Bubble Baths and Stress Tests

In the dog days of the North American summer, August is a month of lethargy and indolence. It pays to remember that while you're still in the grip of Australia's winter. In fact, it's one of the only explanations for how a stress test is not really a stress test. Because a real stress test would, you know, be stressful. And who wants that during the middle of a long, hot summer?

In the big picture, our view didn't really change over the weekend. Money and capital are migrating from the West to the East. Emerging markets are better long-term investments than developed markets. And both are hostage the large amount of volatility that accompanies private sector deleveraging and public sector incompetence.

But in the short-term, we're not quite sure what to make of the so-called stress tests on 91 European banks. The test results were released last Saturday morning in Australia and showed a remarkable amount of vigour in Europe's banking system. Just seven of the ninety one banks failed the test, with five in Spain and one each in Germany and Greece. And those banks require a paltry $5 billion in capital to be restored to full health.

Imagine having chest pains and being referred by your doctor to a cardiologist for further tests. You go, expecting the worst. But you show up and the doctor asks you sit in a big Lazy boy recliner while he fetches you a buck of extra crispy fried chicken to be chased by a big chocolate milkshake and draws you a scented bubble bath. Instead of a treadmill, you get a cakewalk. Would you be confident of the test results?

European regulators are either unimaginative, or the whole exercise was a public relations exercise designed to restore confidence in European banks without really revealing how stressed out bank balance sheets would be in a sovereign debt default. But whether a bank is adequately capitalised to withstand big losses isn't really a matter of confidence. It's just maths. And for the record, the tests measured losses on sovereign bonds, not an outright default by a European sovereign.

In other words, the European maths weren't that stressful at all. The banks in question were subjected to a test in which European GDP contracted by 3% and stocks fell by 20%. That seems like a mild amount of stress. What's more, the tests assumed the banks would take losses on sovereign government bonds held by their trading desks.

That sounds sensible, given the fact that widespread holdings of sovereign debt are thought to make up huge portions of European bank capital. You'd want to see how well capitalised the banks remained if they took losses on those sovereign bonds. But the stress tests excluded write downs on sovereign bonds held by the banks in their normal banking book, where most of the bonds are actually held.

According to Morgan Stanley analyst Huw van Steenis in today's Australian Financial Review, European lenders hold 90% of their Greek bonds in their banking book and just 10% in their trading book. The tests assume lenders will receive full value at maturity of all the sovereign bonds held in the banking book.

Isn't that a bit like saying that as long as you don't count all the debt that could go bad, European banks are well capitalised? Hmmn.

In any event, a clean (albeit dubious) bill of health for Europe's banks ought to be good news for Australian banks who borrow in Europe. Yet another story in today's AFR confirms what we've suspected for awhile: bank interest rates in Australia are decoupling from the cash-rate set by the Reserve Bank of Australia. Instead, they are more and more being determined by the global cost of capital.

Don't expect any of Big Four to push up rates before the election, lest they hand either party a big club to beat them over the head with. But according to Pimco's Robert Mead, "The average cost of funds is going up for banks," in Australia. "To the extent this continues, eventually it will need to be passed on to customers."

"Problems in credit markets caused by the European debt crisis have pushed up the cost of funds that Australia's banks borrow on international financial markets and then lend out their customers," reports George Liondis. The Big Four are set to borrow as much as $170 next year in new and rolled over borrowings. They're competing for that money with corporations and governments.

Sooner or later - later being after the election - you can expect the bank to put up rates over and above what the RBA has decided - even if the RBA lifts rates at its next meeting. This is good for anyone who lives on bank interest and less good for anyone paying a variable rate mortgage.

Do you reckon this makes the banks a buy or a sell? Over the weekend we were thinking of what our friend Dan Ferris calls "world dominating" stocks. He was referring to a handful of businesses that regularly grow earnings, increase dividends, and own or dominate a niche in the market that makes them relatively unassailable. Examples would include Wal-Mart (NYSE:WMT), Intel (NASDAQ:INTC), and Microsoft (NASDAQ:MSFT).

To be fair, these are the bluest of blue chips. You probably don't need a newsletter to tell you to buy these businesses. That said, in the chase for market-beating returns, most investors probably load up on risk and forget the unsexy but reliable companies that deliver growth without requiring leverage. And it can't hurt to invest in a business you actually understand. Why?

About five years ago we used to regularly attend the regular meetings of a private group of accredited investors who entertained proposals from entrepreneurs seeking capital. The deals varied, from income deals to private equity to warrants. There was a crazy variety of opportunities. But you'd be amazed at how few of the entrepreneurs seeking capital could answer two basic questions: what do you do and how soon will I make money?

Does Australia have world-dominating blue chip franchises with a track record of increasing earnings and dividends like clockwork? Or, does its large exposure to the commodity cycle introduce a lot of volatility to earnings? Hmm. That answer is probably self-evident.

But for the rest of this week, we're going to explore the issue of long-term, big picture investment strategies and see how they apply to Australia. Feel free to send your thoughts to us at dr@dailyreckoning.com.au

Dan Denning
for The Daily Reckoning Australia

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