This is not what Europe needed to hear with just hours until the official Stress Test release: while everyone expects the 26 reject banks already listed by Moody's previously to fail (and their "passing" will only further discredit the stress test), nobody had dared to utter a peep about the true shaky behemoths at the heart of Europe's banking system, chief among which is Deutsche Bank. Until today. SocGen analyst Hank Calenti just told the firm's clients in a note that not only Deutsche Bank, but also Commerzbank and Banco Popolare may be "near fails" under the adverse (we assume one exists) Stress Test scenario. To wit: "Deutsche Bank may fall into the ‘near-fail’ zone under the adverse scenario, due to the full application of CRD III in the stress test results. As noted by our equity colleagues in their publication of 19 May 2011, Will the upcoming EBA bank stress test trigger further capital raising?, Banco Popolare and Commerzbank may also be ‘near fails’." He continues: "We do not believe that the possibility of Deutsche Bank as a ‘near fail’ is currently priced in the CDS markets." Guess what that means: "We recommend buying subordinated CDS protection on Deutsche Bank and we recommend selling subordinated CDS protection on HSBC as a means to hedge against - and possibly capitalise on - the results of the EU bank stress tests." Well, there is still 100 minutes in which to put the trade on.
DB reported a Basel 2 Core Tier 1 ratio of 9.6%, as of 31 March 2011. Adding €93bn of market risk-weighted assets, as per the Basel 2.5 requirement, results in a reduction of approximately 210bps to their Core Tier 1 ratio (Basel 2.5 is incorporated in the CRD III requirements). Further adjusting for a possible 100 to 150bps impact of the adverse stress test and DB may move into the near-fail territory. As such, we recommend buying subordinated CDS protection on Deutsche Bank and we recommend selling subordinated CDS protection on HSBC as a means to hedge against, and possibly capitalise on, the results of the EU bank stress tests.
DB begins this test from a relatively low capitalisation level and, as such, may only just pass these tests. HSBC approaches these tests from the opposite condition. At the same time, senior and subordinated CDS trade at their long-term average relative to each other.
We recommend the following:
HSBC Outperformance vs DB Underperformance trade: Sell 5 year subordinated CDS protection on HSBC at approximately 138 and buy 5 year subordinated CDS protection on DB at approximately 180 for a DB / HSBC cross of 1.30x. We target taking profits at 1.42x and recommend a stop-loss at 1.18x. This trade sunsets in one month’s time.
Alternatively, one may position via a short DB, long Credit Suisse or UBS as a means to capitalise on the stress tests. However, note that CS and UBS are not in the EU and, as such, are not subject to the tests.
As for what the tests mean in the short- and long-term:
Given the depth of disclosure and the need for the European Banking Authority to be seen as having been tough on the banks, we anticipate a broad, short-term, positive impact in the market. We expect the market to score these results not based on the number of banks that fail or almost fail, but based on whether those that are expected to fail, actually do fail. This test is simple, the lower the credit rating or the higher the credit default swap number, the greater the expectation of stress test failure by the market.
However, we would not confuse a relief bounce with long-term credit spread recovery. The issue has moved on from when the tests began. We do not mean to pick on any one set of banks, but as an example, in our view, the fact is that the largest Spanish banks pass the EU bank stress tests will not make it any easier for these or any other Spanish institution to issue Cedulas Territoriales or other debt in the capital markets.
The issue is more systemic than idiosyncratic and we expect the market to toss aside these results over time. We note that unlike the Irish banks, Greek banks did not bring their current circumstances upon themselves. These circumstances have come about due to the difficulties of the Greek sovereign to fund itself in the market; until the EU addresses this concern with a creditable, long-term solution, this situation will put pressure on all eurozone banks as the same circumstances could be repeated in other, larger EU countries.
Translation: expect stress test "upside surprise" halflife to be measured in minutes if not seconds.