Tag Archives: Macro

Eurozone Banks Face the Toughest Stress Test

El Confidencial 26/7/14

“Stress tests are like Cuban universities, everyone passes, but the title is worth nothing.” 

If anything has been shown in the recent episodes of negative surprises from some European banks – from Portugal to France or Germany – is that European banks have not yet solved their problems. We confuse the important exercise of transparency and improvement carried out since 2012 with a magic solution to a problem created by a decade of excess. Is impossible to assume that banks have cleaned up their balance sheets when non-performing loans reach EUR 932 billion across Europe, 7.6% of total loans in the eurozone, according to Price Waterhouse Coopers .

When we talk about the bank stress tests (“stress tests”), many analysts regard them as the definitive marks, not as what they really are: a dynamic analysis of constantly changing circumstances . And, of course, these tests are not infallible, as we have seen so many times (Dexia, Savings banks, Cypriot banks, etc..).


It is an analysis that uses a common methodology for all countries, in which the impact on the capital ratio of a bank of various risk events is analyzed .

The general public tends to think of banks as “entities that collect deposits and make a lot of money,” and this is wrong. Because we tend to look at the P&L (accounted profit and losses), and not the cash flow and balance sheet.

A bank, for every Euro received from deposits usually borrows up to 25 times. That deposit is actually a loan, it is not sleeping in a safe.

For every Euro that the entity gives as a loan, banking rules allow the use of more or less capital depending on the risk that is assumed for the operation. If the bank lends to a very safe company with a low probability of default, the percentage of capital required for the loan is very low. The rest is debt.

These loans, if they work, generate a profit, and during the life of such loan the bank generates a margin between the cost of money and the interest rate charged… if the bank gets the principal back. If not, the balance sheet will deteriorate rapidly.

Whhen things go wrong, such “capital” shrinks very quickly. This is why people do not understand how in 2007 a ​​bank could have reasonable solvency and liquidity ratios and in 2008 be on the verge of bankruptcy. A citizen does not see how fast the core capital can disappear when a large percentage of loans become risky (non-performing), which means that there is a high degree of probability that the borrower will not be able to pay the interests and principal. This rapid decline in the middle of a recession can leave the bank without resources.

As such, stress tests aim to analyze whether in a drastic change in the economic environment, banks would retain the 10-11% of capital that they have on average today.


The stress tests aim for two objectives. Firstly, analyze the impact on banks’ fragile financial structures of events like a recession, losses on sovereign bond portfolios, aggressive currency depreciation, etc.. Furthermore, the test stress tries to be righteous enough to not make an unnecessarily negative exercise that endangers the public trust in the institutions.


Many large banks are currently generating returns of around 4% (return on equity), far below the typical target levels of around 15%.

Research by EY suggests that banks will find it extremely challenging to achieve this kind of RoE uplift. Cost reductions of around 35% or revenue growth of more than 20% might be required just to achieve their average cost of equity (10%). Should banks wish to reach 15% RoE they would be required to reduce costs by 66% or grow revenues by 44% — a goal beyond the scope of most banks in the current climate.

A problem of low Return on Equity (peripherals around 2%, average eurozone banks below 6%)  and high exposure to government loans is not solved in two years, but deposits have stabilized and banks have sold large packages of toxic real estate assets. That does not make the sector “totally healthy”.

The stress tests of 2014 will be very demanding and assume , among other risks:

  • An adverse scenario of falling GDP in Europe of 0.7% in 2014, -1.5% in 2015, plus a 21% drop in house prices, added to increased inflation.
  • Losses in the portfolio of sovereign bonds from increases in their risk premiums. Increases of 150 basis points in European premium or 200bps in the US sovereign bonds. Assumes a drop of 6.5% off in Spain, for example, 6% in France and 7.6% in Italy and 4.4% in Germany in the 5-year bonds.
  • Possible 25% depreciation of the Hungarian and Polish currencies , and 15% of the Czech, Romanian or Croatian.

Although these may seem aggressive estimates, the expected impact on banks is relatively small .

However, do not forget that these exercises are theoretical and, like everything else, reality often shows unexpected effects. But the exercise is important.

Do not expect the credit will grow dramatically because banks pass the theoretical examination of the stress tests.

Although the level of private credit has begun to recover slowly, with an expected growth of 0.5% to the private-sector, 4.4 billion euros in 2014 -, the European Union remains, by far, the most bloated financial system in the OECD.

  • European banks are the most intervened, regulated ans State-controlled of the OECD. Not only due to the weight of public sector banks, but because of the disastrous intervention in the M&A and divestment processes , with governments pushing to lend at all costs. let’s not forget the “crowding out” effect of government debt versus households and businesses, encouraging the purchase of sovereign debt through regulation, as explained here  and in English here.
  • In Europe the banks finance 80% of the real economy , while in the U.S. is about 30%.
  • Total assets of the banking system of the euro area accounted for 349% of GDP in 2013 . A reduction of 12% since 2008. Much higher than the U.S. or Japan (Chart courtesy of Merrill Lynch) figure. While it is true that part of it is because European banks have more deposits, it shows a bloated banking system.

  • Additional credit expansion is not the solution , as we forget where we came from … A brutal credit growth since 2001, as the graph below shows (mdbriefing.com). Morgan Stanley estimates that European banks have sold or refinanced only between 20 and 25% of the 700 billion of non-performing loans that the regulation required them to urgently address in 2014.

Banks cannot drink and sing at the same time. It is impossible to strengthen balance sheets, avoid taking excessive risks while lending like 2008 just because we think that credit is the solution. First because they can’t and second because they shouldn’t.

The stress tests of 2014 are not the same as those of 2011. European banks have improved.  Non-performing loans are expected to be reduced in 2014 while operating profit is estimated to be up 4.2% after three years of decline . The risks still exist, but it is not as severe as it was in 2011. Forcing to lend at any cost is a great danger.

Liquidity injections by the ECB do not solve a key problem. Where do we put all that money?  Europe has an average of 25% industrial overcapacity. When I asked on CNBC a senior manager of the ECB where they thought they were going to invest 400 billion euros of TLTRO, he failed to give me a single key sector where those funds would be deployed.

Credit is growing again, but it should not reach the levels of 2004 to 2010 again. As Von Mises said, “no one should expect that any logical argument or any experience could ever shake the almost religious fervor of those who believe in salvation through spending and credit expansion.” 

I’m afraid that with negative deposit rates, liquidity injections and stimuli, we aim to re-ignite the credit bubble before the European banking system recovers its strength. Then, when it bursts, we will surely blame the ‘free market’… and de-regulation. 

Important Disclaimer: All of Daniel Lacalle’s views expressed in his books and this blog are strictly personal and should not be taken as buy or sell recommendations.

Myths and Mistakes of the Iraq crisis

This article was published in El Confidencial on 22/6/2014

“There is no military solution for Iraq” Barack Obama

“Rarely has a U.S. president been so wrong about so much at the expense of so many” Dick Cheney

Getting it wrong is dangerous. Worsening things is lethal. In the case of Iraq , the United States, after spending a billion dollars to remove the regime of Saddam Hussein, has left a global security problem which may be greater than imagined when Obama decided to withdraw the troops . It’s not just about oil. Anyone who lived the Baghdad of Saddam Hussein understood that the regime was a global danger. Similarly, it is essential to understand that the threat was not only Saddam, but the many factions that existed well before the Baath dictatorship, which remained in conflict during the regime and still do so today. Leaving Iraq can become a decision that Obama will regret for a long time.

Why did the U.S. leave Iraq? 

For love and peace? No. Because in 2016 the US will be energy independent -including Canada. The need to defend its interests in the area is today infinitely smaller.

America is already independent in gas and produces 11.3 million barrels a day of oil thanks to the fracking revolution, becoming the largest producer over Saudi Arabia and surpassing the country’s own 1970’s peak.

However, removing the troops leaving behind a timebomb of sunni and shiite factions could end up turning against the United States and the OECD, as it generates an enormous risk of multiple terrorist threats. Energy is not the problem. It is a cultural problem. It is naive to say the least to think that everything will go smoothly leaving Iraq on its own when the country is decimated by clashes of tribes with invasive ambitions. it is the same mistake we have seen in Libya or Egypt after removing a dictatorship regime. The Pandora box of multiple threats opens. I recommend you read ” The Clash of Civilizations “ by Samuel Huntington and “The Lesser Evil”  by Michael Ignatieff. In the West we do not want to understand the culture and customs of these countries, which are very far away from our idea of democracy. Accepting the lesser evil of maintaining a military presence is much more logical than closing our eyes in the hope that the world will move according to our wishes.

Does the Iraq crisis affect its oil exports?

The OECD placed too much trust on the unstable government of al-Maliki. US troops were disappearing and the industry seemed to be recovering. It looked as if everything was on track, but the risk had not gone away, in fact it had increased with the wrong strategic decision to pull U.S. troops from the country without a security contingent.

This week the Iraqi risk rose dramatically after terrorist attacks in the northern part from ISIS (Islamic State Of Iraq and Syria), a jihadist group that even has an annual report of its sinister achievements. See it here (http://azelin.files.wordpress.com/2014/04/al-binc481-magazine-1.pdf ) courtesy of the Financial Times .

When I traveled to Iraq people used to say: “Baghdad is a city covered in gold, but in the south is where the real gold is” (oil).

This map, courtesy of IHS Energy ( press@ihs.com ), shows the location of the main fields and refineries.

Terrorists have taken Mosul, the second largest city in Iraq, Tikrit, Tal Afar, and Dhiluiya Yathrib. However, they have not taken any of the large fields north of the country, especially the giant Kirkuk oil field in the Kurdistan region. the people I knew in the area called this field “the passport of Kurdish independence”. Today it produces 260,000 barrels a day. ISIS terrorists have no ability or desire to attack the Kurdish region.

Most of Iraq’s production, 80%, is exported and more than 77% comes from fields in the South, where terrorist ISIS militants cannot be measured with local forces and private security contingents. There has been no impact as of today in exports, which are made mostly through tankers from the South.

Is it a crisis to regain control of oil from the hands of the multinationals?

Contrary to what has been said in some press, oil in Iraq does not belong to international companies, much less American . All is state-owned fields where international, American, Russian, Italian, Chinese or British companies work with contracts for service , and they are paid to maintain or increase production. That is, the State benefits from international companies’ experience in improving productivity, and therefore has no interest in seeing these companies leaving. This type of productivity contract is what has led to Iraq recovering its pre-war peak production so quickly.

Is it all the fault of Obama or Bush?

The fights and attacks between Sunnis and Shiites are not new. It’s a conflict that has been ongoing for hundreds of years. In the era of Saddam Hussein it was already a challenge to organize security to travel from Baghdad to the border with Kurdistan. In fact, access was banned even for many potential contractors due to constant attacks.

George W. Bush made a mistake thinking that the US would be received as heroes after the invasion, as Wolfowitz expected. The moment that the regime’s repression ceased, the various factions began fighting bitterly. A weak government only reduced the perceived risk. The same mistake has been committed by the OECD in Libya and Egypt.

The Obama administration made a huge mistake by reducing up to three times the number of contingency troops that would support the weak government of al-Maliki. By reducing the promised figure of 50,000 soldiers to 25,000 and then to 3,000, aid became irrelevant, and therefore rejected by the local government.

The lack of involvement of NATO countries in the Middle East problem is part of the disaster. Not only Libya and Egypt have spiralled out of control, but Al-Assad in Syria is now more powerful than ever due to the inaction of the OECD, and Syria has become the launchpad of a strengthened ISIS in North Iraq. Thus, the risk that the area controlled by ISIS becomes a huge camp of international terrorists is not small.

Proposals to divide Iraq into three (Kurdistan, a Sunni North and a Shiite South) would increase the risk of allowing to build a huge training center for global jihadists.

Is the crisis due to peak oil?

Sunnis and Shiites have been fighting for hundreds of years. The problem is not oil … Because in the oil market there is no great risk.

On 11 June, OPEC met in Vienna. Independent analysis (BP Statistical Review) confirmed that there is plenty of oil for decades. Global proven oil reserves have increased to 1,687.9 billion barrels in 2013, sufficient to meet 53.3 years of global production.

Messages from the major oil exporters focused on some aspects that I think are extremely important when assessing the geopolitical risk and not overdo it:

  • The market is adequately supplied and OECD inventories in terms of demand cover are at “comfortable” levels (2,548 million barrels, 55 days, similar to the 55-60 day average level of the past ten years).
  • Spare capacity, ie what OPEC can produce above the established quota of 30 million barrels per day, is today 3.5 million barrels a day.
  • Iraq has reached a production of 3.3 million barrels a day, reaching record highs.

Will Iraq take oil to $ 200 a barrel?

Not likely. The OPEC spare capacity is equal to 100% of total production in Iraq.With the US producing at record levels and non-OPEC production growing by 1.2 million barrels a day in 2014, the market would be adequately supplied even if Iraq fails to export.

Libya, for example, has dropped to almost zero exports from one million barrels per day after the fall of Gaddafi and the oil price has not moved aggressively. The analysis is not “oil has risen to $ 115 per barrel,” but “even after the crisis in Libya, Ukraine and Iraq, oil has only risen to $115 per barrel …” And oil remains in backwardation (the future price is much lower than the spot).

Will the price of oil it create an economic crisis?

Oil does not create crisis. Excess credit and money supply that shoots commodity prices well above the fundamental levels are the ones that create crisis. The price of oil is a consequence, not a cause. In any case, the oil burden of the OECD has not reached 5.5% of GDP, far from levels that are supposed “to trigger a crisis”. The oversupply also helps to mitigate it.

The world has been operating with such crises in producing countries for decades. And the market is always adapting. But linking the Arab problem only with oil is a grave error on the part of all governments.

In the end, as Ignatieff said there is never an ideal solution. To think that the OECD will solve conflicts between Sunnis and Shiites that have been going on for centuries only with military domain is optimistic. Believing that NATO and the United States will be able to opt out of supporting Middle East security without dire consequences for the Western world is suicidal.

Important Disclaimer: All of Daniel Lacalle’s views expressed in his books and this blog are strictly personal and should not be taken as buy or sell recommendations.

Iraq and Ukraine move the commodities market

Geopolitical black swans are impacting commodities this morning, with Iraq conflict worsening and Russia threat of cutting supplies to Ukraine.

Brent is at $113.02/bbl and WTI at $107.32/bbl driven by concerns about Iraq. Markets are reacting well as the physical market is not affected so far but concerns are justified.

Iraq produces 3.5mbpd, or 4% of global production and is seen as a key source of future supply growth. Production is mostly in the fields in the South, so far unaffected by the latest attacks, concentrated in the North, according to JP Morgan.

So far the physical market has not seen a relevant disruption, but markets will remain nervous as long as Malaki continues to lose the grip of the key cities, and the terrorists get close to Baghdad.  Expect oil to move closer to $115/bbl Brent as the market analyses the risk of losing exportable production.

The Islamic State in Iraq and the Levant (ISIL) have seized the city of Tal Afar in Northwestern Iraq yesterday but have not continued to advance to Baghdad, so far only concentrating on northern Iraq. The rebels have control of Mosul, the second largest city in Iraq, along with Tikrit and the small towns of Dhiluiya and Yathrib, north of Baghdad. Iraq’s military spokesman Qassim Ata yesterday said that the Iraq army had killed more than 279 members of the rebel group. President Obama has indicated that he is reviewing military options to help Iraq in fighting the rebel groups.

Kurdistan PM is mentioning in the BBC the possibility of splitting Iraq into three separate regions.

The Kurdistan Regional Government has taken over security of the giant Kirkuk field (260k b/d of production) in the North Remaining oil production in the northern oil fields is another 435k b/d. Iraq has the 5th largest proven oil reserves & is the 2nd largest crude producer in OPEC, behind Saudi Arabia, at 3.5 mbpd. OECD oil inventories were 2,624mb at end April, 77mb lower than the 5-yr average & 53mb lower than last year.

My thoughts:

– The US is unable to get involved in a war. The fact that the US will likely be oil independent (including Canada) in 2016 gives little incentive to take action.

– There is very little real western support for Malaki and the country is currently too corrupt so there is risk of a bad public image and lack of popular support problem.

– Oil companies in the South have very strong armies and security is very tight. I see low risk of oil supply disruptions and the ports are working adequately.

– The three large oil companies must have anticipated these issues as they shipped most of their needed equipment last year. They also doubled security.

– Low probability of the ISIS reaching Baghdad but strong probability of a country that ends up broken in three (Kurdistan, a Sunni North capital Tikrit and a Shiia South capital Baghdad).

Helping reduce the geopolitical risk on oil is the FT reporting that US liquids production hit 11.27 mbpd in April, and is today above its previous peak in 1970 of 11.3 mbpd. With a higher percentage of NGLs, still crude production was 8.3 mbpd in April (now 8.5m), lower than the record high of 10 mbpd in November 1970.

UK gas rises +7.1% at 45p/therm and European gas seems to rise in sympathy as Gazprom threatens to cut supply to Ukraine after the deadline to pay the outstanding bill of $2bn passed with no agreement on  a timetable of payment or price. The Ukraine government is mentioning that the price has to be revised to international levels and that they cannot pay this figure or the revised price of $8.5/mmbtu. The EU is looking for an option that includes a revision of the price for a long term contract and gradual payments. Gazprom will cut off supplies unless Ukraine pays for the gas up front.

Gazprom however, will not disrupt supplies to Europe. 33% of Europe’s gas comes from Gazprom and 50% of it is transported through Ukraine. Ukraine has enough gas in storage (13bcm) to hold on to summer demand as its annual consumption is 33bcm according to UBS. Europe also has a record amount of gas in storage after a very warm winter.

Europe’s largest gas supplier after Gazprom is Statoil who mentions it can “easily” offset any short-term disruption of Russian supply.

 Coal remains weak at $80.40/mt holding on to its support level despite news that freight rates for panamax dry bulk vessels are now below opex, and long-term forward rates have fallen below break-even. Chinese coal import is the most important trade for panamaxes and chinese imports of thermal coal are expected to be lower in 2014 than in 2013. Capesize rates have come down 43% YTD and forward rates for Q4 fell 4% this Friday.Adding to this a 100 milion tonnes of Australian capacity growth, the outlook for both coal prices and the Baltic Dry is not positive. Freight companies are growing the fleet by 4% this year so oversupply is even higher.

The Baltic Dry index is down 3% this month (-60% YTD) driven by oversupply of reights and weakening Chinese imports.

 CO2 rises 53bps at €5.74/mt helped by backloading efforts to reduce the impact on CO2 prices of lower industrial demand and poor thermal output.

US gas rises 65bps at $4.67/mmbtu helped by the past six weeks injection data. It would require a very aggressive change in injection data in the next months to justify prices below $4/mmbtu… I believe we are going to see $5/mmbtu sooner rather than later. Weekly natural gas storage injection of 107 Bcf way below the consensus median injection estimate of 112 Bcf and the bears’ view of 161bcf. Total working storage is now at 1,606 Bcf, 727 Bcf below last year’s level and 877 Bcf below the 5-year average of 2,483 Bcf.

Power prices in Europe are reacting mildly… Germany at €34.70/mwh (-5.35% YTD), Nordpool at €30.78/mwh (-4% YTD). Spanish power prices are down 1.2% YTD and French -5.5% YTD.


Important Disclaimer: All of Daniel Lacalle’s views expressed in his books and this blog are strictly personal and should not be taken as buy or sell recommendations