“Expectations are the root of all heartache.”
At Hedgeye, we use an expression called Big Boy Talks. These are discussions that occur when it is time to have a reality check and sometimes deliver a candid view about performance or expectations. Or, in fact, to deliver news that might otherwise make a person uncomfortable. The presumption is that Big Boys can deal with reality, which can sometimes be unpleasant in the short term.
Later today, the European Banks will be releasing the results of their stress tests. The results will be released at 6 p.m. Brussels time, which is, of course, high noon for the equity markets in New York. The timing, according to European officials, is appropriate to allow any major European banks to address capital issues through the weekend and not have to worry about the market’s immediate reaction.
As always though, there is a market open somewhere that will immediately vote. In this instance, it will be the U.S. equity markets, which arguably have the largest single vote of any equity market globally. The reaction of the markets is the equivalent of an Investor Big Boy Talk. Markets react to facts, or perceived facts, and sometimes that reaction is not all that pleasant.
For weeks, European government officials have been talking up the results of these tests. In fact, as recently as last Friday, George Provopoulos, governor of the Bank of Greece, said in an interview published in the newspaper Imerisia:
“My feeling is that things will go smoothly for the six Greek banks included in the sample."
Typically, releasing results early to the market is called inside information. In the instance of governmental data, it is more like business as usual. Regardless, expectations have been largely set that there will be no major issues with the European bank tests.
In fact, the 54- member Bloomberg Europe Banks and Financial Services Index has risen 9.3 percent this month, boosted by optimism that these lenders will pass. If you didn’t know what expectations were for these tests, now you know.
Further, according to Dutch Finance Minister Jan Kees de Jager, the sovereign tests will not include a write down or the scenario of defaults on sovereign debts. While we have not yet seen the results of the tests, we would of course have to seriously debate the validity of any European bank stress test that does not assume some form of sovereign debt write down.
In fact, as of yesterday’s close, Greek 5-year sovereign debt credit default swaps are trading at close to 800 basis points. Credit default swaps are used, obviously, to insure against potential default. When the cost of insurance against default is trading at such elevated levels, it simply implies that the likelihood of a potential default is not zero. In fact, it is well above zero.
While obviously this is not entirely apples to apples, we have posted below a chart that compares Greek CDS to Lehman and Bear Stearns. If history is a guide, the level of 300 basis points is a bit of warning line for potential default. At least, that was the line at which Lehman and Bear passed the point of no return.
Currently, Greece (which is discussed above), Portugal, Romania, Latvia, and Hungary are trading at or above the 300 basis point CDS level. This certainly doesn’t assure default, but it certainly does assume that there is some potential for default, which should be incorporated into the results of any legitimate stress tests.
As Confucius wrote about expectations:
“The expectations of life depend on diligence; the mechanic that would perfect his work must sharpen his tools first.”
Later today we will get to see how sharp the tools were that the Financial Mechanics of Europe used to analyze their 91 banks. My expectations are not high that these tests will prove to be valid or thorough, and, in fact, may further highlight the real risks and real sovereign exposures of many European banks.
Some key questions to consider ahead of the test results later today are:
- How many banks of the 91 have failed?
- How many have written down sovereign debt? And what is the general exposure?
- What is the general validity of the tests?
Regardless of the answer to these questions, you can be sure of one thing: government invented stress tests are designed for banks to generally pass, and the results will simply reflect that fact.
Whether I’m correct in my assessment of these tests or not is somewhat irrelevant, as Mr. Market will be there to analyze the results and have a post test Big Boy Talk with us all.
Yours in risk management,
Daryl G. Jones