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Daily Forex Commentary EUR/USD, GBP/USD October 1, 2012

As I was going through my news releases over the weekend it did not surprise me that we see the push up on Thursday now be shown as a false push. As I noted in the Sept. 28 forex commentary the Spanish banks stress test results were due and I expected them to paint the rosy picture they did showing that all is well. Well not so fast. When we look close of course there were holes in the results that when accounted for shows a much gloomier picture. Plus as we can see by the price action the optimism before the release was fairly dismal during the London session but once New York opened they didnt buy it for a second and the drop was on without so much as a glance back. I will post that article here a bit later but lets get to the charts first.

The EUR/USD has made the push below the 3 day lows during the Asian session here for a move of almost 50 pips. It does have potential to be the stop run but I highly doubt it and we will see before I get this all written up. If we do get this hourly close below the level the probability of seeing one of two things is high. One being we see it just keep on running from here and never see an entry today. The other is a test of the break out level at Wednesdays or Thursdays lows around the 1.2830 level. We are at a fairly significant daily level so there is a decent chance we get the pullback. A test into that level will be our highest probability trade for the short today.

The GBP/USD is in more or less the same position having played catch up on Friday with a 158 pip move that started during the London session and ran off with little hesitation before New York took over. We had the hourly close below Wednesdays lows during New York and we have a clear first push down. it is also finding support at a daily level so the potential for the pullback to the 1.6160 level is there for a clear manipulation point for the short. Otherwise we may only see the test of the break out of Wednesdays lows of 1.6135. To be perfectly honest we could see it stop anywhere in between but we will need a clear trap move to trade it in there. What I will be most comfortable with would be the 1.6160 level but if the weakness continues during Asia the pullback during London has less chance of getting there.

Forex News Today

Scheduled releases are busy today with a bunch of Manufacturing PMI data from the Euro Zone and the UK. With everything still below the 50 expansion the way I see these is that the only chance for a trend changing event is a surprise above that 50 level of which I have high doubts for any of them to do.

The US has its ISM Manufacturing PMI data also and does have more potential to get above 50 with an expectation of 49.8. that will be the one to watch and if it does give the good surprise it will be USD positive and streatch and EUR/USD move to the downside.

On To The Spanish Bank Stress Tests 

I am going to show the full article here but wanted to give some explanation for those who have a hard time understanding the language in it. Even I had to read it a couple times to get the full grasp of things and I do this all day every day.

First of all we all should have known they would manipulate anything they could to show a good figure. The magic number was 60 billion euros and they came out just shy at 59.3. Isnt that just great? Well not when you look close. What gets me is that the base scenario (meaning the one they expect) seems much too optimistic and the adverse scenario (worst case) shows that the three banks we all know are in the worst shape show that the capital they need is just a little bit more than the base scenario. Now that has to be BS 🙂

Now for a little terminology to clarify one of the phrases used that may need a layman term explanation. It is rehypothecation. In layman terms this is like getting a second mortgage on your house. You are re pledging the same collateral for a loan. The difference is these are most often used for home improvement and will eventually raise the value of the house and offset any potential loss by the bank in increased equity of the house. This is not the same for banks. What they are doing is using the same loans they have given to people as collateral to get loans from the Central banks. Then after they get the first loan the use the same loans to get another loan from the Central bank and then sometimes do it again. So what they have is 2-3 loans from the Central bank using the same collateral that is only worth the risk for the first loan. All it takes is for some of those loans the bank has issued to people or businesses to start going bad and it gets ugly really fast. This is exactly what happened to Lehman in 2008 but was with derivatives.

Here is the full article courtesy of Zero Hedge

How Oliver Wyman Manipulated The Spanish Bank Bailout Analysis

The biggest (non) news of the day was Oliver Wyman (“OW”) conducting an “independent” audit of the Spanish banking system to validate the previously disclosed funding needs of Spain’s banks which were announced back in June (just a week after Mariano Rajoy “insisted” no bank bailouts are needed). What OW really did was exercise 1 in a financial analyst’s playbook: to goal seek a number in excel using a variety of input variables, especially several fudge factors that are tangential to the matter at hand, yet which provide the biggest bang for the buck. In this case the target of the goalseeking exercise was to get a final headline number for bank capital needs to be just as expected, or €60 billion. Sure enough it the number was €59.3 billion, just a little bit less than consensus. This is the total number of cash the bank system will need in order to be considered viable, and unless something has changed drastically, the cash will come from new debt issued by Spain, which in turn funds its bank bailout fund, the FROB (a process explained here). While it is a given that several months from now we will go through this whole entire exercise to find out how much more cash Spain’s banks will need, for now what is curious is to understand what the fudge factor was that OW abused to allow it to get the desired result. That fudge factor is what is known as “excess capital buffer“, whose usage in the model to plug a major capital shortfall gap is non-sensical and shows that the real funding needs of Spain’s banks will be far greater, even absent future deterioration.

What is the excess capital buffer?

First, here is a chart showing the walkthru of the entire exercise.

In the OW report, the consulting company which is happy to goalseek any result requested of it by its client, shows that total projected losses for all Spanish banks, not just those who are now nationalized, under the adverse scenario will be €270 billion. The question then is how to plug this hole. First, Spanish banks have already taken €110 billion in provisions. Next, OW estimates that somehow Spain’s banks can generate profit to the tune of €59 billion, which together with a government-backed loss backstop called “Asset Protection Schemes” in place for BBVA, Liverbank and Sabadell amounting to €8 billion, brings the capital deficiency hole to €93 billion.

Now if it wasn’t for the excess capital buffer, this is the total amount of new capital that banks would have to raise: a number which the market would have thrown up on, as it would effectively raise Spain’s official debt/GDP by an additional ~15%. But thanks to the magic of excel, and consultants of dubious ethical standing, we get what is known a fudge factor.

What is the formal definition of the Capital Buffer. Here it is from pages2 and 53 of the OW report:


To improve the quality of the projected loss absorption, we…utilized a structured approach to model the additional capital buffer resulting from deleverage, by estimating RWA reductions in line with projected entities’ credit volumes by asset type in each scenario.

The capital buffer is the excess available capital above the requirements set for the purpose of the bottom-up stress testing exercise. As defined by the Steering Committee, post-shock capital needs are estimated taking a minimum Core Tier 1 ratio (as defined by the EBA) of 9% and 6%, under the base and the adverse scenarios respectively.


Credit deleverage has the effect of reducing an entity’s total risk-weighted assets (RWAs) and subsequently, capital requirements. This RWA reduction reflects the current specific asset mix of each entity and their growth strategy in different credit segments.

To simplify, what OW has done is to assume that as the situation deteriorates, whether in the base or adverse case, Spanish banks will sell debt, in the process reducing capital requirements, which implicitly makes sense: less debt, less equity needed to support it. Keep that in mind for now.

So the first thing that is surprising about the capital buffer is the following disclosure in the report:


Capital buffer generates approximately €73 BN of extra loss absorption capacity in the adverse scenario (€22 BN in the base scenario)

This is curious. It basically means that in the worst case scenario, it is assumed that Spain’s banks will sell much more debt, ostensibly hundreds of billions worth, in order to get the benefit of Core Tier 1 deleveraging. Visually this is shown as follows:

So basically what OW, Spain, and all those who have endorsed this report and its findings, among them the IMF and the ECB, are saying, is that as the situation gets worse, Spanish banks will delever. In fact, they will delever in the adverse case to an amount that on a consolidated basis fress up more capital (€73 billion), than the entire capital shortfall under the same scenario at €60 billion. This also implies that the total amount of deleveraging is in the hundreds of billions (also keep this number in minds).

That this is the deus ex fudge used by the European brain trust is simply laughable as it raises several quite hilarious questions, the first one being: just whom will these Spanish banks sell said debt to?

Since we are talking adverse case, in which the Spanish economy is imploding, GDP is crashing, and unemployment is soaring, one can assume an ongoing global deflationary deleveraging is the general context assumed by the authors. That someone under these circumstances would offer a bid, any sensible bid to a Spanish bank system which is now known will have to sell should things get far worse, and thus hit any bid, is simply laughable and shows how little understanding of actual capital markets consultants have. In short: in having to sell debt in the open market to mitigate capital requirements, Spanish banks would have to suffer massive P&L hits, which since all this debt, the bulk of which is Spanish sovereign debt to begin with, is market at par would lead to crippling Income Statement losses. Naturally, P&L losses would then make their way to the balance sheet and annihilate all of those €59 billion in OL assumed profits that offset the €270 billion in total future losses. In fact, should Spanish banks have to dump hundreds of billions in debt, and hit any bid, the total losses would be order of magnitude bigger than just €270 billion.

But a far bigger issue is the following. We will let readers figure it out using the chart below:

The chart above simply shows what the complete liquidity needs of the Spanish banking system are, far beyond and above what the Stress Test is calculating for. It shows that in August, the ECB, via any of its numerous funding vehciles, had funded Spanish banks to the tune o a record €412 billion. Why so much? The reason is Exhibit A of just why the Spanish banking system is doomed: the endless and relentless deposit outflow, which we noted yesterday. Here is the chart again in all its glory.

Since bank deposits are bank liabilites, the constant outflow of deposits means three things:

i) either the banks have to generate profits and thus increase shareholder equity, to offset the loss in liabilities, which in the current environment will never happen, or

ii) they have to sell assets, which in the current massively mismarked environment would also never happen as the banks would then have to take great unprovisioned losses on these asset sales, in the process generating greater losses to equity, than offsetting cash creation, or

iii) and this is precisely what is happening, pledge assets (and potentially re-pledge and re-re-pledge using rehypothecation) to the ECB in exchange for cash via any of the generic funding conduits such as the MRO and LTRO.

And that’s precisely where the paradox lies:

What Oliver Wyman is suggesting is that Spanish banks can plug capital shortfalls, modestly in the base case, massively in a worst case environment, by selling hundreds of billions of the very debt they use to pledge as collateral with the ECB! What this means of course, is that as the inventory of dry powder of eligible collateral declines (because the ECB will accept any bank assets, regardless of how worthless it is in exchange for 100 cents on the euro),the ability of the ECB to fund ongoing deposit outflows is eliminated.

And therein lies the Catch 22. Because unless the bank runs are halted, and the need for liquidity from some source, i.e., the ECB, ends, the Spanish banks will need more not less debt on their balance sheets! It certainly means that in reality none of that €73 billion in benefits from “excess capital buffer” will ever become available to the banks. But what it most certainly means is that if someone were to sit down and think through the logic of the OW bailout schematic, the real capital needs for Spain’s banks would far, far, greater, which in turn would crush any residual confidence in the system, which in turn would send the bank runs into overdrive, which in turn would guarantee the imminent collapse of the entire Spanish system, and with it the state of Spain, and thus the ECB and the Eurozone.

Is the picture emerging now?

Of course, all of the above has to be avoided at all costs, which is precisely why OW did what it did, why it fudged the numbers the way it did, and why the Eurozone, the IMF and the ECB rushed to give their seals of approval to an analysis which cracks after 15 seconds of critical thinking. But at the end of the day it is all about confidence, and the last thing the people of an entire insolventworld continent can afford is the truth.

Finally, and the biggest irony of the entire farce that is the Oliver Wyman analysis, is the unexpected sideffect of their conclusion which has more capital being formed for three of Spain’s banks, Santander, BBVA and Bankinter under the Adverse scenario than under the Baseline.

In other words, in order to appear better, these three banks would have every incentive to crash the Spanish economy!

Happy Trading


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  1. Dimo
    Dimo October 01, 06:28

    Hi Chad,

    I hope you’re doing well.

    Been following you guys for a while now (not a member yet, as i’m a newbie in the fx), but already opened a real acc (after 3-4 months demo-ing and) with a small sum to see how it goes.

    I found you guys on google when I decided to lean the forex trading, and been following you since my day #1 in the fx world.

    Having read your daily commentary today, I’m wondering about the GBP/USD, and why you only considered it as a first clear push to the downside?

    When I look at my charts (1hr time frame), I see a 3 clear pushes to the downside from the stop run at the highs of 1.6308/09. Following your strategy, I counted 3 clear pushes to the down side on GBP/USD (each of a min 90 pips) in a course of a week, so I’m wondering why you only considered the last push as a 1st push down and not a 3rd push down, and where I did wrong with my “homework”? 🙂

    Thanks in advance,

    Reply to this comment
  2. Nicholas Kellagher
    Nicholas Kellagher October 01, 08:10

    Hi Chad
    thanks for posting this and discussing it
    I think in practice what this means is that the Spanish banks will hold onto all their loans – a) so they dont have to crystallise losses and b) so that they have “assets” to secure continual tranches of ECB loans
    We are moving to the zombie bank stage – where Japan has been for years

    Reply to this comment
    • Chad
      Chad October 02, 00:58

      I couldnt agree more Nicholas. Now we also have them getting ready to take the bail out LOL

      Reply to this comment

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