Stressing Out over European Bank Stress Tests

By Marc Chandler

The newly created European Banking Authority will be overseeing the stress tests on almost 90 European banks. Recall that the stress tests last year met broad criticism for the lack of rigor. It was anticipated that the EBA would indeed provide for a more robust test this year. However, doubts are already being raised.

Initially there are two areas of concern. The first is on the definition of Tier 1 capital, which is that part that can absorb unexpected losses. The early indication is that the EBA will likely allow countries to use their own definition of Tier 1 capital. The UK, for example, is believed to have a more stricter definition than say Spain. That would give Spanish banks an advantage.

The second area of concern is the level of stress to be measured. Reports indicate, for example, that banks will be tested for, among other things, a 17% loss on Greek debt. The last stress test reportedly has a 23% loss on Greek bonds. Moreover, the current 10-year differential is near 935 bp. That suggests that there is about a 55% chance of a 17% loss on Greek holdings. A rating agency previously warned of the risk of a 50% loss, which would help bring the debt/GDP ratio back into line the Stability and Growth Pact. That said, given that the ECB purchases may be skewing price discovery process in the Greek bond market. Our analysis of the CDS market places the odds of a substantial haircut higher. That said, one may want to shade that as well, given liquidity concerns and the use of the sovereign CDS to also express on view on Greek banks. In any event, the point remains valid that at first blush the stress tests do not sound all that stressful.

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ECB's "One Size Fits Germany" Policy; Portugal 10-Yr Debt at Record Yield; Greece, Ireland Near Highs; 3 Hikes by Year End? Rate Hikes to Stress PIIGS

ECB president Jean-Claude Trichet uses the word "vigilance" as a market signal he is going to hike. Trichet has used that word a couple of times recently.

Today, outgoing German Central Bank president Axel Weber expressed agreement with Trichet regarding "vigilance", going so far as to say he would not correct the market's expectation of 3 hikes by year-end.

Please consider Axel Weber: Markets have understood ECB correctly

Markets have understood the European Central Bank's policy signals, ECB policymaker Axel Weber said on Tuesday, adding he did not want to correct expectations for rates to be at 1.75 percent by year's end.

"I think President Trichet said the right thing: it's possible but not on auto-pilot," Weber told reporters when asked if a rate hike should be expected in April or May.

"I think markets have understood this kind of language, which is a bit stylized, in the past very well. And I think they've got it this time."

Asked if he was comfortable with market expectations that ECB rates will rise from their current record low of 1 percent to 1.75 percent by year's end, Weber replied: "I wouldn't do anything to try to correct market expectations at this point."

One Size Does Not Fit All

Pray tell what inflation is the ECB worried about?

One cannot find it in Greece, Spain, Ireland, or Portugal, where various austerity measures have reduced both jobs and wages.

Here's a better question: Where was the ECB when credit was exploding in Spain and Ireland, fueling enormous property bubbles?

Nowhere is where. Inflation in Germany was close to 0%.

One Size Fits Germany

It was in the best interest of Germany to ignore reckless credit expansion elsewhere. Now, because gasoline prices are soaring in the wake of a crisis in Libya and the Mid-East, Trichet wants to be vigilant.

Here's the deal. This has nothing to do with the price of oil or the price of anything else. Trichet is using the price of oil as an excuse to do what he wants to do, and that is hike.

Why does he want to hike? Because recent wage negotiations in Germany have headed much higher as noted by Factbox.

Public Sector 3 PercentChemical Industry 7 PercentGerman Construction Unions 5.9 Percent
Wages have collapsed in Ireland and Greece, and are lower in Spain and Portugal. However, Germany and France call the shots because they have the largest economies.

Those rate hikes will increase the already significant stress in the rest of the Eurozone.

10-Year Yield Greece: 12.331%

10-Year Yield Ireland: 9.416%

10-Year Yield Portugal: 7.558%

10-Year Yield Spain: 5.381%

10-Year Yield Italy: 4.893%

10-Year Yield Belgium: 4.279%

10-Year Yield France: 3.623%

10-Year Yield Germany: 3.273%

Sovereign Debt Spread to Germany Jan 2010-Mar 8 2011
CountryJan 01May 07Dec 30Mar 08
Portuguese, Irish, and Greek sovereign debt yields are at or near record highs as are yields relative to Germany. Moreover, the ECB's "One Size Fits Germany" policy is not going to help those countries any.

The ECB ignored rampant inflation in Spain and Ireland, and other problems elsewhere because it suited the interests of Germany and France at the time. Now the ECB is ignoring rampant deflation in those same countries because it suits the interest of Germany and France.

The ECB is not concerned with such matters or what countries it wrecks. It is just concerned that Ireland, Greece, and Spain pay back debt owed to German and French banks.

Here is the key question: How long can the other countries survive in a one size fits Germany setup?

For more on the mess in Europe including a look at gasoline prices please see

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

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