In mid-2010, some well-known Spanish banks were sending us investment proposals in Greek sovereign debt. The reports and analyses we kept receiving insistently said that it was foolish not to take advantage of the yield differential between the bonds of Eurozone countries. They argued vehemently that we should not forget that, after all, this was an EU country, and that the Greeks would never be allowed to default, not even if their bonds depreciated by much more than they did at the time, with yields still hovering around 6%. In other words, little more than the yield on Spanish debt today. The arguments put forward were reasonable and reasoned, except for one small detail: They forgot that two and two are four.
At the time, Greek sovereign bonds «enjoyed» a spread over French or German bonds, which only the «ignorant» should have let slip through the fingers of these banking analysts. Why invest in Spanish, Italian or Portuguese sovereign debt when Mr. Market's fool offered a few basis points more for a Greek paper as European as the rest? The brainy analysis departments of these banks, some of which call themselves intelligence (sic) banks, regularly send this type of reports and circulars to their network of professional clients so that they, in turn, sell or propose this type of investment to their clients. In this case, and without serving as a precedent, there was no special commercial interest in placing their products (commissions, brokerage and custody apart, of course) but simply an erroneous interpretation of the financial scenario, imprudence, unconsciousness, incompetence, blunder or whatever we want to call it. The fact is that at that time Greek sovereign bonds had a «bargain» value of ninety-something... and today they are worth half that. Moreover, their loss of value, as we have seen in what happened in Argentina 10 years ago, is and will be permanent, because in 30 years time they will all be bald (see what we said in «The unbearable lightness of fixed income«).
Merval index vs. the price of Argentine sovereign debt from the pre-corralito era to the present day.
Graph included in the presentation of Cluster Family Office «Capital preservation and growth in today's environment«. You can access the full presentation here.
And what does all this have to do with the stress test? Let's get down to it. Holding this type of sovereign fixed-income asset, which over time is likely to depreciate sharply and irreversibly, turns fixed-income portfolios, which are supposed to avoid the risk of equity markets, into very high-risk portfolios. And we say very high precisely because of the inability of fixed income to recover losses when a credit event occurs. Unlike the price of shares of good companies bought at reasonable prices, whose value recovers quickly after a period of panic (Merval index chart above), a fixed income investment that misses the mark is a definite loss. More than two decades ago, a friend and executive at the Citibank Private Bank In his opinion, investing in equities was the equivalent of driving a car with rear-wheel drive. In other words, in which skidding (market fluctuations or stressful situations or stock market crashes) are more manageable and regaining control after the ups and downs is more feasible, despite the shocks and the expertise required. On the other hand, I said, in a front-wheel drive car (fixed income), the sways and skids are almost never encountered. The ride is calmer and the feeling is more akin to the safety of being on rails. However, when we go beyond the limits of the tarmac, the weather conditions become more difficult and we reach the limit of adhesion (credit events), skid control is much more difficult.
In other words, if we invest in fixed income, we had better make sure that the risk of slippage is almost nil, because if it does occur, we will have little chance of avoiding an irreversible disaster, i.e. a very large and permanent loss. And the worst thing is that it will have occurred precisely in the portion of our assets that we needed to keep away from the risk of losses and the volatility of the stock market.
At this point, most of you will agree with me that holding peripheral debt today, from countries such as Greece, Ireland or Portugal, is more than likely a risk. And that holding Italian or Spanish debt is not exactly running on rails. In fact, if you read us again, over the last two years we have been denouncing this risk against all odds (majority opinion two years ago) and against all odds (politically correct discourse). And of course none of our clients hold peripheral sovereign debt or banking products in their portfolios, as we limit our use of banks to the mere depository of more solvent investments (certain investment funds, corporate bonds, private equity, etc.).
Well, when we talk about the Spanish banks' passes or fails in the stress test (interestingly enough the positive language which the government uses millimetre by millimetre by calling it «endurance exercise«The risk contained in sovereign assets that already stink at the bottom of their balance sheets is ignored: almost a third of the debt issued by the Treasury up to June has been placed with Spanish banks and savings banks, i.e. more than 195 billion euros. The exposure of Spanish banks to the country risk of our own sovereign debt is so high that in eminent entities such as BBVA or Santander itself, the proportion of Spanish debt purchased with respect to the total world sovereign debt that they have stuffed in their balance sheets, exceeds 50 and 40% respectively! You can read the laughable adjustments made for the falls in Greek bonds, grossly manipulated to minimise their effects on the balance sheets of the banks under examination, at this article of the Wall Street Journal.
The stress test, by definition, should not assess the current impact of the depreciation of bank portfolios; that is what a proper balance sheet does. What a stress test should assess is the impact that different variables will have on the bank's balance sheet, such as the future devaluation of its assets, by considering a series of more or less likely negative scenarios. From the most plausible scenarios to the most negative or stressed. And among them, it is an aberration that the substantial depreciation of the sovereign debt of countries such as Spain, Italy or France is not contemplated, whether or not they have the accounting obligation to provision them (maturity or trading portfolios), since we are talking about future but plausible and near future scenarios. This would be a real stress test, but of course, if we enter this swampy terrain, let him who is free from bankruptcy cast the first stone. Because the variables that are being considered as negative scenarios are designed to be hammered out, that is to say, tailored to the results that are being sought, and not the other way round, as they should be. Only scenarios as negative as the acceptable percentage of failures in the stress test and political correctness make it advisable are being considered. And the slogan is that the depreciation of peripheral sovereign debt must be denied beyond all evidence, to the point of reaching such surreal and dangerous heights as the denial of the very same Greek credit event, which even the trileras risk rating agencies they find themselves unable to deny!
The rise in the risk premium of the periphery (including recently even France) relative to the German bund is the big white elephant in the room which the stress tests strive to ignore. Because if the massive holders of Spanish debt, i.e. our own banks, should be examined under the assumption of a realistic depreciation of that sovereign risk (not to mention their real estate), then that is the end of the story, although for many it will be stay and pay. For me, of course, it is no good politicians and bankers boasting about getting a good score in the stress test or having little exposure to Greek debt compared to French banks, for example.
The interconnection is spooky, it's summer, the temperature is rising and we have no firewalls. What a stress...