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CEBS Details Stress Test Parameters Ahead of Results – Placebo Effect Comes to Mind (FXA)

EUR is down, European bank stocks are down, sovereign CDS prices up from lows and yet some in media are claiming the stress test details released in the last hour by CEBS (EU agency overseeing stress tests – coordinating body) are severe and hence credible. 

 

Sorry to disagree but if the adverse scenario is given a 5% probability of happening (US bank stress test adverse scenario was a 15% probability), by definition it is borderline statistically insignificant.  No matter how high unemployment rates go (6% points) or market rates rise (125 basis points on 3-mo rates), with a 5% chance of happening, it is borderline meaningless.  Moreover, no sovereign default scenario was applied. Haircuts on Greek 5-year notes was 23.1% based on the end of 2009 valuation (the real depreciation occurred in May and June – 5-yr Greek notes traded as low as 75% discount to par).  But these haircuts are meaningless as banks have the discretion to move any of Club Med debt (or subprime loans) into a long-term investment account at par and have it count toward capital ratios.  We know already that some large banks in Europe have put tens of billions (euros) in distressed securities into the long-term investment account avoiding mark-to-market. 

 

I have argued this week that markets were part of the charade this week on stress tests as interest between trader/investor, banks and regulators are aligned…they all need each other and need passes not fails.  EUR moving down to under 1.28 from over 1.29 on the CEBS press release earlier does little to change my view on the farce unfolding in Europe and to be displayed shortly as the results are published.

 

I have attached DJN story on CEBS release below and see for yourself if the stress test parameters are credible when the most adverse scenario is borderline significant statistically.   

 

David Gilmore

09:50 23Jul10 DJN-DJ EU CEBS: Stress Tests Don't Simulate Sovereign Default

09:52 23Jul10 DJN-DJ EU CEBS: STRESS TESTS DON'T MODEL FOR LIQUIDITY RISKS

09:53 23Jul10 DJN-DJ EU CEBS: 6% TIER 1 CAPITAL RATIO IS ONLY SUCCESS THRESHOLD

09:56 23Jul10 DJN-DJ EU CEBS: TESTS MODEL ADVERSE SCENARIO AND SOVEREIGN RISK SHOCK

09:56 23Jul10 DJN-DJ EU CEBS: SOVEREIGN SHOCK ASSUMES GENERAL RISE IN MARKET RATES

09:57 23Jul10 DJN-DJ EU CEBS: SOVEREIGN SHOCK ASSUMES SEIZURE OF INTERBANK MARKET

09:57 23Jul10 DJN-DJ EU CEBS: SUPERVISORS ASCRIBE 5% PROBABILITY TO ADVERSE SCENARIO

09:58 23Jul10 DJN-DJ EU CEBS: US TEST ADVERSE SCENARIO HAD 15% PROBABILITY

09:59 23Jul10 DJN-DJ EU CEBS: SOVEREIGN SHOCK ASSUMES 1.25% RISE IN 3-MO MONEY RATE

09:59 23Jul10 DJN-DJ EU CEBS: SOVEREIGN SHOCK ASSUMES 0.75% RISE IN 10-YEAR YIELDS

10:00 23Jul10 DJN-DJ EU CEBS: SOVEREIGN SHOCK ALSO ASSUMES COUNTRY-SPECIFIC PREMIA

10:01 23Jul10 DJN-DJ EU CEBS: ADVERSE SCENARIO SEES 4-NOTCH SECURITIZATION DOWNGRADE

10:02 23Jul10 DJN-DJ EU CEBS: SOVEREIGN SHOCK IMPOSES HAIRCUTS ONLY ON TRADING BOOKS

10:02 23Jul10 DJN-DJ EU CEBS: NO HAIRCUTS ON SOVEREIGN BONDS HELD TO MATURITY

10:03 23Jul10 DJN-DJ EU CEBS: SHOCK MODEL ALSO SEES RISE IN POTENTIAL LOAN DEFAULTS

10:04 23Jul10 DJN-DJ EU CEBS: SOVEREIGN SHOCK APPLIES 23.1% HAIRCUT TO 5Y GREEK BONDS

10:04 23Jul10 DJN-DJ EU CEBS: SOVEREIGN SHOCK APPLIES 12.3% HAIRCUT TO 5Y SPANISH BONDS

10:05 23Jul10 DJN-DJ EU CEBS: SOVEREIGN SHOCK APPLIES 14% HAIRCUT TO 5Y PORTUGUESE BONDS

10:07 23Jul10 DJN-DJ EU CEBS: TESTS WILL SHOW ALL EU SOVEREIGN EXPOSURE OF 91 BANKS

10:11 23Jul10 DJN-DJ EU CEBS: DIDN'T CONSIDER HEDGES IN ASSESSING SOVEREIGN EXPOSURE

DJ EU CEBS: Stress Tests Don't Simulate Sovereign Default

 

     DJ EU CEBS: 6% Tier 1 Capital Ratio Is Only Success Threshold

 

    LONDON (Dow Jones)--European Union regulators applied only one measure of success 

or failure in the stress tests conducted on 91 of the continent's largest banks, 

the Committee of European Banking Supervisors said Friday. 

    Success depended only on being able to prove a 6% ratio of Tier 1 capital to 

assets under two basic scenarios. The adverse scenario, as already reported, 

assumed a 3 percentage-point shortfall in gross domestic product in the EU over 

the next 18 months, effectively implying a modest double-dip recession. 

    In addition, the tests modeled for the effects of a "sovereign risk shock", 

by assuming a generalized rise in interest rates of 1.25 percentage points for 

three-month money and 0.75 percentage points for 10-year bond yields. On top of 

that, a country-specific discount was applied to all bonds, effectively 

correlated to their historical volatility. These assumed, at their most severe, 

an average-weighted 23.1% discount on Greek bonds, a 12.3% discount on Spanish 

ones and a 14% discount on Portuguese ones. 

    The euro has fallen fast Friday after investors pre-emptively judged the 

stress-test results to be overly lenient, with just hours to go before the 

results are officially released. 

    Traders have reacted negatively to news that the tests would cover only 

banks' trading books, rather than their outstanding debt holdings, with the euro 

shedding around a cent against the dollar to trade under $1.28. 

    However, the tests do also model for the effects of the sovereign-risk shock 

on default rates in the banks'  overall loan books. The only thing they 

explicitly exclude, as reported, is an actual default by a European sovereign. 

 

    -By Adam Bradbery and Geoffrey T. Smith, Dow Jones Newswires; +44 207 842 

9291; geoffrey.smith@dowjones.com 

 

    Click here to go to Dow Jones NewsPlus, a web front page of today's most 

important business and market news, analysis and commentary: 

http://www.djnewsplus.com/ge/al?rnd=mupTzEtpreWtG7vapQS%2BrA%3D%3D. You can use 

this link on the day this article is published and the following day. 

 

 

    (END) Dow Jones Newswires

 

 

 

 

 

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