The EU Stress Test that Wasn’t

How much trust and respect would you place in a cardiologist whose idea of a “stress test” was to ask you a series of questions about whether or not you think you could handle a one mile jog at a 6% incline, instead of actually putting you on a treadmill and measuring the effects of the induced stress?

The fact that only 7 out of 91 European banks failed the so called stress test with a mere 3 Billion Euro shortfall is shocking. About as shocking as the aforementioned cardiologist telling a sedentary person that they are ready to compete in the Tour De France.

The imposed stress tests assumed a double dip scenario which would have increased unemployment by 6%, economies were assumed to shrink 3% in 2010 and 2011, while equities were assumed to fall by 20% each year in 2010 and 2011 – banks were deemed failing if they could not maintain a tier 1 capital ratio of 6% under each stress test scenario. We here at Alpha Fiduciary believe the EU-ECB has managed an awful program of stress tests, run independently in each country which by design ignored banks Sovereign debt holdings unless they were held in the banks trading books.

While it is true that the EU has an enormous fund which could be tapped, if say one or two countries were to default on their debt, it is in no way capable of mitigating the stress on the web of Sovereign debt that the banks hold. French banks have enormous Greek exposure, the UK has a serious problem brewing with its exposure to Irish debt, and Spanish banks hold 110 Billion of Portugal’s debt and for that matter exposure to Spain’s debt is enormous across Europe and outside Europe in the U.S. and Japan. Japan holds 22 Billion of exposure to the debt of Greece, Ireland, Portugal, and Spain. While the EU stress tests accurately tested the effects of stress on its private sector, they ignored by design the effects of stress on public sector debt.

The much celebrated stress tests failed to test the effects on Sovereign debt held to maturity (accruals), only Sovereign debt held in trading books was tested. The only reasonable conclusion one can draw from these tests is that the EU will not allow any Sovereign debt to fail – and beyond that, if say Spain goes down then the entire EU system is likely screwed and thus no amount of capital raising today would really help. So the only two possible outcomes are the far to optimistic one or the complete meltdown. While the financial markets chose to celebrate the news with no desire to be told the truth, I have found at least two respected analysts who have delved deeper over the weekend and are suggesting that something north of 50 banks would have failed, requiring capital in excess of 76 Billion Euros had Sovereign debt held in accruals been stress tested.

For those who prefer not to keep their heads in the sand fearing the danger, we’ve taken the liberty of detailing the countries with the highest cumulative propensity of default. (CPD).

Latvia 22.9%
Portugal 23.26%
Irag 24.83%
Dubai 27.22%
Ukraine 34.30%
Pakistan 39.96%
Greece 48.32%
Argentina 50.36%
Venezuela 58.69%

And while were at it, let’s look inward at the precarious position our own state governments are in, and their cumulative propensity to default.

Virginia 12.3%
Texas 15%
Ohio 20.9%
Massachusetts 22%
Nevada 32%
Michigan 33.8%
New Jersey 34.7%
New York 35.3%
California 39.3%
Illinois 41.2%

We believe the stress tests on closer inspection will fail to restore financial confidence, causing spreads to widen and borrowing costs to escalate for those countries considered less than safe bets. This has the possible effect of increasing defaults and further increasing the need for austerity measures.

As always, Alpha Fiduciary is focused on the big picture and will continue to closely monitor this situation as it develops.