Europe Waited Too Long

BRUSSELS, Belgium ( TheStreet) -- As the results of Europe's bank stress tests trickled out on Friday -- indicating that just seven banks weren't up to snuff and would require only ¿3.5 billion in new funds -- the real question became whether investors can trust the government.

ARM Holdings

The question first emerged in the fall of 2008, when U.S. regulators invoked an array of resolution approaches for troubled firms and Congress wavered back and forth over a bailout package that climbed in scope to $700 billion as time wore on.

By the following spring, the government was once again seen as a source of strength. U.S. stress tests were viewed as a sign that big banks were doing OK - even if they still required $75 billion in fresh capital -- and that rescue programs were, in fact, effective. The idea was validated by surprisingly strong first-quarter results, starting with Wells Fargo ( WFC) and moving down the line to Bank of America ( BAC), JPMorgan Chase ( JPM) and Goldman Sachs ( GS).

But the European debt crisis showed two things: That the global financial system is too interconnected to isolate problems to one country -- yes, even the U.S. -- and that the regulatory system can be just as flawed as the financial system it oversees. Keep in mind that this is not round one, but round two, of European stress tests.

The problems became evident last fall, when Europe released its first stress test results and Greece's problems were mounting. The tests were widely panned as weak-kneed, and the results were considered irrelevant by the market. Greece's government, meanwhile, continued to give empty assurances about the state of its finances.

Yet the truth was evident and had been evident for some time: Greece has a long history of borrowing a lot and producing very little.

As that was all occurring, investors began examining the finances of other not-so-creditworthy countries in Europe. Among the targets of the sovereign-debt spook were Portugal, Ireland, Italy, Greece, Spain and, eventually, Hungary -- creating the lovely acronyms of PIIGS and PHIIGS. Sensing the fact that something might be amiss, ratings agencies started to downgrade bonds, fueling the crisis rather than warning investors ahead of it.
Stress Test
The marble statue of ancient Greek philosopher Socrates stands in front of the headquarters of Bank of Greece, in central Athens, on Friday, July 23, 2010. Six Greek banks were included in the list of 91 European lenders undergoing stress tests by the European Union.

Meanwhile, Europe's complex patchwork of regulators kept trying to figure out what to do -- who needed financial assistance, how to structure it and who would provide the funding. Countries that actually had their financial houses in order, like Germany and Luxembourg, weren't so thrilled about contributing. And while neighbors were figuring out how to bail out Greece, its residents were rioting in the streets because they might have to work more and receive fewer state-sponsored benefits.

None of this was exactly comforting.

By December, the euro had already begun its downward spiral and the sovereign-debt markets were in a tailspin. From there it took five more months for a broad rescue plan to be unveiled, but it seemed the window of opportunity had closed. Its $1 trillion price tag failed to inspire confidence in the system; worry and doubt has lingered on til now, when the second set of stress tests were unveiled.

Spain had pressured E.U. regulators to release another analysis when it became evident that even "healthy" banks were being shut out of funding mechanisms. The tests were conducted in consultation with top U.S. regulators, including Treasury Secretary Tim Geithner, since the stress tests across the pond had been seen as successful in restoring confidence.

On Friday, the Committee of European Banking Supervisors released the long-awaited results: Seven E.U.-based banks would fail the test's requirement that Tier 1 capital ratios remain at or above 6%. As a result, they must raise ¿3.5 billion, or $4.5 billion, in new funds. The committee was upbeat about its findings.

"The aggregate results suggest a rather strong resilience for the EU banking system as a whole and may appear reassuring for the banks in the exercise," said the report.

It emphasized, however, that banks are still heavily reliant on government support and that the economic recovery is uncertain.

Early news stories and analyst reports speculating on the results had indicated that the tests might, once again, be deemed feeble and ineffective. There was concern that EU stress-testers had excluded certain bonds that were more worrisome than others, and not factored in the effect of credit-default swap insurance. However, when the report was released, the committee said that both trading and banking books had been tested, along with off-balance sheet assets.

The test assumed no economic growth and haircuts of 19% on assets in a benchmark scenario, and 36% in an "adverse scenario." It didn't take into account any new regulations, divestitures or capital raising that occurred after July 1.

The committee didn't outline which specific banks had failed the test, though they emerged as the day wore on.

Hypo Real Estate, which was already bailed out by the German government, was one of the earliest known to have failed the stress test. The bank said results had "limited relevance for HRE" since it didn't take into account all of its recapitalization efforts.

The other six were Spanish lenders Banca Civica, Cajasur, Diada, Espiga and Unnim, none of which were publicly traded, and whose problems were well-known, as well as the Greek bank ATE. Several lenders announced new capital-raising efforts on Friday, around the time results were released.

Banca Civica said it had raised ¿450 million, or $579 million, in new funds, while ATE said it would raise ¿242.6 million, or $313 million. Separately, Greece's largest bank, the National Bank of Greece, announced it had also raised ¿450 million and Slovenia's NLB said it would seek to raise ¿400 million, or $516 million.

On Friday, stocks were little changed and the bond and credit-default swap markets were relatively calm. They reflected more fear about the fate of the so-called PHIIGS countries than others, with the cost of insuring against default on Greek, Portugese, Hungarian or Irish tracking 4% to 6.5% higher, and the cost of insuring against German-debt default relatively flat, according to Dow Jones Newswires.

There was a sense that someone had hit the "pause" button on volatility as the market digested results. But since mid-April, when the European contagion really started gaining ground, stoking fears of a slowdown in the global economic recovery, shares of large U.S. and European banks -- including Goldman, JPMorgan, Deutsche Bank ( DB), Credit Suisse ( CS), Barclays ( BCS) and UBS ( UBS) -- have all fallen roughly 15% to 30%. Even if their headquarters lie across an ocean, their fates are closely connected.

The U.S. was successful in restoring confidence in the market, mainly because the stress test was hyped up for a few months, assumptions were deemed credible and the results were delivered by a single administration. But the E.U. has 20 nations with different rules, agendas and financial situations. There's no single entity leading the ship. And it's taken many months of delays and false starts to get this far.

As a result, it will be a lot harder for investors to take the European stress-test results seriously.

-- Written by Lauren Tara LaCapra in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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