Why the European Bank Stress Test is Almost Meaningless

European banks just completed a "stress test" designed to indicate whether a bank could survive a further economic downturn.  The primary measurement in this test is whether the bank is adequately capitalized, another way of saying whether its assets can absorb losses that may occur in such a downturn. Therefore, the definition of capital assets, in this case "Tier 1 Capital," is critical.
The Test
Assume a cumulative two-year probability of a

1. Default rate of 15 percent on property and corporate loans, 
2. 10 percent loss on mortgages and 
3. Stringent "haircuts" (write-downs) on their sovereign debt 

would the bank retain a 6 percent core Tier 1 ratio?
 
Tier 1 Ratio Defined
Included in the European bank stress test's definition of Tier One capital is

1. Deferred tax assets.  These are primarily losses taken by a bank that are in excess of the amount that can be deducted in a particular year, and are carried forward to future years, which cannot absorb new losses
2. Hybrid bonds.  These are loans to the bank that are convertible to common stock, which, again, cannot absorb losses.
3. “Silent participation” stakes, which resemble sovereign debt rather than cash, which has been injected into banks. Nevertheless, it counts this towards its core Tier 1 capital.

Which Banks Would Have Failed Without Using These Items in Tier 1?
According to Reuters, almost all big European banks would have passed.  It's a different story for the
smaller state-owned banks. Germany’s landesbanks, for example, have an average core Tier 1 ratio of only 5.9 percent but a total Tier 1 average over 9 percent, according to KBW. Using a stricter definition of Tier 1 capital would probably mean taxpayers having to stump up much more in the event of an economic decline as described above.

What Was the Purpose Performing the Test Using Such Lax Standards?
Had core Tier 1 capital been applied without including deferred tax assets, hybrid bonds and sovereign debt, the number of banks that would not have passed the test would have been significant enough to cause panic and further economic downturn.

But, by concluding that  only 7 of 91 banks failed the stress test, most people will be reassured that a further European economic downturn won't result in widespread bank insolvency.

Don't bank on it.

The Case Against Goldman Sachs: Epilogue

Last April, I outlined the case against Goldman Sachs.  In that discussion, I posed the following questions:
1.  Should rating agencies rate securities on their own merit (not by considering who may or may not be investing in them)?
2.  Since ACA chose the securities in this investment from a list given to them by Goldman (from a Paulson list), was it a misstatement that ACA was "Portfolio Selection Agent?"
3.  Since banks and pension funds are defined as "sophisticated" investors, should they analyze the investments they are considering on their own merit (not by considering who may or may not be investing in them)?
Those questions have been answered by the Security and Exchange Commission in their settlement with Goldman.
In that settlement, the SEC found that Goldman omitted the material fact that Paulson & Co. was on the other side of the trade.  That finding assumes that ACA would have selected securities differently had it known that Paulson was taking a position against, rather than investing in the securities it was analyzing.  Stated slightly differently, that is analogous to saying that I would report findings on the financial health of Johnson and Johnson, the Washington Post, Moody's and Kraft Foods differently if I knew Warren Buffett was selling them than if he was buying them.  That doesn't say much for me as an analyst.  There's always someone selling when another is buying.  When must that be disclosed?  When the person is well respected?  Smart?  Well known?
The SEC additionally noted that material facts need by disclosed whether or not investors are "sophisticated" or not.  Again, that doesn't say much for banks and pension funds, which generally have staff analysts who review the financial health of potential investments.  Does the SEC feel that these analysts will conclude differently if someone they know is selling, rather than buying a security?  I taught Security Analysis and Advanced Security Analysis at UCLA, and focused upon balance sheets, cash flow statements and other fundamental measurements of financial health.  Not once did I recommend researching whether other people were buying or selling a stock when making a determination of its financial viability.
Put into perspective, the fine against Goldman was approximately three days' earnings, so even though it was the highest fine assessed so far by the SEC, it will not materially effect Goldman's earnings.
Further, Goldman admitted no wrongdoing in its acceptance of this agreement.  Consequently, those lining up to recoup losses from their investment will have a much higher burden of proof.
My assessment of this settlement is that of a business decision by Goldman to pay a fine rather than engage in a protracted battle with the SEC.  But the more meaningful message is this:  The SEC has little confidence in either analysts or rating agencies.
Should you?