European Stress Tests--You Ain't So Tough

Some reports suggest that the stress that European banks may be tested for include a 17% loss on Greek bonds and a 3% loss on Spanish bonds German bunds and possibly French bonds will not be stressed--that is to say the stress test will not include a loss on bonds from those two.

While these details have yet to be confirmed, the stress on Greek and Spanish bonds seem too modest. Greece pays 750 bp more than Germany on 10-year bonds today. If one were to assume a 17% haircut, the pricing would suggest a ball park odds of that haircut at about 44% (750/17)--on the idea that the premium over the risk free assets is a function of the size of a hair cut and the odds of a haircut. The 3% haircut in Spain, given the premium of 205 bp would suggest almost 70% chance of that side haircut (205/3). Moreover because the ECB has bought about 59 bln worth of sovereign bonds, mostly believed to be Greek, the price discovery process in the periphery bond markets may be skewed. The credit default market seems to be pricing in the odds of a larger haircut.

This is only preliminary reports and a quick back-of the envelop calculation, but these kind of numbers do not seem particularly robust that would ease market anxiety. If more people conclude this, the euro may come off.
European Stress Tests--You Ain't So Tough European Stress Tests--You Ain't So Tough Reviewed by Marc Chandler on July 07, 2010 Rating: 5
Powered by Blogger.