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  • Stress Test Is Really No Stress for Euro Banks
      The Committee of European Banking Supervisors announced their much anticipated stress test results of 91 major EU banks. The result was that out of 91 banks tested, all but seven (Hypo of German, Agriculture Bank of Greece, and the 5 Spanish cajas) passed with flying colors (even the Irish banks). This farce seems to have worked for US markets with the Dow up around .5% at the time of this writing. I have read the 55 page summary of the stress test results and have listed a few important facts:



    The stress test focuses mainly on credit and market risks, including the exposures to European sovereign debt. The focus of the stress test is on capital adequacy; liquidity risks were not directly stress tested.

    This is just one of the major limitations of the stress test results as they do not assume a real world scenario. During times of economic dislocations and fears, the market becomes increasingly concerned about bank liquidity considering they are all leveraged 20 or more to 1 and face significant rollover risk of short term debt instruments (e.g. Bear Stearns). I guess the EU test assumes the central bank will always be there to provide liquidity to all major banks regardless of their collateral quality. The report goes on to say:


    This results in a set of haircuts to be applied to all EU sovereign bond holdings in the trading books of the banks in the sample.


       In my opinion, this is the most significant deficiency regarding the stress test. Under the scenario, banks only have to take a haircut on their holdings if they are in their trading book as compared to their banking book (held to maturity). Morgan Stanley did a recent survey and found that 90% of sovereign debt held by banks is in their banking book, and only 10% is in their trading book. All debt classified as a held to maturity does not face mark to market accounting. I wonder how banks are accounting for Greek 10-year debt which they bought under 5% since it is now trading at 10%? I guess they can assume that since the EU decreed that no country will ever default, then they never have to adjust the value of their Greek holdings. In reality, the debt should be written down by about 30-40% because it is, as we say, "significantly impaired." Another interesting fact in the stress tests is the amount of government support to the European banking system:

    It should be noted that the aggregate Tier 1 capital ratio incorporates approximately 169.6 bn € of government capital support provided until 1 July 2010, which represents approximately 1.2 percentage point of the aggregate Tier 1 capital ratio. As such, government support form an integral and stable part of the Tier 1 capital ratios of the banks in question. It is not expected that any withdrawal of government support measures could take place without appropriate substitution by private funding sources, where relevant.

       You can see what a real sham this test was since the conclusion was that the majority of European banks need no new capital. European banks have currently received 170 billion in capital from various governments, which represents 1.2% of their mandatory 6% tier 1 capital or 20% of their total capital. It seems that this financial support is likely permanent unless the banks can con a few sovereign wealth funds to invest in them. In conclusion, the EU report states:


    The aggregate results suggest a rather strong resilience for the EU banking system as a whole and may appear reassuring for the banks in the exercise, although it should be emphasized that this outcome is partly due to the continued reliance on government support for a number of institutions.

    So let me get this straight--the entire European banking system is strong, healthy, etc., as long as it is completely back-stopped against losses by national governments (taxpayers). Under this specious reasoning, why even have a stress test since banks no longer have to suffer losses and can rely on unlimited financial support from governments in perpetuity?


    Disclosure: none
    Tags: DIA, SPY, europe
    Jul 23 3:05 PM | Link | Comment!
  • Rail Traffic Indicator Derailed

       The American Association of Railroads (AAR)  just came out with their monthly report on railroad traffic. The major news is that railroad carloads declined in June as compared to May by 1.3%. This will mark the second consecutive monthly decline in railroad carloads. However, carloads were up 10.6% year over year in June.  One would expect some improvement considering we were at depression levels last year. But as you can see from the chart below, railroad volume has never fully recovered from the highs in 2006 and 2007, which shows that despite all the hype about a recovery, the US economy is still depressed.









     If you are worried that this indicates a possible double dip, the AAR is quick to set you straight:

    The declines in rail carloads over the past couple months have not been huge,and theycertainly don’t prove that the wheels are coming off the economy’s bus. After all, the improvement in carloads this year over last year is still significant: U.S. railroads originated 136,136 more carloads in June 2010, and 454,708 more carloads in the second quarter of 2010, than they did in the comparable periods in 2009.

    It was the AAR which had the first sentence in bold to make sure you don't get the wrong idea. I guess the AAR is part of the "hope bandwagon" which believes that a recovery is possible as long was we all believe in it. Forget data, forget facts, logic, reason, etc--just believe. Then right below the above paragraph, the AAR throws viewers a screwball statement like:

    That said, an economy several months into a recovery from the worst recession in decades should be yielding rail traffic levels heading north, not south. (Remember, demand for rail service occurs as a result of demand elsewhere in the economy for the products that railroads haul.)

    If you are confused by the two seemingly contradictory statements, you are not alone. On one hand, you are supposed to ignore the decline in carloads as just another inconvenient truth about the economy, but, on the other hand, remember that carload data is an important economic indicator. What are we to believe?  Oh, it is so easy to just drink that bullish Kool-Aid, but for some of us, the Kool-Aid has a foul taste.

    Disclosure: none
    Jul 14 3:15 AM | Link | Comment!
  • Markets at Key Juncture: make your bets
     Well, the market certainly liked the news out of Alcoa even though I think the market reaction is somewhat misguided. Alcoa did beat earnings, but they were reduced estimates from 30 days ago. It is a really simple trick: under promise and over deliver (and Wall Street will love you). Anyway, with Wall Street optimistic about company earnings, the market is up strongly today. This brings us to interesting level in the market, which sets up for a good risk/reward trade--the 200 DMA. If we are indeed entering a bear market, the market should stop its advance at the 200 DMA, which makes this a good place to begin shorting. You can put a stop-loss at say 5% above the 200 DMA to give the trade some leeway. If you are a bull, you can wait until the market holds the 200 DMA for a week and then go long with a similar stop-loss for protection. Personally, I am taking the bear side because we are already below the 200 DMA and have been repulsed here before in June. Furthermore, the slowdown in China and the US is going to continue since the stimulus packages have both run their courses. Also, the real estate market rolling over should put strain on the already fragile banking system as well as the consumer. Hard to see a sustained recovery under these conditions.  Gentleman, make your bets.



    Disclosure: None--but I will look to short stocks in the next few days.

    Disclosure: None--but I will likely be shorting in the next few days
    Jul 13 1:17 PM | Link | Comment!
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