This is a note of a trade on the European banks on the ensuing EU bank stress test result, an event-based trade, if you will.
The rationale behind the trade is that uncertainty is the nemesis of the market, and more so in the banking business where the asset values float in line with the macro. A stress test, which puts into light the prospectus of safety and soundness of the financial institutions, would hopefully clear the cloud over the investors and increase the market valuation of the tested along the way by diminishing perceived risks.
The idea came to me earlier this week when the news of the EU stress test was all over the business media. The result set to come to the open Friday, I have since been contemplating buying EUFN (iShares MSCI Europe Financials Index) throughout the week. A delay of action has cost me, when EUFN’s suddenly jumped 5% from $20 to $21 Thursday. Standing behind my expectation on what the stress test could do, however, I decided to put significant weight into EUFN in my portfolio, purchasing at $21.
The U.S. Stress Test and its Market Impact
What inspired me into such a trade is the bank stress test conducted by the Fed in the U.S. last year— in my opinion a highlight stroke out of the arsenal in the all-out war against the financial crisis by the regulators.
In February 2009, still lingering deep in the woods of the crisis, the Fed organized the bank stress test, called Supervisory Capital Assessment Program (SCAP), in an effort to gauge the collective health, and in some cases the viability, of the top 19 big U.S. banks, which consisted aggregately of 60% north of all U.S. bank assets. The test simulated under two what-if scenarios—one normal and the other more adverse, with more dire macroeconomic assumptions—the credit losses and the subsequent capital adequacy of the tested for 2009 and 2010. Those who failed would set out to raise capitals.
As the result showed by the Fed on May 7, 2009, the accumulative credit losses under the more adverse scenario would hit $599.2 billion for the 19 towards the end of 2010, on a basis of risked weighted assets (I don’t know what it means) of $7.8 trillion. After offsets by earnings and government support, $74.6 billion of additional capital needed be raised—$33.9 billion for BofA alone, and another $13.7 billion for Wells.
I was puzzled, however, looking into the market movement in the two-week span on both sides of the May 7 publication of the stress test result.
- During the trading week before, May 1 - May 8: S&P500 +2.42%, IYG (Dow Jones U.S. Financial Services Index Fund) +9.93%, BofA +36.51%, Citi +25.62%, Wells +16.21%;
- The week after, from May 11 – May 15: S&P500 -2.9%, IYG -6.47%, BofA -17.54%, Citi -9.84%, Wells -6.26%.
If you stretch the time zone back from the March-9-2009 low till today, IYG’s +116.91% beat by miles SP500’s 61.66%. BofA was up 264%, and Citi 298%.
If the time frame started from the May 7 result publication, however, S&P500’s +20.28% outperformed huge of IYG’s +10.33%. BofA gained a meager 5.6%, 6% for Citi.
All these wild swings mean different things to different people. What is clear is that my thesis of a short-term trade on the EU stress test breaks down, according to what I observed in the U.S. theatre. There was no observed correlation between the stress test result and the market performance—if anything, the market tumbled upon it.
The Reading of the EU Stress Test
The Committee of European Banking Supervisors (CEBS), mandated by the ECOFIN of the European Council, in cooperation with the European Central Bank (ECB), the European Commission and the EU national supervisory authorities, conducted a bank test similar to the U.S. one in 2009 on 22 cross-border European banks.
The EU bank stress test of 2010 is a second-run, only on a larger-scale, expanding into all banks whose assets should cover at least 50% of total bank assets in every of the 27 EU member states. Such a new rule drew in total 91 banks with total assets of €28 trillion, or 65% of the EU banking system.
The 50% coverage rule also resulted in an even distribution of number of banks from different countries. On the two ends of the extremes, there is only one bank from Poland, but 28 from Spain. Although the names of 20 countries on the list seem familiar (7 are inexplicably missing), skimming through all the 91 names of the banks, I found myself not knowing most of them.
The methodology of the test stayed more or less the same: the estimation of capital adequacy under one base-line scenario, one adverse scenario, with an additional sovereign shock in light of the recent sovereign debt crisis in Europe.
The Friday result showed that 7 banks from the 91—five Spanish, one Germany, and one Greek—failed under the worst case scenario the threshold of 6% tier 1 capital ratio, a standard seemingly lower than the U.S. one. In all, a mere €3.5 billion needs to be replenished. It is a result better than expected, as it should have been. The final estimate, also under the worst case scenario, is €565.9 billion in total credit and trading losses until 2011.
What is more striking than the outcomes is the property price assumption used. Even in the base-line case, property prices run flat in all countries, with those in Spain and Ireland down 5-15%, commercial doing much worse. Under the adverse one, property prices are assumed to be down 10% across the board.
The Trade
I have to say that I made the purchase Thursday on EUFN intuitively, with more an intention for a short-term ride on the momentum.
Now with the stress test result refresh at hand and the time for after thoughts, I believe there is value in the medium term nonetheless. Despite of the complexity of the issue (United States of Europe, macroeconomic forecast, FX, housing, banks, ETF) and information deficiency, I see on the iShare website that EUFN trades at 1X book value, while its U.S. equivalent IYG trades at 1.6X, and EMFN (MSCI Emerging Markets Financials Sector Index Fund) at 2.5X. I may be comparing apples to oranges here—think aggregated asset books kept on quite different accounting standards and you lose all sense of accuracy—but the valuation gap is stark and in my personal opinion more than reasonable, despite the sovereign debt crisis, deteriorating real estate market and decelerating growth in Europe.
At any rate, the game is on.
