Where Do You Stress?

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The European stress tests continue to be discussed in the media. The irony is that the stress tests were intended to de-stress the markets. Instead, the response has been all over the place.

There were the suspicious:

“European Union stress tests found banks need to raise 3.5 billion euros of capital, about a tenth of the lowest analyst estimate, leaving doubts about whether regulators were tough enough.”

The smartypants:

“Had the Tier 1 threshold been 7 percent [1% higher], 24 [18 more] of the banks would have failed, said Andrew Sheets, Morgan Stanley’s head of European credit strategy in London.”

The disappointed:

“If we had at least one bank which the markets hadn’t really expected to fail, that would have given the stress tests more credibility,” – Lothar Mentel, chief investment officer at Octopus Investments Ltd.”

The wishful thinkers:

“The European tests ignored the majority of banks’ holdings of sovereign debt. Regulators don’t believe there will be a national default, European Central Bank Vice President Vitor Constancio said July 23. The evaluations took into account potential losses only on government bonds the banks trade, rather than those they are holding until maturity…

The book-talkers:

“The results give you the go-ahead that it’s safe to invest in banks,” said David Serra, co-founder of Algebris Investments. “We have just had one of the biggest crises and the message from these tests is that the banking system can withstand a double dip.”

The pragmatic:

“Banks passed because the European industry has raised 220 billion euros in the last 18 months to bolster capital.”

And the Daily Reckoners:

Bill Bonner, the original Daily Reckoning founder, wrote about what makes a person a Daily Reckoner. Supposedly they are outsiders, people that don’t make good small talk and people who do things their own way. They don’t conform.

So where does that leave us on the judgement of stress tests? Dan discussed this and Bubble Baths on Monday.

Andrew Sheets criticism that far more banks would fail a stress test with a 7% capital threshold sort of displays the nature of the flaw in stress testing in the first place. Bank management is all about toeing the line, in terms of liquidity and capital adequacy. That’s how profit margins are determined. If the regulator legislates for a 6% tier 1 capital ratio, you sit at whatever the regulators round up to 6% from.

Any higher and you could be making more $$$. Any lower and you get a call from the regulators. So the inherent risk in the system isn’t about the banks’ management of their capital. It’s about the regulator’s management of banks’ capital. And the key question is, where will the capital adequacy percentages sit for the magical constructs of Tier 1 and Tier 2? And how will these Tiers be calculated?

In Basel, way back in the heady, more or less respectable days of banking, they came up with answers. The capital adequacy rules and the calculation of the Tiers have changed over time. Basel 1 and Basel 2 were some of the creative names given to the changes. One of the more flawed ideas was to make the Tiers largely dependent on the ratings agencies’ ratings.

For the limit pushing banks, that meant paying for AAA ratings on their high risk, high return asset base. This allowed their capital base to get the regulatory tick, while real risk and return was much higher than it appeared. Whether the fraud was perpetrated by the banks or the regulators is up to you. Making such activities legal is worse in our opinion, either way. Then reinforcing the lies with “stress tests” is outrageous.

Having capital adequacy determined in Tiers will end in tears. Banks should have to define what line they are toeing. That of a high risk, high return bank, or something else. Then people could them judge properly.

Apples and Oranges … and Fruitcakes

Nancy Pelosi, the Speaker of the House in the US, has come up with a brilliant way of dealing with Social Security’s funding problem:

Social Security is going to start paying out more in benefits this year than it’s collecting in taxes — close to $29 billion more. It will be Social Security’s first deficit since it was over-hauled under former President Ronald Reagan in the 1980s.

Pelosi’s solution is to pretend funding Social Security isn’t relevant:

“To change Social Security in order to balance the budget, they aren’t the same thing in my view,” the Democrat said today at the Netroots Nation conference in Las Vegas. “When you talk about reducing the deficit and Social Security, you’re talking about apples and oranges.”

Think tankers from the The National Center for Policy Analysis disagree:

“Even if the CBO projections are correct, and the deficits racked up by Social Security do not grow quite as fast as the Trustees predict, the government will still have to find a new way to fully fund promised benefits by 2019. The impact on taxpayers will be huge.”

The Berlin Wall comes to Ocean Grove, Australia

A while back we outlined some of the flaws in the green loans program, as well as the government’s insulation murders. But poor Julia isn’t getting a break. This story from The Age displays another example of stimulus in action – the school building stimulus package:

“Ocean Grove Primary School principal Darryl Diment said a construction fence was put up 12 months ago, but construction of new buildings was yet to begin and the children had been left without a playground.”

”The children look longingly between the gaps in the fence for signs of progress. ‘In something akin to the Berlin Wall, it segregated our children from the bike shed, the chook shed, the vegetable patch and the remnants of the oval.”

The Berlin Wall! It would seem Julia’s hopes for re-election have been dashed in this particular community. The other shortcomings are a long and impressive list.

But the true score remains Julia 1, political accountability 0. Why?

“A comprehensive performance audit of the program was scheduled for the 2012-13 financial year.”

What wonderful timing.

And yet it seems Labor has been upstaged by the Americans. Just the Pentagon in fact:

“A U.S. audit has found that the Pentagon cannot account for over 95 percent of $9.1 billion in Iraq reconstruction money.”

95% is difficult to beat. Although it’s not entirely fair to compare politicians with the military. In the global private sector, it seems there aren’t many Aussie dominators either. Still, its’ convenient to pretend there is for the national budget’s revenue.

Time to Buy … and Sell

Goings on in the US housing market have been rather odd lately. Considering it was the straw that broke the camel’s back last time around, it is worth paying attention. And who knows, it might be important for Australians to find out what a post-bubble housing market looks like.

“About 18.9 million homes in the U.S. stood empty during the second quarter as surging foreclosures helped push ownership to the lowest level in a decade.”

“The number of vacant properties, including foreclosures, residences for sale and vacation homes, rose from 18.6 million in the year-earlier quarter, the U.S. Census Bureau said in a report today. The ownership rate … was the lowest since 1999. “

Ok, so that’s not good. Neither is it good that the “Housing Market [is] Still in Basement“. Nor that “June Was The Second-Weakest Month On Record” for new home sales.

Agora publication The 5 Min Forecast reports that “Prime home borrowers are entering foreclosure at a record clip, according to a report from the firm Lender Processing Services. The number has grown 425% since January 2008, and the biggest increase came just in the last two months. That’s a whole lot of inventory that’ll be coming on the market soon. And it gets worse…”

Worse! It’s no wonder that “Home shoppers taking fresh look at renting“.

Only there seems to be some contradictory evidence to all this gloom and doom.

“Sales of new homes rebounded strongly in June from May’s record low, pushing the number of houses on the market to the lowest level in nearly 42 years.”

So we have the lowest number of houses on the market, with the highest amount of houses standing empty…

By the way, if you are wondering why “new home sales rose nearly 24 percent in June from a month earlier“, well surely you know where to look by now. A tax credit.

But why does America need a tax credit when Obama is on the case with his HAMP plan? (Home Affordable Modification Program)

Well, because HAMP isn’t working. That’s not entirely true. It was not working. Now we don’t know if it’s working or not because “the Obama administration has revised its latest monthly report on its signature foreclosure-prevention plan, deleting a heavily-criticized performance metric used to measure whether assisted homeowners are re-defaulting on their taxpayer-financed mortgages.”

Heck, why not do away with debt figures too!

Going Back in Time

Further evidence that the Austrian School of Economics is going mainstream has arrived. This from The Economist:

“Critics tend to agree on what is wrong with current macroeconomic forecasting. A hearing of the House of Representatives Committee of Science and Technology on July 20th targeted the “dynamic stochastic general equilibrium” (DSGE) models used by the Federal Reserve and other central banks.”

But why the sudden loss of faith? It’s actually not sudden, nor a loss of faith. Instead, economists have gone off on a mathematical rampage during the past 60 years and have learned that this has no merit.

In plain English, economists discovered “it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data” (the Lucas Critique), so forecasters looked to equilibrium in their analysis. The idea being that the economy will have a tendency to approach an equilibrium, but be subject to shocks. Now it turns out that didn’t work either. “Efficient financial markets” and “rational expectations”, which universities taught as overly simplistic, have turned out to be overly simplistic. Who knows why people relied on them for forecasting, knowing this full well.

Instead, economists have discovered “Agent-Based Modeling” (ABM).

“An ABM uses a bottom-up approach which assigns particular behavioural rules to each agent.
In mathematical terms the models are “non-linear”, meaning that effects need not be proportional to their causes.”

This reads like an Austrian Economics textbook, except for the “mathematical” and “modeling” parts. Behavioural rules, or principles of action, are the basis of economics Austrian style and non-linear relationships are the inherent implication. But it seems economists haven’t quite abandoned their mathematical games. Pretty soon they will find these to be flawed and they might rediscover they are back where they started 60 years ago.

Get Her to Keynes

The Australian population debate has turned out to be a major election issue. The idea that government should control population is a dangerous one. Seeing as Australia has a lot of “Lebensraum”, the politicians have to come up with another reason to interfere in people’s lives. How to fill that “Lebensraum” is what they have come up with.

Perhaps Julia and Tony should take a close look at a poll released in Die Bild Zeitung recently. 72% of Greek women polled declared that the financial burden of their nation has influenced their sexual life (for the worse). The effect this could have on the Australian population and economic management debates might make all the difference to the election. Claiming to be the better economic manager would discredit a “small Australia” policy…

One thing is clear. Even Keynes’ stimulus could not improve the Greek women’s plight.

Something Fishy Going On

There has been an important development in the BP oil spill. No, it’s not the record loss BP posted. Instead, it seems the oil has disappeared off the face of the earth. Nobody can find it. Except for Shrimper Salvador Cepriano. He has discovered its secret location.

“It’s in between the bottom and the top of the water.”

Until next week,

Nickolai Hubble.
The Daily Reckoning Week in Review

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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