Previewing the European Union Bank Stress Tests
(July 23, 2010)
Dear Subscribers and Readers,
I finally got my Amazon Kindle yesterday – a device that I have been itching for over the last couple of years. I love the preview feature, and of course, that I no longer need to find places to put my books. And of course, traveling with the Kindle (as opposed to three or four books that I happened to be reading) is a breeze. With a retail price of $189, it is highly worth it for avid readers, even if its price converges to zero in the next few years.
Turning to the global macro economy – the results of the European Union bank stress tests will be published at 17:00 London Time, followed by a press conference at 18:00 London Time. According to the mainstream media, five of the six Greek banks that are being tested under the European Union wide “stress tests” will pass, while the two major Irish banks (Bank of Ireland and Allied Irish Banks) will also pass, with the latter contingent on the success of a planned capital raising before the end of this year. According to a Goldman survey consisting of 376 participants (hedge funds 28%, long-only investors 38%, other 34%; Europe 66%, U.S. 23%, Asia 7%, and other 3%), the average response suggests that 10 of the 91 financial institutions tested will fail the test, with a subsequent expected capital raising of €37.6 billion. Spanish, German, and Greek banks will raise the most capital, with half of the capital coming from the public and half from the private sector. The opinion is split on whether the European banking sector would outperform the broad market three months post the stress test.
Interestingly, 37% of respondents still feel that European banks would be undercapitalized following the stress test, and more ominously (or bullish from a contrarian standpoint) only 35% feel that the stress test is a “credible reflection of bank resilience in a downturn.” That is, many investment managers (65% of respondents) don't feel the assumptions built into the stress test are sufficient to bring back investor's confidence. Note that 36% of the respondents were financials specialists, while 64% were generalists.
As I mentioned in yesterday's email – in light of Bernanke's recent (dovish) testimony to the Senate Banking Committee – it is instructive to look at the size of the Fed's balance sheet in order to gauge what the Fed is thinking with regards to creating new liquidity facilities. That is, if the Fed is seriously thinking of easing further, it should first manifest itself in more agency MBA purchases in the week ending last Wednesday, as there remains another $140 billion of “allowable” agency MBS purchases under the Fed's self-imposed $1.25 trillion limit. Interestingly, the securities (Treasuries, agency debt, and agency MBS) held by the Federal Reserve has remained steady at the $2.06 trillion level since mid-May. As of Wednesday afternoon, the Fed still has $140 billion left under its commitment to purchase $140 billion of agency MBS, although it is not obligated to purchase the full amount. More importantly, the Fed only purchased $755 million in securities for the week ending last Wednesday, as illustrated in the following chart:
Despite the Bernanke's dovish comments on Wednesday, the Fed has not made any meaningful security purchases in the week ending last Wednesday. My sense is that the Fed is waiting for the publication (and more importantly, the market's reaction) of the European Union stress tests before making any more purchases. Should the publication of the EU stress tests (and subsequent capital raising) inspire more investor's confidence, then the Fed may actually reverse course and stand pat, for now. This is especially plausible if the increase in confidence leads to a virtuous of increased lending among both U.S. and EU banks (we can only hope).
My sense is that investors will generally react positively to the publication of the EU test results. Sure, there will be some dilution even among some of the major banks in the EU, but the publication of the stress tests will no doubt instill more confidence in the balance sheets of the EU banks, and by extension, the European credit situation and the economy as well. The market action for the rest of the summer thus looks much better now, especially in light of an increasingly dovish Fed and an improvement in the technical conditions. Don't be surprised if we shift to a 100% long position in our DJIA Timing System soon! More to come this weekend.
Henry To, CFA