Stocks Finished Lower on Monday

Stocks finished lower again on Monday as traders around the globe failed to bite on the idea that the European stress test results were a reason for celebration. It was obvious from the wee hours here in the states that fears of contagion and the potential for a replay of the global credit crisis was driving the action. And although the bulls did manage to find a few friends near the end of the day, another drop of 95 Dow points can hardly be described as a moral victory.

The problem is that while the powers-that-be across the pond continue to struggle with the question of what to do about Greece and the rest of Europe’s little PIGI’S, the fear of contagion seems to grow exponentially. Some will argue that “fear” of contagion is actually the wrong word to be used here because the soaring prices for credit default swaps around the continent means that contagion is already happening. For example, in Greece, which, of course, is the poster child for this crisis, prices for CDS have soared 61% in the last month alone. And while the situations in other countries are much less dire, traders seem to be taking a sell-first-and-ask-questions-later attitude.

Several stories made the rounds Monday about the idea that Greece is basically bankrupt. The exact details escape me, but the gist of the story is that Greece owes more in interest each year than it currently takes in. Thus, the talk of a default in Greece is looking more like a question of when, not if.

Which brings us to the issue of the European bank stress tests. In short, the test results are more than a little confusing and need some explanation. According to the EBA (European Bank Authority), out of the 90 banks tested, only 8 failed to show a “Core Tier 1 Ratio” (a measure of capital on hand) of less than 5% – which was the line in the sand between a passing and failing grade. An additional 16 banks were deemed “thinly capitalized” with CT1R’s of between 5% and 6% while there were 29 other banks with ratios between 6% and 8%. Thus, almost 60% of the banks tested had CT1R’s of less than 8%, meaning that there is risk in the system if a problem were to occur. However, it is worth noting that the results were actually a bit better than expected.

But the fly in the ointment, and the reason for the big losses on the European bourses Monday, is the fact that the so-called stress tests didn’t actually test for the situation most likely to occur – a sovereign debt default. If you dig into the report, you will find that sovereign debt was NOT marked to market in the test. This is due to the fact that most sovereign debt is held on banks’ “banking books” and not on their “trading books.” So, while the test assessed the likelihood of losses on the trading books, it did not make this assessment for assets deemed to be “held until maturity.” Hmmm…

Here’s the problem. According to the tests, only 2 banks in Greece “failed.” But with Greek banks holding about two-thirds of all Greek sovereign debt, one might wonder how this is possible. It’s simple really as only a small amount of Greek sovereign debt is held on the “trading books” of Greece’s banks. Therefore, the way the EBA looks at things, there is no problem! Well, unless of course, Greece was to default on any of its sovereign debt. The bottom line here is that a default by Greece would put a massive hole in the capital of Greek banks.

So, with politicians on both sides of the Atlantic seemingly incapable of getting anything done, traders have apparently decided to take a stand. Or perhaps more appropriately, buyers have decided to stand aside for the time being.

With the U.S. market down only 3.5% from the recent high seen on July 7th, one could argue that all of this Greek stuff isn’t really impacting our markets to any great degree. However, I’m fairly confident that if we start to hear any other countries, such as France, which holds 9% of Greece’s debt, mentioned in the discussions of sovereign debt contagion, things might get ugly. But then again, if the global leaders can get their act together, this might just go down as another summer of discontent instead of a Greek tragedy.

Turning to this morning… The mood has improved this morning on the back of higher markets across the pond and a host of good earnings news from the likes of IBM. Stock futures are currently pointing to an up open.

On the Economic front… Housing Starts jumped 14.6% in June to an annualized rate of 629K. This was above the consensus for 575K. Building Permits for June rose 1.9% to 624K. This was also above the consensus of 603K and last month’s reading of 612K.

David Moenning
Editor: The Daily Decision