Reality vs. the European Stress Tests

by: Michael Shulman

The results of the stress tests of the US banking system set the stage for the massive rally that began on March 9 of last year. These were not real “stress” tests; the results were built using faulty assumptions, such as an 8.9% unemployment rate in 2009, acceptance of the suspension of mark to market accounting rules and the disregard of off balance sheet liabilities. This was theater, and Geithner and Bernanke won an Oscar for their success in calming financial markets.

How did deeply flawed stress tests do this? The support of the results by Geithner, Bernanke et al, told the world – told the markets – the US would do anything to make sure the big banks did not fail, a la Lehman. Which was true; it was the salient point of the entire exercise. So, even though many big banks, based on 2007 accounting standards, are insolvent, they are doing business every day. When they build a Mount Rushmore for financial types, Uncle Ben and Cousin Timmy need to be out there, along with Hank Paulson.

Will Europe be able to pull off the same trick? The markets are debating this right now.

Today, the Spanish central bank governor got fed up with delays in reaching agreement on how to politically support European banks and said he would soon release stress test results for Spanish banks. He did not say what level of detail would be provided. Prompted by this move, the Germans said the same thing. Spanish banks were fairly quiet after this announcement; German banks, based on their ferocious objections in the previous weeks to making stress test results public, are most probably furious. And if my reading of the situation is correct, there needs to official German government or perhaps Bundestag approval for the results to be released to the public.

Tomorrow, finance ministers, bankers and eager reporters will assemble to debate how to conduct, normalize and release stress test results across the eurozone. One part of the market believes they will listen to what cousin Tim Geithner told them recently – behind closed doors; this is my assumption – “Fake it, make it look good, above all, let the markets know you stand behind your big banks.” The other half of the market says they will dilly, they will dally and they will release very macro level, national results and obscure the truth about individual banks.

In my opinion, both things will happen. As a whole for nations and for the continent, the powers that be will make sure the results show the banks are essentially sound and with a little, manageable tweaking, properly capitalized by European standards, standards much lower than in the US. And they will bury as much detail as possible, for there are gigantic problems in several major categories of banks, notably Spanish regionals exposed to their real estate crash and German state banks, arguably the worst managed banks on the developed world, some rumored to be levered 50 to 1.

As with US stress tests, major problems will be ignored, most notably the deteriorating quality of European sovereign debt. The European Central Bank (ECB) has already waived requirements for a certain level of ratings quality in this debt to be counted as core capital, enabling banks to continue to use Greek debt, now rates as junk, as part of their core capital. The upcoming recession in Europe, driven by austerity measures, a spike in energy prices due the declining euro and a lack of confidence in anything among investors, will be ignored. And so on.

But can they pull a Geithner? The head of Deutsche Bank, Josef Ackermann, has said as recently as last week that public disclosure of these results would be, and I quote, “very, very dangerous” if the European Central bank or the government of Germany does not put in place “backstop facilities” to provide more capital if needed. Who will provide that backstop? The ECB? Or will it come out of the trillion dollar bailout fund partially approved over the past few weeks? The deciding factor in whether there will be a backstop facility, and how it is shaped, depends 100% on Germany and the German voter. The Germans are dead set against letting the ECB expand their balance sheet and printing money; German voters are very unhappy with the current regime and see all bailouts as unfair and a waste of their taxes.

It is most probable the Europeans will do what Paulson did with the TARP money – ignore its original purpose and use that bailout money to shore up the core capital of the banks, somehow. But working out the details is going to take time, and time is against everyone involved in this mess. LIBOR spreads are rising, banks have drastically slowed their lending to each other, and the various credit markets around the world are way ahead of the politicians and bank regulators. And, as with the Greek crisis, the longer this plays, the harder and more expensive it will be to patch up the problem.

There is no short term fix. European banks are woefully undercapitalized, too much of their core capital is in sovereign debt that will be restructured, they serve and generate from flailing economies, and voters hate them. Long term, the banks will have to be-capitalized based on retained profits and the dilution of existing shareholders. Without government assistance and with a modestly growing economy, this will take at least a decade, assuming new international banking requirements for core capital are permanently shelved and accounting rules form 2007 are not reinstated.

Disclosure: No positions.