Markets Worry Stress Tests Too Easy on Sovereign Debt

All but a handful of European banks passed their stress tests but investors remained worried about the methodology, which many viewed as too easy on sovereign debt.

Among those that failed were Germany's HRE, Greece's Atebank and Spain's Banca Civica. But most banks passed, according to the early results.

But what worried investors was that the stress tests exclude the possibility of a sovereign default. They don't require any reduction in value ("haircut" in trader parlance) for sovereign debt classified as “hold to maturity,” assuming only the possibility of losses due to sovereign debt held in trading portfolios.

That's an important distinction because much of sovereign debt is held outside of trading portfolios.

When sovereign bonds held as trading assets trade lower in the markets, banks are required to mark those assets at a lower value for balance-sheet purposes. The stress tests assume banks may suffer mark-to-market losses, as high as 23.1 percent in the case of Greece's debt in the trading portfolios.

But assets classified as "hold to maturity" need not be written down due to market fluctuations, unless there is a permanent impairment, such as a sovereign default.

The fear is that the stress tests may underestimate possible losses by banks by excluding the risk of a sovereign default and could undermine their credibility as indicators of the financial health of European banks.

The Committee of European Banking Supervisors is expected to formally release the criteria and the results of the stress tests for 91 EU banks around 12:30 noon Eastern Time today.

Three European banks announced that they are seeking to raise new capital as an assurance ahead of the release of the stress-test results.

Stocks in Europe and the U.S. swung wildly as investors digested the results. The euro fell sharply against the dollar.