Banks Fairy Tale Stress Tests

By: Mike_Larson

Of all the questionable bailout and backstop programs the government rolled out in the wake of the credit crisis, the whole “stress test” episode for the banks stands out the most.

The idea was that the Fed and Treasury would evaluate whether 19 major U.S. banks could survive a recession without a catastrophic erosion of their capital.

The problem: The tests were never stressful enough!

One of the main reasons the whole exercise “worked” — and if by worked you mean it successfully propped up bank stocks — was that the government made clear that any at-risk institution would essentially get bailed out anyway. True “failure” was not an option.

Oh, and at the same time …

• The Fed was pumping hundreds of billions of dollars into the markets by buying mortgage and Treasury securities with newly created cash,
• The government was offering tax credits to first-time home buyers to artificially boost the housing market,
• And the Obama administration and Congress were showering the economy with almost $800 billion in stimulus funds.

Result: The 10-of-19 banks deemed to be needy had no trouble raising the required $74.6 billion in capital.

Europe’s banking supervisor is conducting stress tests to determine how individual banks would hold up to economic and market shocks.

Hoping to achieve the same results, Europe is now conducting its own stress test exercise. The Committee of European Banking Supervisors (CEBS) is evaluating 91 banks that represent roughly two-thirds of the European Union’s banking industry. The results will be released by July 23.

I don’t think I’m going out on a limb here by saying that just about all the institutions will pass with flying colors. Sure, there’ll probably be a few sacrificial lambs. But all in all, the banks will get rubber-stamped.

There’s just one twist: I don’t think the results will be anything like what we got here in the U.S., and I’ll tell you why …

This Time, It’s Different!

Those are dangerous words to use in the investing world. But they ring true now.

For one thing, we’re not coming OUT of a recession like we were at the time of the previous stress tests. Instead, it looks like we’re sliding IN to a “Double Dip” one! That means credit loss rates aren’t peaking. They’re about to start rising again.

For another thing, the credit crisis has morphed. We were worried about PRIVATE credit risk sinking the banks last time around. This time around, we’re concerned about something much more serious — SOVEREIGN debt defaults!

In other words, it’s not individual mortgage or credit card borrowers that are sliding towards default. It’s actual European countries! That’s a much bigger problem.

Still another difference …

At the time of the U.S. stress test exercise, governments could borrow and spend all they wanted to in order to bail out failing institutions. Now the bond vigilantes are putting their feet down. They’re forcing countries like Greece, Spain, Portugal, and the U.K. to stop throwing money at struggling institutions.

Last but not least, the European stress test assumptions look way too optimistic. That means the markets will likely disregard any rosy results.

Case in point: The CEBS is reportedly going to apply a haircut of just 17 percent on Greek sovereign debt when computing potential bank losses.

By contrast, credit markets were recently suggesting losses on Greek debt could be as high as 60 percent. And a JPMorgan analyst implied that anything less than 25 percent would be unrealistic.

Spanish bonds reportedly will get a paltry 3 percent haircut, compared with a more realistic 15 percent.

And no haircut at all will be applied to bonds issued by the largest European economies, like Germany and France. This despite the fact those countries are putting their own balance sheets at risk in order to bail out their profligate PIIGS neighbors!

Believe in Fairy Tales At Your Own Risk

Washington was able to hoodwink investors, now Europe will try the same shenanigans.

Look, if some investors want to trust the happy talk coming out of European banking regulators and Washington spinmeisters, I can’t stop them. But I sure don’t buy it. I think this is a clear case of “Fool me once, shame on you. Fool me twice, shame on me!”

Bottom line: I find it extremely hard to believe that a bogus European stress test exercise will have the same impact the U.S. stress test exercise had more than a year ago.

So rather than load up the truck with bank stocks in anticipation of another major rally, I’d cut my exposure into any bounce. And I’d continue to batten down the hatches against the increasingly likely scenario of a double-dip recession.

Until next time,

Mike

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