Nov 23, 2011

The Impact of Government Default on European Banks



It is important to know what would be the effect of eventual government default. Reuters Breakingviews has created stress test calculator for estimating what possible implications to Euro banks and governments in such case would be.

Recently conducted stress test of European banking system in July has been widely criticized. Often stated was the fact that requirements in the test were lowered, which question credibility of the test. According to the results most of the EU lenders had enough capital to sustain tough economic conditions. The problem is that minimum capital requirement in the test conducted by EBA (European Banking Authority) was 5%, far low below EBA’s current 7% threshold. Moreover after latest painful developments European banking regulator has discussed option for rising capital requirement to 9% as additional buffer. Another pitfall of the test is that includes only half of EU banks and excludes smaller ones.

The Breakingviews Euro Zone bank stress test aims to be more stricter than previously conducted. There are some details to be considered when reading the output. As described in the test notes it uses the same data as EBA. Results show how many banks would fail, which of them will suffer most, what amount capital is needed to cover core Tier 1 ratio and the impact of the recapitalization on each Eurozone country’s debt. General assumption is that calculations are made with 12 Oct market prices for 5 year bonds.
If we consider 63% Greek bonds haircut and 40% Portugal with 7% Tier 1 capital threshold, then capital shortfall would be €95.6B. Most of the burden has to be taken from Greece as €31.9B must be raised, Spain - €15B, Germany - €13.8B. In this case most vulnerable are Greek banks: NBG, Eurobank EFG, ATE Bank, Piraeus, Italian Unicredit, German Commerzbank and Deutsche Bank.
Euro zone stress test with Greek and Portugal haircuts
If we assume worst case scenario with Spanish and Italian haircuts of 30% (added to Greek and Portugal) and implementation of 9% core Tier 1 ratio, the picture looks ugly. Banks considering significant capital shortfall are – Unicredit, RBS, BNP Pariba, Santander, Banco Bilbao, Deutsche Bank, Commerzbank. Capital shortfall is close to €400B. In this case Spain must raise additional €104B, Italy - €58B, Germany - €53B, France - €53B, UK - €45B. Unfortunately in such conditions credit markets are practically paralyzed and funding is impossible. Where does money come from? The European Financial Stability Facility (EFSF) was designed to help stressed EU countries. With latest approval for increase of its funds to €780B there should be some relief that even worst case scenario is manageable.
Euro zone stress test with Spain and Italy haircuts
After the both tests conclusion is that there are certain banks considered to bear additional risk of capital shortfall in extreme conditions. Countries with highest recapitalization level (cost of recapitalization/GDP) are Greece, Cyprus, Portugal, Spain, and to lesser extent Germany, France, UK, Italy. In real terms, however, Spain, Germany, France, UK have greater impact of recapitalization related to total shortfall. It is clear that problems are not lack of funds but rather lack of decisions i.e. political willingness for quick resolving of the crisis.

You could perform your own stress test here!


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Is 2008 Comming Back Again?



If you look around there are many similarities. Should we worry about next economic downturn or market crash?

Almost one month ago markets enthusiastically cheered EU leaders’ agreement over Greek debt drama. Since then, however, the situation is not getting any better. This is obvious looking at the market indices performance over that period. S&P lost 9.85% since its 27 Oct. peak, yield on Italian, Spanish and even Belgian government bonds are persistently climbing despite ECB efforts to keep them low. There are more and more signs that we could face similar financial storm. Growing borrowing costs, freezed credit markets, higher volatility and frightened investors are common scars between present and 2008.

Current problem has no short term solution as it have been accumulated over years. Now we are witnessing painful process of deleveraging which could last longer than previously thought. The core of the entire mess is lost credibility as it appeared in 2008. This is seen with undersubscribed German bond auction few days ago. According to the latest research Japan investors prefer investing in UK gilts rather than German bunds. As to Japan it is one of the countries with highest level of debt as percentage of GDP (199%* as of 2010 according to CIA) and Standard&Poors has risen concerns over its ability to reduce it. As result is latest announcement from the rating agency for possible credit rating downgrade. This could be additional shock to already vulnerable markets.

Back to Europe France’s credit rating could also be reviewed as consequence of possible rescue plans for Belgian bank Dexia which suggest higher French involvement. Markets have been calculating eventual difficulties since July as spread between German and Belgian bonds is gradually widening since then. In addition Italian yields are stubbornly staying above crucial 7% level despite massive buybacks from European Central Bank. Up to now ECB manages to keep situation under control but rising speculation and losing investors’ confidence could undermine those efforts if market switch to panic mode.
Belgian-German 10 year bond spread

Considering all latest developments Federal Reserve recommended stress test to largest US banks. Such step in current situation is two sharp knife. Good results could strengthen investor and banking management confidence in the system but the fact that this test is undertaken now suggest growing concern for the economic conditions.

Negative news continues flooding news wires and we imperceptibly go to downward spiral. To get out of this firs and most important is returning credibility. This is the toughest part of the plan. Unfortunately Eurpean leaders still lack necessary attitude to return investors trust. In addition in most troubled countries there are no signs for growth, hence difficulties paying their obligations rise which additionally frustrates investment public. Ultimately help from countries with cash surpluses such as China is logical solution but for now there in not clear sign for action in that direction.

Definitely there are difficult times ahead but situation if still far from 2008, at least for now. Realization of consequences of destructive event such as defaulting of given (European) country has led to enormous efforts toward resolving the problems. Decisionmakers pressured from financial markets have no other choice accept moving toward stabilization. Election of new technocrat governments in South Europe prove the process is on the move. Specialists take responsibility now and crucial steps have been undertaken. Unfortunately measures for restructuring debt levels taking place now will have long term impact. Short term improvements are needed at the moment because new failure similar to Lehman Brothers this time of government scale could destroy entire financial system. The world cannot afford another financial disaster. Important decisions in Europe have to be made untill 8-9 Dec. (European leaders meeting) hopefully it is not too late.

 *Japan’s public sector debt is very high, however savings rate is relatively higher which compensate debt burden to some extent


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Should You Start Buying



It is clear that better buying falling stocks than skyrocketing, which is not to be mistaken with buying bad stocks. Opening position in oversold market is one of the keys for successful trading as you buy at discount. The fortune question is when is that time? Recent correction has uncovered numerous opportunities and still the markets are falling.

Closer look at market breadth indicators could give us perception about current market mood. To measure current market state we use numbers of stocks in S&P index above its 50 day moving average. Latest pullback of the index drove percentage of stocks above mentioned level to 38.7%, lowest since early October. The threshold indicating buying signal is 30%. That level is -1 standard deviation from its mean and is considered to be extreme level.  As indicated on chart numbers under 30% coincide with correction bottoms.

% of S&P 500 Stocks aAbove 50-day Moving Average

Quick view of the long trend indicator – S&P relative to its 200 day moving average suggest market is under the trend. Long term trend of the indicator itself is negative showing markets having bigger slumps under its 200 day MA.

S&P 500 Realtive to Its 200-day Moving Average

Fear gauge VIX is still leveraged now at 32. Readings above 30 indicate downturn and high volatility. Although market rallied and VIX touched 25 in late October current slump rises markets fear. In such conditions VIX levels above +1 standard deviation (31.58) is proven to be best time to load.

Volatility Index VIX

Definately market have been under pressure last month and prices now are attractive. Unfortunately things first go wrong before start going better and this is would be the case for next couple of days considering current negative market sentiment. However this is the time to be cautious in order to catch the following sweet rally.

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