The carefully choreographed results were announced yesterday. Markets reacted by doing nothing until the ECB held a PR conference. Markets then gained a little less than 1%.

The results are that 91 banks across 20 countries were tested. 7 banks failed: 1 in Germany, 1 in Greece, 1 in Slovenia, and 4 in Spain. Failure of the test means that tier 1 capital falls below 6% under either of 2 scenarios. Tier 1 capital is common stock plus retained earnings (for those that are interested).Tier 1 capital is the money that a bank can very quickly get its hands on if it had to (in theory).

Scenario 1: An economy showing these attributes:
·        A 3% contraction in GDP over this year & next.
·        A 6% increase in unemployment
·        A 6% increase in interest rates
·        Large currency swings (I could not get more details than that)
·        Bank book value dropping 36% over this year and next
·        A debt downgrade of 4 notches

Scenario 2: A Sovereign bond issue.  NOTE:  NOT a sovereign default:
·        Several haircuts to bond values were applied that range from a 4% loss on 5 year German bunds to a 15% loss on Portuguese 5 years bonds, to a 42% loss on 10 year Greek bonds.

One German bank failed: Hypo Real Estate. This was expected since it is in the process of being recapitalized by the German government. The rest of the banks that flunked have already secured the additional capital they need.

The issues I have with the European bank stress tests are the following:
1.   The worst case scenario tested is nowhere near a worst case scenario. There’s no point in having a test if it is rigged to let everyone pass except those that didn’t have the best lobbyists or that were already known to be under reconstruction by their federal government.
2.   Not all the systemically important banks were included in the test.
3.   I don’t trust that bank executives won’t massage their test results before they hand them in to the ECB. Where’s the independent auditor on this process?  We’ve seen how US bankers have played with their balance sheets. But we’re supposed to assume European bankers will be more trustworthy?
4.   There’s no equivalent to the Fed in Europe. So in the event of a sovereign default -and I’m saying we’ll see Greece default inside the next 2 years — a coordinated and cohesive strategy on monetary policy will be nearly impossible. There are 25 separate EU member states. They each set their own capital and accounting rules.
5.   The measure of creditworthiness a European bank is how a given bank is likely to be supported by its federal government, and how that government is in turn able to borrow from the ECB & the IMF — not the banks own balance sheet.
6.   The eurobank stress test has been a great PR exercise.  But!!!!  Let’s see whether European banks start lending to each other next week. And let’s see if Deutsche Bank stops shorting Spanish banks.

When we held our bank stress tests in May of 2009, equity markets ran up before the announcement, then sold off afterwards. I’m looking for something similar to happen this time as well.
Here’s what it all means. Europe remains the largest economy on the planet, and has seen its economic growth constrained by high debtload, and graying population for years.  The solution is broad-based austerity measures that will further slow an already anemic economy for years to come. Incidentally, if this sounds like what we’re facing here in the US, you’re right.   But I’ll rely on the Greeks to do what they’ve done half the time for the past 200 years: default. Apparently we won’t see an economic meltdown that starts in Europe this summer because of the success of this PR exercise. We won’t know for sure for a few more weeks. I’m still not interested in owning equity or debt in Europe until reality sets in and there’s a reconciliation. Vegas looks safer.