Sunday, July 25, 2010

Stress Tests Results: Recovery Will Never Come

The news of the day Friday and throughout the weekend has been the "successful" results of the European stress test. 

The worry in the European banking sector has been with debt the banks hold on their balance sheets of other European countries.  If a bank holds x amount of Greek debt for example, and those bonds become worth only a fraction of their original purchase value then the bank has to take a write down.  If banks are forced to write down a large enough amount of bad debt they will have to close their doors.

If another bank is worried that this bank may go out of business then they do not want to lend them money.  The banking system is a liquid market that relies on banks lending to each other.  Otherwise you have a freeze up, which causes tremendous stress in the financial system.

(The same exact scenario took place in our banking system in the fall of 2008 with subprime debt)

The Europeans decided to "stress" test all the banks to determine their level of risk.  Their hope was that when this became available to the public then banks would then trust the strong banks, and the weak ones would close.  The term for this is transparency.

Here is the catch:

The only assets that were stress tested on the balance sheets were the ones held on the "tradable" accounts.  This means bonds that banks are holding in a specific account that they are planning on selling.

There is another location that banks can hold bonds; in an account called "held to maturity."  This location on the balance sheet was not tested.

So guess where banks put their bad debt?  On the held to maturity location!  Doing this means they have to raise no capital to cover the loss of value on the bonds.  They can count the bond value as the same price they originally paid for it.

Does this sound familiar?

It should.  The same exact scenario took place in March of 2009 in the United States.  Our government leaders changed the way banks could value their assets with an accounting change called FASB 157.

The banks simply took the real estate that was only worth a fraction of its original value, and by putting it into the "held to maturity" location they could now count the asset as the price they paid for it.

For example; a commercial building purchased in 2007 for $10 million is most likely worth $6 million or less today.  This new accounting rule allows banks to value the asset at $10 million.

The is the reason why the banks are sitting on a trillion dollars of cash and not lending it to the public or businesses.  The losses are still sitting on their books, they now just lurk in the shadows.

Because the system cannot cleanse itself, it can never recover.  Japan pursued the same exact strategy after their real estate and stock market bubbles burst in 1990.  They have had two lost decades, and both their real estate market and stock market are still over 70% lower than where they were 20 years ago.

We received word on Friday with the European stress tests that they plan on making the same terrible mistakes as Japan and the USA.  There will be no real recovery until the system is allowed to cleanse itself of the bad debt and the prices for assets fall to free market levels.

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