmark, Germany, the Netherlands, Switzerland or Austria. I do expect stress in Spain, Ireland, the UK, France, and Greece.
Eastern Europe will rebound quickly.
By the way, if certain institutions and countries are bankrupt, you should document it and sell to the New York Times.
Cheap talk, particularly cynical talk these days, is very cheap.
The New York Times and MSM journalism does not “buy” from bloggers. At best, it takes story ideas from them and re-reports them so it can claim them as their own. I’ve had it happen here and seen it happen with other bloggers.
And your “you should document” it charge is a cheap shot and a straw man argument to boot. Does this post, ex a Greece default, which is WIDELY expected among informed observer, mention “insolvency”? The word is absent from the post. I’ve pointed to AMPLE evidence that Eurobanks are undercapitalized and carrying lots of assets at phony marks. Steve Waldman has pointed to how fuzzy a notion bank equity levels are. You should know damned well it takes access to internal data to “prove” insolvency in a financial institution. As I mention in ECONNED, outsiders cannot know the solvency of a financial firm (at least prior to it being grossly in trouble) because its financial statements quite deliberately omit critical information necessary to make informed judgments. What is the most important thing an investor needs to see to judge the solvency of a financial firm? Detail on its assets and liabilities, in real time. What is THE MOST competitively sensitive information a trading firm has? Detail on its trading positions, meaning assets and liabilities in its trading book, real time.
Look at Lehman, it was OBVIOUSLY in trouble, this blog discussed at length how dubious its accounting was and how it was grossly making up assets where the mispricing was verifiable. A bank has to be in desperate shape to need to misvalue assets so badly that outsiders can tell (it will mark up assets and down liabilities that cannot be checked first). Even so, NO ONE, including skeptics, anticipated Lehman would have as massive a hole in its balance sheet as it did (and that is even after you allow for the price-depressing effect of its disorderly collapse).
Yves,
You can not reason with some of the European posters here regardless of whatever you lay out. They always try to shift the burden to the issues of the US even though you also point out the issues of this country as well.
It’s simple nationalism that make them blind. Northern Europeans (read Denmark, the Netherlands, etc.) are mostly analytical minds compared to mostly emotional types of Spanish, French, Greek etc.
Hey Diego et al. learn to be border blind in your analysis and don’t shoot the messenger (Yves). It can only benefit you.
Cheers..
Albatross,
I’m trying to start an informed, well-reasoned discussion. I’m suggesting alternative possibilities, some lateral thinking in a time of too broad consensus.
The consensus on European debt revolves around two fallacies: the gold standard and the North/South divide.
The Euro is not a gold standard; it’s a fiat currency. The eurozone is as free to trash it as the US is with the dollar. It’s a political decision.
The consensus’ assumption is that, somehow, the eurozone won’t take a political decision for the collective good of its member states. I wouldn’t make any bets on people not doing what’s good for themselves.
The fault-line is Merkel/Germany. But, as I argued two days ago (with no “analytical” minds answering me), Germany can easily change its opinion and Merkel can be easily ousted.
One year from now, the manufacturing boom that is sweeping Europe (including Spain’s car manufacturing industry), which possibly is based on worldwide inventory accumulation, may have turned to bust. Inventories are once-off effects. Then German growth will stop, and the mood may turn for deficit spending.
Bye bye austerity. Hello pan-European Keynesianism.
The North/South divide may be less permanent than some take for granted. US people even resort to long-lasting cultural differences to explain trade deficits… well, the fact that Spain’s growth has been based on high savings and growth in exports til just the last decade is obviously unknown to those “analytical” minds.
Yves
Are the stress tests really just for sovereign debt – or only the sovereign exposure will be published? Don’t these banks have as much or more difficulties with other asset classes?
If they are indeed getting a pass on other asset classes, maybe the European PR machine is not as bad as you think.
No, the details have not been released, but if the tests hew to the US model, they will be tested for the adequacy of their equity levels assuming a sorta normal business going forward scenario, and an “adverse” scenario, which will assume an economic downturn of some type. The sovereign haircut will get bundled into that.
The problem is that what investors are MOST concerned about is default exposure, and per the post, the loss levels being assumed in a downside scenario are no where near tough enough.
The US stress tests didn’t work completely. There was still a doomsday scenario overhanging until the people in charge twisted some arms at FASB and got the rules changes, allowing the bank to conceal their toxic condition by not having to mark to market. Looking back, that’s when the equity market took off.
I think the idea that the oh so clever Obama administration fooled the press with its stress tests is a bit overdone. There was an Saturday Night Live skit lampooning the tests as being shams.
The issue simply faded away over time. Of course it helped to not build up the story the way another bank or two was taken over each week with an announcement coming out, like clockwork, late in the afternoon every Friday.
There is new stress ahead due to an expertise questioning the compliance of the European rescue package with German & European constitution & laws.
This is an attack by an advocacy group: the expertise has been produced by the Center for European Politics, a think tank of “Stiftung Ordnungspolitik” (the bigger sister of Hayek-Foundation). Yet this might become important since Hans Tietmeyer (Mr. Bundesbank) and Roman Herzog (ex Federal President and ex head of German constitutional court) are members of its board.
http://www.welt.de/politik/deutschland/article8302944/Euro-Rettungsschirm-verstoesst-gegen-das-Grundgesetz.html
here the link