Comments on: Interpreting The Stress Tests

By: Jose

Jose — Sun, 08 Aug 2010 20:50:32 +0000

I liked your description of PD and LGD calculations. I agree with you that common sense needs to be applied to these calculations rather than mere history because otherwise we would miss the outliers.
One example. While working for a large spanish Caja, the head of risk once told me that developer loans had 0 defaults. That´s right, 0. Not a single developer loan had gone under since records started at the bank. Like most spanish Cajas, lending to the private sector in earnest had not begun until the 90´s.
Why were developer loans so robust?
Because in a growing real estate market when one developer went under (extremely rare anyway) another one took over the development and assumed the loan the next day. I.e. if prices are increasing real estate can always be sourced.
What happens when prices fall? Exactly the opposite. Even the good developments are doomed because not even selling your apartments at market prices (now reduced) are you capable of returning the loan to the bank.
Essentially developer loans display an almost binary default curve, 0 under good economic conditions and 1 under bad economic conditions. A 1 means that you default but not necessarily lose everything, i.e PD approaches 100% but LGD can remain still moderate.

By: Jose

Jose — Sun, 08 Aug 2010 20:27:08 +0000

Great article. I would add a few points.
1. Isn´t it curious that the deadline for spanish SIPs (Cajas cold mergers) was 30 June and stress test were released end July.
2. Isn´t it cheeky to include as part of the new capital of the new SIPs (still to be approved by Cajas boards) the theoretical FROB allocation. The FROB allocation still needs to be obtained from the capital markets by the Govt to lend to the Cajas. It is by no means clear how this capital will be injected into the Cajas.
3. Isn´t it adventurous to stress test Cajas SIPs that only exist on paper and ignore the existing Cajas pre-merger?

In my view too many coincidences.

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By: theyenguy

theyenguy — Wed, 28 Jul 2010 14:14:05 +0000

Thanks for the article.

You write: “They were, it seems to me, essentially designed to free up lending in the short term European interbank market, nothing more, nothing less.”

Yes, but I do not have any evidence that suggests the tests were successful in that regard.

You write: “This would be useful since it would enable the ECB to step out of playing this particular role.”

Yes, it would enable the ECB to step out of playing this particular role. But, I believe that now that the tests are in and we have had a terrific rally in the European Financials, traded by the ETF, EUFN. I think the banks will be come market decapitalized and I think that the currency traders are going to short the Euro, traded by the ETF, FXE. Which will cause the ECB to step back in to its role.

MarketNews reports EUR Libor at Highest in 11 months, hits 0.8275%. I believe it will be going higher as interbank distress increases.

As you note there is large quantity of asset backed securities of one kind or another that need to be re-financed in the months and years to come. Frankly given all of the above negatives, I do not see how the debt can be refinanced.

You state “I think made reasonably clear is that no EU bank or sovereign will be allowed to fail between now and the end of 2011.”

This is very true. I believe that capital will become so tight, that something entirely new is going to happen. I perceive a severe credit deflation scenario. On July 27, 2010, US Treasuries traded by TLT, turned parabolically lower. And for four days Aggregate Bonds, AGG, fell lower. Now interest rates will rise across the board, this will drive corporate bonds down, and raise the cost of doing business at a time when corporate debt globally is coming due. This means many, many businesses will close and unemployment will soar at a time when Spain, traded by the EWP, and the European Financials need to rollover a number of asset backed investments. This will induce a credit exasperation and liquidity evaporation. Government finance ministers and state leaders will have no choice but to jointly announce austerity measures and bypass their national legislatures. Governments will become seignior, that is they will exercise seigniorage and become the first, last and only provider of credit. Then only food stamps and strategic needs will be financed.

In the linked chart-article, I wrote an editorial entitled: What Is It That Six Of The Fourteen German State Banks Are Hiding In Not Publishing Details Of The Debt Holdings As Required By The Stress Tests Standards. I believe it makes for an insightful read.