Anticipating the Market's Response to EU Stress Test Results

The Needle And The Damage Done

Instead of using a knife to rip a hole in the curtain of uncertainty about EU banks, the EU used a small needle to offer a narrow peep hole.

Like initial attempts by the EU to reduce market uncertainty about Greek solvency early this year, Friday’s effort to ease fears about EU banking will backfire by removing any doubt that there is a problem, and raising questions about what skeletons remain hidden.

Here’s what you need to know.

The Good

As Felix Salmon concludes here, the only real good to come out of the stress test results was that they’ve led EU bank regulators to move towards greater cooperation and improved data gathering. In other words, they’re now finally beginning to move closer towards the greater transparency and standardization already present in the US.

The Bad

1. Only seven out of 91 failed, two of which are already nationalized. No one believes so few banks are in trouble.
2. The total capital required has been badly underestimated – less than four billion dollars – given the real risk of sovereign defaults once we get beyond the coming 2-3 years and expiration of the €750 aid package. Markets have priced in an over 70% chance of Greek default in the coming 5 years on the assumption that the EU will not continue support indefinitely. A default or mere restructure (aka partial default) by Greece or any single sovereign will likely cost far more than that, even before considering that any single default will likely lead to others.
3. Spanish banks alone are expected to need about 10x this amount for proper recapitalization.
4. Markets had anticipated that 30-90 bln Euro total recapitalization would be needed.
5. The above 4 points alone indicate a very unrealistic picture, which suggests that the reality being obscured must be much worse.
6. The tests did not even consider risk of loss from holding sovereign EU bonds to maturity, which will strike even casual observers of the EU sovereign debt crisis as very unrealistic looking beyond the next 3 years. About 90% of bank sovereign bonds are classified as ‘hold to maturity.’ Again, markets will wonder just how bad the truth must be to require this degree of leniency to produce a sunny tone.
7. As of the close Friday, credit markets remained skeptical, with 3-month Euribor rates at their highest levels for the year.
8. Per Christopher Whalen (see here for full details) the results are inherently untrustworthy because:
9. 1. Unlike the US stress tests, those of the EU lack the consistency, transparency and independent validation that comes from having a single unified regulatory body overseeing the tests and applying common standards.
   2. Data on EU banks is not publicly available and thus unverifiable.

Conclusion

By failing to remove suspected uncertainty about EU banking, the stress test results have confirmed suspicions that certainly the system could never withstand a realistic test.

Thus the key question remains the same as before. For how long can the EU continue to prevent a collapse of a sovereign state and/or a too-big-to-fail bank?

Likely Market Affects

Expect downward pressure at the start of the coming week as markets drop to price in the revived and increased uncertainty. Similar to early failed EU attempts to calm markets about Greece early this year, the EU has again made the situation worse by removing any doubt that it had a problem it was unprepared to resolve.

Thus plan for a bias to safe-haven assets and a pullback from near term resistance for risk assets, especially stocks and risk currencies, particularly the Euro.

Disclosure: No Positions