Stress tests: Buy the EBA failures; sell the SIFIs

Now that everyone’s had time to digest the results of the stress tests and incorporate mitigating factors, I’m just as nonplussed if not more so than before. While everyone now accepts that the exercise was pitifully inadequate, there was one real plus point, the copious amounts of data disclosure.

Like a lot of people, I went into the weekend intending to pore over the several hundred pages of data. I’m afraid this went the way of all good intentions: I did start, but retired injured after suffering an early bout of data blindness-cum-tedium. What I did do, though, was to see what the banks that failed the tests and those that scraped through with CT1Rs of between 5% and 6%, along with their respective central banks, had to say about the results. Not surprisingly, they all said they had really passed, even Agricultural Bank of Greece, which emerged from the tests with a stellar CT1R of -0.8%.

Despite having 12 of the 24 banks in that dodgy bracket (henceforth known as the Group of 24 or G24), Banco de España’s response was fabulous: “The stress test on the European banking sector co-ordinated by the European Banking Authority shows that no Spanish bank needs to increase its capital as a result of this exercise,” crows the first line. Not exactly how I read the results, but what a tremendous piece of nationalistic defiance!

Mind you, reviewing the individual situations of the G24 did throw up some conundrums. First of all, the EBA’s exclusion of general provisions is harsh. As many of the Spanish banks in particular have moaned, inferring that provisions set aside specifically to cover losses are not loss-absorptive is counter-intuitive and is a big call.

Excluding, too, the impact of mandatory convertibles was also a big shout. Fine, so it is nominally contingent capital, as the instruments hadn’t converted by the April 2011 deadline, but a bunch of the banks in the ill-fated ‘Group of 24’ have short-dated mandatory converts outstanding that will definitely result in core capital, so you do wonder.

Beyond these examples, whether it’s silent participations, in-process exchange offers for sub debt, loan portfolio offloads, approved capital raising, corporate restructuring programmes etc, you do wonder what to take into account and what to ignore. You end up with so many riders, so many what-ifs and ‘if you take this or that into account’ that you start to lose the plot.

I’ve produced a table showing what each of the banks said about themselves. Take a look and tell me it’s not convincing.

Bank stocks were a little queasy throughout Monday’s session. (I was getting a little peeved at the inane business TV reports in the first couple of hours of the European morning trading session attributing everything that was in decline on the stress tests. I know it’s only eye candy, but honestly …)

What there was in the run-up to the open was a vague sense of malaise that lasted throughout the trading day. But it was largely down to what the stress tests didn’t show: the impact on European banks of a Greek default or a creditor haircut. The EBA included the impact of a 15% write-down on 10-year Greek government bonds, but if there is a bail-in at close to market trading levels of 50 cents on the euro, with milder write-downs on Irish and Portuguese debt, European banks will show a significant capital shortfall.

In a wonderful piece of reverse schadenfreude, a senior executive from Spain’s Banco Pastor — one of the worst performing banks with a stressed CT1R of 3.3% — gleefully went on Bloomberg TV on Monday to warn that the risks to investors in the European banking sector were to those banks heavily exposed to Greece, Ireland and Portugal, not lenders like Pastor, which has negligible external exposures. Touché!

The EBA returns revealed €98.2bn of European bank exposure to Greek sovereign debt (one-third held by non-Greek banks, including 9% by German banks and 8% by French banks). Banks’ exposure to Irish debt was €52.7bn (39% held by non-Irish banks) and to Portuguese debt €43.2bn (37% held by non-Portuguese banks).

Analysts calculate that 20 European SIFIs and quasi-SIFIs would have a capital deficiency some €80bn under more stringent default calculation scenarios against incoming Basel III minimums. That would certainly account for the dreadful trading performance of Europe’s leading banks, many down as much as 20% in July alone.

Conclusion? In my tradition of putting on perverse trading strategies, here’s one for you: going long the banks that failed or almost failed the stress tests (because they passed really if you believe domestic regulators) and taking the short side of an index of leading European banks (which definitely passed but would be hammered under any remotely realistic stress scenarios brought on by a sovereign restructuring).