Ancient Greek mothers would often finish mythic tales told to their children (wholesome stuff like Oedipus, Electra and so on) with ‘…and then the story came true’, goes an apocryphal historical canard.
A lesson on tragic predestination and omnipotent fate, apparently.
With that in mind, we’ve looked back at the ‘sovereign shock’ scenario employed during the famous July 2010 stress test of European banks. (Which was an answer to banking contagion fears around… Greece.)
To remind of what this scenario involved: regulators set out to model large rises in eurozone government bond yields (and thus, haircuts for those bonds’ market prices) in their impact on banks’ trading books — which would be marked to market and thus incur losses. Importantly, five-year bonds were in focus, because the regulators found five years amounted to the average maturity of banks’ sovereign debt holdings.
(Annex 2 of the stress-test report goes into detail here.)
This model didn’t include the effects of an actual sovereign default on banks’ (often much bigger) held-to-maturity bond holdings. However, this yield shock was still regarded as extreme enough to constitute the upper-bound ‘adverse’ outcome for 2010 and 2011.
Adversity, meet reality.
This chart shows the stress-testers’ estimates of yield increases in five-year government bond yields over the benchmark and adverse models. Observe the ‘Adverse 2010′ figures for peripheral names like Spain or Portugal. Click the chart to enlarge:
What’s striking is that for one or two peripheral sovereigns, the real-world yields at the end of 2010 meet or surpass what the stress test modelled as only ‘adverse’ (and by implication, unlikely) for bank risk.
For example:
Stress-test ‘adverse 2010′ five-year Spanish yield = 4.74 per cent
Real-world five-year Spanish yield, 15 December 2010 = 4.75 per cent
Stress-test ‘adverse 2010′ five-year Greek yield = 11.03 per cent
Real-world five-year Greek yield, 15 December 2010 = 12.79 per cent
Stress-test ‘adverse 2010′ five-year Irish yield = 4.5 per cent
Real-world four-year* Irish yield, 15 December 2010 = 6.54 per cent
Real-world six-year* Irish yield, 15 December 2010 = 7.28 per cent
(*There’s no five-year Irish bond in issue).
Other peripheral yields come in just under:
Stress-test ‘adverse 2010′ five-year Portugal yield = 5.83 per cent
Real-world five-year Portugual yield, 15 December 2010 = 5.5 per cent
Stress-test ‘adverse 2010′ five-year Italy yield = 3.9 per cent
Real-world five-year Italy yield, 15 December 2010 = 3.2 per cent
Spooky. Weird.
Weirder, the stress-test yield shock was in part composed from a general 75bps rise in yield curves across the eurozone. Peripheral-specific yield increases were much more varied in the model. In the real world’s 2010 there was no general shock, however.
Regulators helpfully also constructed a chart of simulations in ten-year government bond yields, which weren’t used in the stress test, but do allow us to compare — finding similar real-world convergence (but not surpassing, as of yet) between stress-test-land’s adverse 2010 and ‘our’ 2010:
Again, comparing stress-test 2010 / real-world 15 December 2010:
Spain 5.81 per cent / 5.4 per cent
Greece 11.84 per cent / 11.976 per cent
Ireland 6.65 per cent / 8.3 per cent
Portugal 6.96 per cent / 6.5 per cent
Italy 5.39 per cent / 4.569 per cent
What to conclude here? That the stress test underestimated what the eurozone would face in 2010? We all knew that already, however.
Instead perhaps this is another lesson about the idiosyncratic (or you might say agent-based) risks facing peripheral sovereigns in 2010/11.
Sudden margin calls on your bonds. Your local hegemon pushing for a bailout mechanism that facilitates haircuts on your future bond issues. Markets realising what contingent banking liabilities you’re facing – or liquidity risks regarding issuance. A dying asset class, a central bank to the rescue, a threat of risk-weighting. We could go on — but the point’s made.
Except to regulators, it seems.
Related links:
Building a better European stress test – FT Alphaville
BIS > stress tests – FT Alphaville
A two-tiered bond market in Europe – FT Alphaville