Tuesday, 27 July 2010 13:20

Here's More Proof of the Sheer Lunacy of the European Bank Stress Tests: Passed Banks are Already Trying to Collect on Defaulted Claims of European Nations

Much of the mainstream media has carried articles that were at least somewhat skeptical of the European bank stress tests. I think being "somewhat skeptical" is about 5 leagues below where they should be, but its a start. After all, the EU actually passed a bank that is literally insolvent. I don't want to pound on the actual insolvency of this German bank, since I already went into detail on this topic earlier, but it is imperative that my readers understand the depth and extent of the travesty (or lies) that are being promulgated in the name of "transparency". I ridiculed the basis of these stress tests last week (European Bank Investors, Don’t Look Now – You’ve Been Hoodwinked, BamBoozled…), but now it is time to show you that these tests which assume the biggest threat to the European banking system (sovereign default or restructuring) will not occur and capriciously passes banks that not only will be hampered in the future, but are actually quite insolvent (by nearly any realistic means measurable) now, have actually proven that the risks of restructuring and/or haircuts are virtually guaranteed. This leaves the results of the stress tests a farce, at best and an insult to capitalism and common sense.

The tests assumed that there would not be a sovereign default. The tests also refused to mark "hold to maturity" inventory to market, despite the fact that said inventory may be permanently impaired. The logic? Europe will not allow a default. But how about a restructuring? And how will Europe handle more than one sovereign coming to the restructuring trough? I've already demonstrated the damage that can be done in A Comparison of Our Greek Bond Restructuring Analysis to that of Argentina.

Price of the bond that went under restructuring and was exchanged for the Par bond in 2005


Price of the bond that went under restructuring and was exchanged for the Discount bond


If one considers the leverage used by the banks to buy these bonds, there is no wondering how Greece Killed Its Banks (see the contagion model below). Let's delve further though, for their is already ample evidence of distressed banks that passed the EU stress tests that already have ample holdings of bonds that are already defaulted. Yes! That's right, the default has already occurred.

Revisiting the bank that I call (without a shadow of a doubt) insolvent, Deustche PostBank. you will find that it had €57,033,065.20 in claims against the Icelandic Kaupthing Bank. But isn't that bank in bankruptcy? If the bank is in bankruptcy, under the remote scenario that PostBank will get ANYTHING back, it would most likely be pennies on the dollar. But I thought default wasn't in the cards, according to the European authorities. Their credibility is shot, and has been since this crisis began. See Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse! to mark the track record of EU prognostications to market. Since the crisis began, they have been wrong nearly ALL of the time, and each time the error was skewed to the OPTIMISTIC side.

What many central bankers and government officials fail to realize is that there is constant contingent of watchful eyes and analytical prowess available thanks to the socially collaborative power of blogs and the distribution prowess inherent in the Internet. Thanks to Wikileaks, we know have a listing of $40 billion euros of claims against this tiny bankrupt entity that proves the point that assuming no defaults when so many nations are on the path to default is pure lunacy. The leaked document is very hard to get due to traffic (the document is over 500 pages of bank secrets), but any free registered member of BoomBustBlog can download it here: File Icon kaupthing-claims.

So who else has claims against this little bank that can payout very little? Goldman Sachs, Deutsche Bank, Credit Suisse, Morgan Stanly, Exista, Barclays, Commerzbank AG and a vast number of others totalling over $40 billion euro. In case nobody realizes it, neither the bank nor Iceland itself has the money handy to return to the creditors. As a matter of fact, Deutsche Bank and Deutsche PostBank have double the exposure due to their unusual relationship. Subscribers, see

So, I assume some of the naysayers quip, "Well, Iceland is a one off occurrence, and a very small country!" Right, in the case of Greece, Portugal and Ireland, it's different this time. They are all Ovebanked, Underfunded, and Overly Optimistic, this is the new face of sovereign Europe:

Sovereign Risk Alpha: The Banks Are Bigger Than Many of the Sovereigns


This is just a sampling of individual banks whose assets dwarf the GDP of the nations in which they’re domiciled. To make matters even worse, leverage is rampant in Europe, even after the debacle which we are trying to get through has shown the risks of such an approach. A sudden deleveraging can wreak havoc upon these economies.

If you don't think another Iceland is about to happen momentarily, take a glance over at Hungary. Although this country has adequate (for now) reserves, the game of chicken it is playing with the IMF is bound drive up rates and isolate it from global financial markets which will further swallow a country that already has the 4th largest debt to GDP ratio (80%+) in the EU. If the current Hungarian forint weakness pursues, Hungarian banks will assuredly face additional stress. This stress will be compounded since Hungarian households have borrowed heavily in Swiss francs (CHF), potentially spreading financial and economic contagion. The banks have a large inventory CHF-denominated loans, hence a surge in NPLs and NPAs is imminent.

Of course, we have nothing to fear, since the EU stress tests administrators have made it clear that there will be no defaults or restructurings, you know, like the ones in Iceland. Let's revisit how easily and quickly financial and economic contagion can spread via The BoomBustBlog Sovereign Contagion Model:

The gorging on quickly to be devalued debt was the absolutely last thing the Greek banks needed as they were suffering from a classic run on the bank due to deposits being pulled out at a record pace. So assuming the aforementioned drain on liquidity from a bank run (mitigated in part or in full by support from the ECB), imagine what happens when a very significant portion of your bond portfolio performs as follows (please note that these numbers were drawn before the bond market route of the 27th)…


The same hypothetical leveraged positions expressed as a percentage gain or loss…


The BoomBustBlog Sovereign Contagion Model

Nearly every MSM analysts roundup attempts to speculate on who may be next in the contagion. We believe we can provide the road map, and to date we have been quite accurate. Most analysis looks at gross claims between countries, which of course can be very illuminating, but also tends to leave out many salient points and important risks/exposures.

foreign claims of PIIGS

In order to derive more meaningful conclusions about the risk emanating from the cross border exposures, it is essential to closely scrutinize the geographical break down of the total exposure as well as the level of risk surrounding each component. We have therefore developed a Sovereign Contagion model which aims to quantify the amount of risk weighted foreign claims and contingent exposure for major developed countries including major European countries, the US, Japan and Asia major.

I.          Summary of the methodology

  • We have followed a bottom-up approach wherein we have first identified the countries/regions with high financial risk either owing to rising sovereign risk (ballooning government debt and fiscal deficit) or structural issues including remnants from the asset bubble collapse, declining GDP, rising unemployment, current account deficits, etc. For the purpose of our analysis, we have selected PIIGS, CEE, Middle East (UAE and Kuwait), China and closely related countries (Korea and Malaysia), the US and UK as the trigger points of the financial risk dissemination across the analysed developed countries.
  • In order to quantify the financial risk emanating in the selected regions (trigger points), we looked into the probability of the risk event happening due to three factors – a) government default b) private sector default c) social unrest. The probabilities for each factor were arrived on the basis of a number of variables determining the relative weakness of the country. The aggregate risk event probability for each country (trigger point) is the average of the risk event probability due to the three factors.
  • Foreign claims of the developed countries against the trigger point countries were taken as the relevant exposure. The exposures of each developed country were expressed as % of its respective GDP in order to build a relative scale for inter-country comparison.
  • The risk event probability of the trigger point countries was multiplied by the respective exposure of the developed countries to arrive at the total risk weighted exposure of each developed country.

Additional reading of interest... Interest parties may click here to subscribe.

  1. With the Euro Disintegrating, You Can Calculate Your Haircuts Here”

  2. What is the Most Likely Scenario in the Greek Debt Fiasco? Restructuring Via Extension of Maturity Dates

  3. The ECB and the Potential Failure of Quantitative Easing, Euro Edition – In the Spotlight!

  4. Introducing the Not So Stylish Portuguese Haircut Analysis

  5. Introducing The BoomBustBlog Sovereign Contagion Model: Thus far, it has been right on the money for 5 months straight!

You can find the full Pan-European Sovereign Debt Crisis series here.

Last modified on Tuesday, 27 July 2010 13:20


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