From Win Thin, Senior Currency Strategist at BBH.
Newswires have reportedly gotten hold of the draft document for the stress tests, and it’s not pretty. It appears that the worst may be true with regards to how bonds would be subjected to testing. Draft said that haircuts would only be on bonds held in banks’ trading book and not those held in the banks’ banking book, and that no default assumptions were made. The distinction is quite important, as it allows banks to basically underestimate their exposure to distressed peripheral debt. As we understand it, the trading book is meant to capture positions set up by prop desks that would benefit from market price movement, with positions usually held for a limited amount of time and profits determined by mark to market. The banking book contains assets held for a longer amount of time and profits are usually calculated on an accrual basis if held to maturity. We do not know of any analyst that thinks Greece can avoid a debt restructuring. Does it make sense to assume that they will be paid off at par if held to maturity? By leaving out stress tests on the banking book, then a true picture of bank balance sheets will clearly not be obtained.
Assumed haircuts are slightly more aggressive than previously leaked, with 23.1% on Greece, 14% on Portugal, and 12.3% on Spain, while also assuming a 4.7% haircut on Germany, 10.2% on UK, and 5.9% on France. Previous reports had no haircuts on Germany and France. But, these haircuts don’t really matter if applied only to the trading book. Not surprisingly, the euro is taking it on the chin and making new lows on the day. However, markets probably wary of putting all their eggs in one basket based on the draft document leak. This week’s low around 1.2730 is the next near-term target, after that is 1.26 (38% retracement of the euro’s rally from early June). Official stress test results are due at 1200 EST/1600 GMT today.