...This is an important aside for the markets. In an environment where nation-states can freely choose to renege on repayments citing their sovereignty considerations, where do the people providing marginal capital at risk go for insuring their risks? In other words, if Greece later on chooses to renege on its austerity pledges, or choose to exit the eurozone altogether (the currency union, not the economic free-trade area), where will the buyers of the 5 billion euros [US$6.6 billion] of debt today go to reduce their losses? The only plausible answer is the CDS market. That makes it more useful to global bond investors than the European governments calling for its ban. (See "The blame game", Asia Times Online, March 6, 2010.)

Instead, the report said there was "no evidence of any obvious mispricing in the sovereign bond and CDS markets". It concluded: "CDS spreads for the more troubled countries seem to be low relative to corresponding bond yield spreads, which implies that CDS spreads can hardly be considered to cause the high bond yields for these countries."

... The EU probe was instigated in March following heavy pressure from France and Germany to crack down on speculative trading, which, it was argued, had contributed to the spike in Greek borrowing costs. The conclusions of that inquiry were never published, although officials said at the time they were influential in the subsequent drafting of proposed legislation to cover short selling and the sovereign CDS market. However, the Financial Times has now seen a copy of the officials' report, which makes clear that investigators lacked any serious evidence that CDS trading was contributing to higher borrowing costs.

They analyzed market data from 2008 to the first quarter of 2010 and concluded that changes in spreads in the two markets generally took place at the same time. "CDS and bond markets are basically equally likely to lead or lag each other," their report says, adding that these relationships have been stable over time.

... Readers will remember that little bit of concern that, oh I don't know, the whole world had concerning the potential for European sovereigns to default due to excessive debt loads. The infection from that view to European banks was led by the simple fact that they held the greatest proportion of European sovereign debt. So what do the folks doing the tests - the Committee of European Banking Supervisors - do in this situation? Do the right thing and assume that banks are "stuck" with the sovereign debt and suffer massive defaults? Or do they quietly whitewash the issue?

Here is what they did. They put the whole lot into a "hold to maturity" account for banks, and assumed that any sovereign default that did occur (say Greece) would have a fairly small impact ("severity" in the lingo). In other words, there was no need for banks to worry about the volatility of holding European government bonds, and even if there was an actual default actual losses would be minimal.

If that wasn't bad enough, there is no actual evidence that the banks' liquidity access to the European Central Bank (ECB) was stress-tested. In other words, what would happen to the liquidity position of European banks if the ECB were to change collateral eligibility requirements (say due to pressure from the German government)? What would happen to European banks if a large institution were to collapse? How about the "what if" scenario associated with more than one European sovereign going into refinancing stress later this year?

The obvious conclusion from all this is that the European stress tests were designed for banks to pass, not fail. That alone ensures that the design and implementation of the tests was faulty from the first day.