Stressful stress testing

EU leaders yesterday agreed to publish the results of stress tests, performed by European banks. Spain was forcing the hand of her fellow Euro-zone members by declaring that the results of stress tests performed by Spanish banks would be published irrespective of the EU decisions. The stated goal of conducting stress test and of publishing the results is to increase transparency. Hopefully this will calm down the markets, which are now increasingly doubtful about Spain's public debt.

A stress test is a series of calculations, aimed at simulating losses incurred by a bank under a series of specific assumptions about the economic developments. The purpose is to show whether the bank has sufficient capital to survive if accident strikes. US banks were subject to a stress test in 2009 and some banks were revealed as being undercapitalised. The US government subsequently provided help to those banks under the TARP program.

The direct reason for the EU move is the increasing rumours concerning the health of the Spanish banking sector. Spain is currently undergoing its own savings bank crisis, with most of the 45 regional savings banks having ventured into lending activities that are now killing them. 16 of the savings banks are on the brink of collapse and one, CajaSur was taken over by the central bank.

Markets now fear that a) the commercial banks are in similar dire straits and b) that healthy banks will be forced to take over the unhealthy ones, given that the government finances will not allow a bail-out.

The Spanish government and central bank (who had impeccable credentials before the creation of the Euro) have attacked the issue head-on. They have pushed Spanish banks to bring losses forward instead of hiding them, as it is now allowed under European accounting rules.

This step towards transparency has already brought two consequences: Spanish banks have underperformed their European counterparts, and they are already rumoured to come out on top once the stress tests are performed and presented. Seen on this background, the Spanish government had little to lose by releasing the stress tests.

Not surprisingly, virtually every European banker has taken to the microphone in the past 18 hours. 'Stress tests are a not a bad idea, but please do not publish the results' seems to is the message they convey.
This looks like a living proof how little bankers have learned from the crisis over the past couple of years. They still believe that their businesses are best protected behind a shroud of secrecy, when it is increasingly clear that transparency is the way to create reassurance.

Of course some European banks are badly capitalised. European governments have tried to make bank rescue packages on the cheap and that will show. But the correct way of handling this is not by pretending that the problems do not exist.

Armies of financial analysts are convinced that Spanish banks are carrying tonnes on hidden bad loans on the books. This is a clear sign that the secrecy thinking is deeply entrenched in Europe. It can only be bad for business.

In a past life I worked in an investment firm where we almost never had European financials in the portfolio – for the simple reason that they were not sufficiently transparent. While stress testing for sure has its shortcomings, there are only reasons to cheer the EU for the decision to force the banks' hands. Obfuscation is no solid basis for business.

Rating agencies under heavy pressure

As an element in the ongoing political battle for financial reform in the US, the newspapers report a victory for the rating agencies. Well, sort of.

First, for those who have not yet heard of rating agencies, an ultra-short primer. A rating agency is a commercial company that produces ratings of various debt instruments, paid for by the issuer. The ratings are supposed to be based on a thorough analysis of the issuers' ability to repay the debt. There are three US based rating agencies that have government authorisation, Moody's, Standard and Poor's, and Fitch. Across the world, pension funds and insurance companies have used the ratings to "control risk" in their portfolios.

Many of financial institutions have a provision that if one of the rating agencies has issued a rating below investment grade, the institution simply cannot hold the security in their portfolios. US government agencies are required to use the ratings. Further, the ratings agencies have been protected under a peculiar interpretation of the Constitution, whereby their ratings were considered an expression of "free speech", meaning that it was impossible to sue them for any kind of malpractice. Their ratings are – despite the supposedly thorough analysis – just an opinion.

In the aftermath of the dotcom bubble, the reputation of the agencies took a bad hit, as the ratings of companies such as Enron dropped from the coveted AAA to "junk" in a matter of weeks before the company went bankruptcy (and months after the stock price had fallen by more than 90%). Surely the ratings agencies should have seen it coming, if they really had checked the books.

In the wake of the Sub-Prime Crisis it became abundantly clear that the rating agencies had "adapted" to the wishes of the issuers and had bestowed their highest ratings on packages of dodgy debt based on a paper-thin assurance from badly capitalised insurers. Who had by the way also been rated by the very same rating agencies.

And most recently, the rating agencies began to meddle with the EU as they have lowered the rating of Greek debt to "junk" status, despite a massive underwriting by the EU. Yes, the rating agencies defend themselves, but the underwriting will end in three years. Apparently their experience with both Sub-Prime issues and Enron or WorldCom have taught them a lesson about being ahead of the curve. But many institutional investors decided not to sell their holdings of Greek government debt, breaking with the diktat from the agencies.

Now their previously unassailable status is under heavy attack. The EU is actively trying to promote European rating agencies. The planned US reform of the financial sector will most likely lead to a change in the constitutional protection (so they can be sued for telling fibs), US government agencies will not any longer be required to use the services of the rating agencies. There will have to be far more openness and transparency about their ratings and analysis.

Amid all this bad news for the rating agencies, it is made out to be a victory that the US Congress has dropped an idea of assigning rating assignments on a random basis. Some victory.

For the rest of us who take an interest in risk management, what is going on is highly interesting. In a recent blog post I laid out how some of the thinking members of the financial community have arrived at the conclusion that mathematical models of risk are useless when they are most needed.

Now all of those who had used ratings as an excuse for independent thinking are receiving yet another blow. If you cannot consider the ratings as the results of proper diligence, how should you then manage a portfolio of debt instruments? I am afraid that I again come back to my conviction that there is no alternative to independent thinking.

In the real world, businessmen know that there is no such thing as a free lunch. Risk exists, even if you would really, really like it to go away (or to be sold off in tasty little morsels). Faced with this categorical imperative, too many risk managers have for too long relied on mathematical models and ratings. The mathematical models are built on assumptions alien to the real world. Ratings are issued by commercial companies who have shown clearly that ratings are a product which can be moulded to the clients' needs. For sure it is not quite as independent and well-founded as rating agencies would like us to believe.

Risk managers of the world, unite. You have everything to lose if you don't start thinking.

New risk regime – or “Houston, we have a problem”

We have long been adamant that risk models based on Value at Risk (VaR) or other backward-looking statistical models are close to useless. The reason is that the underlying correlations between financial variables are inherently unstable, and that this instability is most pronounced in periods of strong market movements.

In a remarkable piece, Jim Caron, Morgan Stanley's Head of International Bond Strategy admits to have found out that something is wrong. In a recent piece, he admits to having been wrong on interest rates and bond yields. It may well be so, but the more interesting is his observation of recent market movements.

"April and May were difficult months for us and others, judging by fund data on market performance. We did not properly discount the risks associated with peripheral Europe. As a result, we had a larger risk exposure than we should have. We measure the return potential for our positions on a per-unit-of-risk basis, similar to a Sharpe Ratio. That unit of risk turned out to be much higher than we anticipated. This will force us, and many others, to right-size our risks."

In other words: the models used to discount risk have understated the risk. Caron is optimistic that it is possible to "right-size". It counts in his favour that he actually tries to find a way out of the problem. He suggests the following

Liquidation of risk exposure: Portfolio positions turned out to be much more correlated than we had initially anticipated. Traders seek to reduce correlation by liquidating many positions, leaving behind perhaps only a few core positions. We saw these liquidations in May and early June

Sit, wait and re-assess: Traders will now have to evaluate the new risk relationships. Since there is great uncertainty, traders might start by making small and short-term tactical bets to get a feel for the risks. Again, only a few core positions may still be left on.

Right-size risk: As the new market environment becomes somewhat better understood – albeit still marked by great uncertainty and higher realized volatility – traders could now start to make an assessment on the proper risk they should have relative to the increased level of expected volatility of returns. For example, if the market is twice as volatile today as it was before, then one should run positions with half the size of risk.

For better or for worse – the introduction of a new tail risk: Given the losses taken and positions liquidated in the past few months, the new tail risk is for risky assets to reverse sharply higher and for yields to rise. This could cause traders to chase performance, so as not to be left behind relative to their peers. Similarly, if markets turn against them, then they will be quick to exit. This introduces two-way risk: traders may start to react equally to both good and bad news. Previously, the tail risk traders were mostly focused on a worsening of risky assets. Now they have to be concerned about both tails, for better or for worse, which will add to market volatility.

It all sounds very reasonable. But it sidesteps one important issue: the complete collapse of predictive models when multiple sigma events like the May Flash Crash and the accelerating sovereign collapse of the past several months occur.

Carons observation that "Portfolio positions turned out to be much more correlated than we had initially anticipated" hammers the point home - markets are not inherently stable. But the situation is more serious than Caron thinks: There are no models that can model the behaviour of the financial markets when disaster strikes. The solution is to introduce much simpler and much more pragmatic ways of dealing with risk, once it appears. Risk cannot be dealt with by a machine, however clever. This has been known for ages outside of the financial markets. The financial markets need to reconnect with the real world.

EU Commission is (again) told to back off

The week started off in a way that looked constructive. Facing a major run on the Euro and the debt of the Club Med members, EU responded constructively. A prototype of a European Monetary Fund was launched and the ECB assumed wider responsibilities than seen before in running day-to-day monetary policy. So far, so good.

To anybody with a bit of insight it has been clear that the Eurozone was a project where everybody wanted the benefits of a common currency without being willing to sacrifice political sovereignty. Everybody wanted to maintain the fiscal policy as a purely national matter.

The "Stability Pact" was a feeble attempt at establishing some rules that would at least impose some limits on the most profligate members. The Pact envisioned a system of economic sanctions on those member states that did not adhere to some simple rules regarding government debt and budget deficits.

As it is now obvious, nobody took those rules seriously, and the sanctions were never applied. Greece's lack of budgetary discipline threw the EU into one of the deepest crises ever.

Some of the ideas flying around after last week-end's panic summit were in fact quite sensible. One idea presented yesterday was to equip the European Commission with some powers to approve budgets before they were implemented. In order to avoid the nasty idea that the EU Commission would try to exert influence on national budgets, the approval was suggested to take the form of a "peer review". This would imply that representatives of other EU countries – but not the Commission - would review a country's budget.

The idea was then to let the "review committee" suggest changes and ultimately even sanctions that could take the form of withdrawal of EU subsidies.

This seems reasonable, particularly given that German Chancellor Merkel and French President Sarkozy in the days leading up to the summit jointly vented the idea of giving EU more authority in budget matters.

But now the crisis is over (?) and we are back to reality. And the reality is that France has no intention to hand over budget authority to Brussels. A French government spokesperson briefly stated that the authority over budgets lie with the national governments and not with the Commission. The Swedish prime minister expressed that the peer review was only necessary for country with "bad finances". One can only guess about the reaction in London, but it is unlikely to be positive.

So it goes. The reality is that Europe is not yet ready for the political demands of having a monetary union. Everybody wants a free ride on Germany's tailcoats. One can only guess how many more crises are necessary to either break up the Euro Zone under the weight of huge differences in government finances and productivity or to remove the political resistance to the necessary integration.

Nationalism was invented in Europe in the aftermath of the 1848 Paris Commune as sovereigns tried to protect themselves from revolutionary ideas spreading. Among the many results were national hymns, the sudden creation of national languages, national education system, a professionalisation of the administrative systems.

And it may still lead to the collapse of the most ambitious attempt at creating a European Union.

Small but important steps in fixing the monetary union

Most of us harbour bad habits and it often takes a life-threatening event to make us change our ways. It seems to work that way in many other contexts as well. EU or the Euro Zone was badly under pressure last week as the financial markets began to doubt the viability of the Euro project.

In some of my earlier posts, I have expressed my doubts about the long term prospects for the Zone, given the huge structural differences between the countries and the lack of integration. The EU summit in Brussels this weekend addressed none of that, but took clear steps in overcoming some of the most glaring deficiencies.

Right from the start it has been a problem that the Euro was launched without the creation of strong institutions to support it. In order for a currency union to work, one would expect a strong central bank, and a central budget instance with the possibility of financing deficits in the markets if needed.

Instead we got a central bank with a very limited charter (inflation fighting), and no central fiscal authority. Plus an increasingly unwieldy decision process as a steadily increasing number of members have resisted handing over authority to the EU institutions.

The Greek crisis forced some changes to all that. We now have the first steps towards establishing the Commission as a fiscal authority (managing the huge stand-by facility for countries in need of credit while dealing with fiscal problems), ECB announced that they suspend the rating limits for Repos, and will begin to make open market purchases in bonds issued by institutions and companies in Europe. ECB will also become more active in offering overdraft rights to commercial banks, something that the US Federal Reserve and Bank of England did already in 2008.

While market participants may complain that the underlying budget issues have not been resolved, the steps agreed by the EU member states have all the potential to become a game changer. EU just made a significant move in the direction of strengthening the monetary union. It may not dispel all doubts about the debt of the Club Med members immediately. However, I believe that the markets will eventually realise that this is meant very seriously.

So compared with the situation a week ago, we have now seen that the EU has moved to strengthen the community institutions, to give the ECB a good deal more muscle, and to show that fiscal solidarity is available to member states who take determined action to address their fiscal deficits. The only question that lingers is: why did it take so long until something happened?

That is an issue for the history books, but it has to do with Europe being made up of sovereign states which have a very hard time accepting to play together as it is needed in order to have a monetary union.

For now, we should see the panic sentiment seep out of the market. The market panic was based on ignorance about the fiscal and financial effects of the Greek loan package. With the new stand-by package, such worries should be addressed. ECB's new liquidity facility for the banks should remove the fears between European banks. Markets should recover. The long term problems inside the EU will, however, persist and will rear their heads again. But that is for tomorrow's markets, not today's.

Another Greek lesson

The misadventures of the Hellenic Republic continue to roil the financial markets. Despite a considerable stand-by loan package from IMF and the EU, the markets continue to react as if there is an imminent danger of a Greek debt default. Stock markets fall, yield spreads continue to increase, crude oil has plummeted, other commodities are falling, and the Euro is heading south. Junior parliament members are taken as witnesses that the European governments will renege on premises, and all the Euro-sceptic analysts in the entire English-speaking world have come out of the wormholes. There is apparently only one possible reaction: SELL!

I have repeatedly stated my conviction that the initiatives taken by the IMF and the Euro Zone in concert will be sufficient to solve the current situation at least for the next 3-4 years, and it follows that my take on the market reaction is that it is blown out of proportion.

Greece is the black sheep of the Euro Zone, no doubt. 13-14 per cent budget deficit, fudged budget numbers, lax accounting standards, collusion with Goldman Sachs to "hide" debt. The list of misdemeanours is long and impressive. Worst of all, however, is the culture of tax evasion. In a country of more than 11m inhabitants, less than 5000 persons filed a tax return stating taxable revenue in excess of €100,000 in 2008. Apparently large swathes of the population do not pay income taxes at all, and predictably, it tends to be the better off who enjoy this privilege.

No wonder that it will take a while to fix.

But even when the package is in place and the financial markets have caught their breath, there are certainly issues to address. One was raised by Germany's Merkel and France's Sarkozy in concert. Their point is the simple, that in order to make the Euro work better, there has to be a much better budget discipline among the member countries. Their solution would be to strengthen the central oversight – i.e. to create some kind of Euro Zone budget watchdog.

Sounds fair enough, but the question would be what kind of powers would be invested in the new central budget authority. Already, there is a draconian system of fines put in place. But as the Greek adventure has shown, the sanctions are dropped once the going gets tough. So let me guess.

Merkel and Sarkozy want to create a central budget authority that can, could, would kick out countries with an insufficient budget discipline. Such as Greece in three years' time if a comprehensive tax reform is not in place.

Productivity is another issue. Germany built its economic success in the Post-war period on having a stronger productivity growth than all other countries. It gave Germany a huge economic advantage and room to keep inflation down by constantly revaluing the D-Mark against the trade partners.

When Germany purchased the neighbouring DDR at an inflated price it took some 15 years until the German productivity miracle was back. In the meantime Euro had replaced D-Mark and countries with higher inflation and much, much lower productivity growth had managed to gatecrash. And this is the fundamental problem of the Euro, if there ever was one. Combining national states, different languages and cultures, and low labour mobility with pronounced productivity differences and a common currency is not exactly the recipe for success, EU had expected.

Germany, which has been bankrolling EU for decades, is understandably worried about the contingent claims that may be forthcoming. Referring to Germany's success, officials have been busy promoting German budgetary virtues everywhere. But the issue really is not the budget. It is only a beginning. The issue is what it takes to maintain a currency union across huge differences. It may well be that all the political will and all the stand-by loan facilities may not be enough.

Headlines and other lines

The Greek story continues to take the headlines and is being used as the explanation for the continued weakening of the Euro. I see no reason to buy the story. When you have finished listening to the news programs and reading the newspapers, all telling that the Euro is doomed, try and think objectively, you might end up reaching a different conclusion.
For starters, it is useful to watch such a thing as the USD trade-weighted index. Since December 2009, this index has increased by 13 percent. So when somebody says that the Euro has weakened by 15 per cent against dollar, 13 per cent of that change comes from a strengthening of the dollar.
Of course, part of that has to do with the fact that the Euro-zone is one of the USA's largest trade partners. But it nevertheless indicates that the talk about "the" European sovereign debt crisis as being the reason for an imploding Euro completely misses the point.
At the outset of the global economic crisis, virtually every major currency weakened against the Euro. Probably many reasons could be given for that, nevertheless the result has been that European exports have suffered and increasingly it looks as if the European economic could enter into a "double-dip". Even if it was not announce that way, the situation looks like a replay of the competitive devaluations of the '30s.
USA, UK, Japan, and Sweden have all pushed some of their economic problems over to the Euro Zone. When the Euro weakens, the member countries of the Euro Zone recover some of their lost competitiveness. Probably this is the reason that no comments at all in order to support the EUR have been forthcoming from ECB or any other quarters in order to reverse the trend. European politicians appear quite happy to see a stronger dollar.
Meanwhile, the US economy appears to have turned the corner and has repeatedly seen growth data well ahead of the expectations. The US trade deficit has shrunk visibly (even if it again trends towards a widening). US corporations are making money and more than widely expected. So buying dollars rather than Euro is not a hard case to sell.
It has also become popular to refer to the PIGS countries when talking about the southern European EU members. Apart from the obviously derogative content of the abbreviation, it also belies the fact that the 4 countries have very different situations and very different problems.
Greece has a huge debt and chaotic public finances. Portugal has a huge debt, but relatively well run public finances, Spain's debt is by comparison low, and the main problem is the soaring unemployment. Italy has a high debt, but did not see a disastrous deterioration of the budget deficit in 2008 and 2009.
Summing all of this up, it means that we should not fear a weaker Euro, as it will only create better possibilities for European exports, and we should not be led to believe that the southern European EU members have uniform problems that require uniform reactions. In particular, their current problems do not threaten the Euro.
If we should begin to look for European fault lines, we could begin to talk about the fact that the productivity differences between the various EU countries have widened markedly in the past decade, with Germany having made the most convincing progress. But this kind of talk does not easily translate into market talk, and is largely ignored.