Were the Government’s Stress Tests a Bogus Exercise in Deception?

Here we go again. Australia’s Federal budget-revealing glorious new deficit, is coming is coming next week. But this week will be all about tomorrow’s Reserve Bank meeting and today’s house price data from the Australian Bureau of Statistics.

Oh wait. We forgot about the ‘stress tests.’ Remember that’s the official government report of how the 19 largest U.S. banks would hold up under further loan losses or asset write downs. It’s designed to give investor (and the banks) a transparent picture of how much capital the banks need to be unequivocally healthy.

Actually, it’s not designed to do that at all. The ‘stress tests’ are a white-wash. There’s no way the government would release a report to the market that said the banks were in horrible shape (insolvent) and needed billions more in capital to make up for billions of losses in residential and commercial real estate.

That means either the ‘stress tests’ were a bogus exercise in deception. Or, to the extent they uncovered anything legitimate, it will be leaked in the press and priced into the relevant banks shares before the tests ever hit the public. Besides, the ‘stress test’ began in 2007. The market’s already told us what it thinks of the banks.

One more quick note on commercial real estate. Is it still ‘the other shoe to drop’ on the banks this year? Maybe it already dropped! The Guardian reports that, “Global sales of investment grade real estate plunged 73% to $47 million in the first quarter from a year ago, or just one-sixth of the level two years ago, according to real estate research firm Real Capital Analytics on Friday.”

A 73% cliff dive is as good as a crash in our book. But that figure only refers to new sales. There is a lot of existing debt that has to be refinanced. “Making things worse,” the Guardian adds, “the number of properties that need to refinance or need capital infusions is soaring. New reports of defaulted mortgages and failed commercial property companies surpassed $55 billion in the first quarter, bringing the total known distressed commercial properties to $153 billion.”

This is one reason to remain suspicious of property and financial stocks this year. In fact, you can pretty much bank on the idea that these stocks will never lead the market again in the way did over the last five years. The sector that leads the market up in a credit boom never really fully recovers as the best-performing sector (think tech stocks).

One thing to watch for? The financial sector and state governments using the Federal wholesaled funding guarantee to trash the country’s international credit rating. Macquarie Group used the Fed guarantee to raise $14 billion on international debt markets at the end of the financial year. The company has already set aside $200 million to pay the Feds for the use of the guarantee this year (think about that for a second, this government is ‘selling’ its credit rating for $200 million).

Macquarie is raising capital this way, “Mainly because Macquarie could actually save money on its deals because it did not have to rely on its lower (and therefore higher risk-rated) single “A” credit rating. Analysts have estimated Macquarie’s benefit at $580 million for every $10 billion of new debt raised,” reports Danny John in today’s Age.

To be fair, Macquarie is also raising money from equity investors too. After announcing write downs that slashed its full year-profit in half, the company told the ASX it had sold $540 million in new equity to institutions. So here’s the question…what is the bank loading up for?

By ‘loading up’ we mean that it’s essentially re-arming itself to get back in the market…and do what? “Macquarie is already aiming to build a global stock-broking business centred on Asia, London and New York and to become significantly bigger in energy trading, specifically in oil and gas. It plans to buy new businesses and increase its existing operations with capital injections on the other side of its balance sheet.”

Hmm, oil, energy, and Asia? That sounds like a strategy based on decoupling. Remember that? It was the idea that the credit crisis would hurt the U.S. and Europe but not so much the emerging market countries. But it depends on what you mean by ‘hurt.’

Equity investors everywhere were ‘hurt’ in the last 18 months. Nowhere was safe. Nothing was decoupled. So now the question is which economies will recover first: the high-saving emerging markets with growing populations and rising incomes, or the highly-indebted industrial economies that are going even deeper into debt to bail out financial institutions (this is not a trick question.)

By the way, Western governments have been so fixated bailing out their banks they haven’t noticed how Chinese banks and companies are providing critical capital to world-class mining projects. China picked up another valuable pebble when China Non-Ferrous Metal Mining Company picked up a controlling stake in the world’s largest non-Chinese rare-earths producer for the paltry stake of $505 million on Friday. We’ll have more on the sad strategic case of Lynas Corporation tomorrow and whether there is good news buried in the story of Aussie resource investors.

Is it fair to blame the government for leaving strategic assets hung out to dry? That’s debatable, and the Treasurer still has to sign off on this deal. But obviously the government has other problems on its mind. On Friday, Treasurer Wayne Swan said government ‘revenues’ would be about $100 billion less than he expected with last May’s budget.

What does all this lead to? We reckon the combined burden of Federal, State, and government-guaranteed bank borrowing is going to put a lot of pressure on the Aussie dollar and lead to higher interest rates. State governments are already under pressure. “Victoria may lose its prized triple-A credit rating as the State Government pushes the state deep into debt to fund new roads, railway lines, hospitals, schools and water projects, one of the big four banks has warned,” today’s Age reports.

The Wall Street Journal (and international investors) are on to the story too. The Journal reports that, “Australia’s major states are all expected to post in the next six weeks a significant deterioration in their fiscal positions, strengthening expectations of a surge in state government bond issuance. A dramatic erosion in traditional revenues from land taxes and mining royalties will be a common theme for all states.”

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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