oz housing collapse: sell bank shares ?, page-2

Why Fitch is Wrong About Australia?s Banks

by Kris Sayce on 14 October 2010

Hogwash!

There?s a few other words we could use, but that?ll do for now. The boys and girls at Fitch Ratings have given Australian banks the all-clear.

According to Bloomberg News, ?Australia Can Handle Worst Mortgage-Loan Defaults, Fitch Stress Test Shows?. Well that?s alright then.

Bloomberg reports that:

?Banks would see a maximum A$10 billion ($9.9 billion) of losses in the third year of a severe mortgage stress scenario and mortgage insurers would lose a little more than A$7 billion.?

OK, what about the first and second years? Anyway, Fitch used three stress-test scenarios:

?Fitch is testing? mild stress, with mortgage defaults of 2.5 percent and a 20 percent drop in home prices; medium stress with 6 percent defaults and 30 percent decline in prices; and sever stress with 8 percent defaults and a 40 percent price slump.?

Let?s not kid ourselves on where we think the housing market is heading. We?ll ignore the ?mild? and ?medium? stress tests because those are nothing more than McDonald?s cheeseburger-sized blips en route to the Eagles cheeseburger-sized housing crash:

Not your editor eating a 5lb cheeseburger

Source: Eagles Deli, Boston

I mean, do the numbers. The estimated size of the Australian housing market is $3.5 trillion. Which is helpfully inflated by around $1 trillion of mortgage debt.

Those are pretty big numbers by anyone?s standards. It means you?ve got a loan to value ratio (LVR) of about 28%.

So if we take the value of Australian housing and apply the severe collapse in prices as modelled by Fitch, the total value of the Australian housing stock will fall to just $2.1 trillion.

And the LVR will increase to just under 48%.

Of course, that?s based on the entire housing market. But as the property spruikers are keen to tell us, about 30% have a mortgage, about 30% of people rent, and about 30% of people own their home outright.

So, we?ll adjust the numbers. Trouble is, it makes the result even worse, and we?re not even factoring in the super-leveraged investment property mortgages where paper profits are used as a ?deposit? on an additional investment property.

But if we just look at the 30% of owner-occupiers with a mortgage, that puts the value of their properties at a total of $1.05 trillion. And according to the latest numbers from the Reserve Bank of Australia (RBA), residential mortgage debt stands at $672 billion.

That?s an LVR of 64%. More than twice the LVR than if you look at the mortgage position across all properties.

Now, if we assume a 40% drop in house prices as modelled by Fitch, you?re looking at the total value of the housing stock owned by those with mortgages falling to just $630 billion.

In other words, that segment of the market, those with mortgages, would be in negative equity.

Now, of course that assumes owner-occupiers don?t sell, or if they do then the buyer is buying with a similar amount of leverage.

And, considering that so much of household wealth is tied-up in the family home, the effect of those without mortgages selling into a falling market shouldn?t be discounted either.

If all you?ve got to live off in retirement is the equity in your home, odds are you?ll want to bail out while there?s still some value left in it.

But if we take Fitch?s numbers and say that 8% of this segment of the market defaults, that works out to around $53.8 billion of housing that the bank is left in the lurch with.

$53.8 billion of housing that it would need to sell into a depressed housing market. A housing market that has just fallen by 40% mind you.

How are they going to do that we wonder.

And considering a bank such as the Commonwealth Bank [ASX: CBA], currently holds around a quarter of all Australian mortgages, that puts its potential liability at at least $13.4 billion.

Even if you assume mortgage insurance will mop up say $5 billion, you?re still looking at the CBA holding $8 billion worth of property and defaulted mortgages.

And here?s the thing. You?ve got to remember that people?s behaviour changes under such extreme stress. Anyone can do some sober back-of-the-envelope analysis today when the markets are booming and flowers are blooming.

But all that goes to pot when the fit hits the shan.

Think about it this way. In late 2008 the Australian housing market didn?t collapse. It didn?t fall by 10% let alone 40%.

Yet how did the banks behave? What condition did the banks find themselves in during a time when the value of their biggest asset didn?t fall?

That?s right, the banks went crawling and begging to the Australian federal government for a bunch of taxpayer handouts. Handouts that prevented each one of them going bust.

Never forget this?

If it wasn?t for the Australian government guaranteeing the deposits of every dollar in a savings account, Australia?s banking system would have collapsed.

If it wasn?t for the Australian government guaranteeing the wholesale debt issued by Australian banks, Australia?s banking system would have collapsed.

If the Australian Office of Financial Management hadn?t agreed to use taxpayer dollars to buy residential mortgage backed securities, Australia?s banking system would have collapsed.

And if mortgage funds ? such as Commonwealth Bank owned Colonial ? hadn?t frozen redemptions on those mortgage funds, Australia?s banking system would have collapsed.

That?s why I tell you that the so-called stress test by Fitch is hogwash. We dare say it?s based on fancy computer models. Computer models that are based on various inputs. Perhaps they?ve factored in job losses and higher interest rates too.

But there?s one thing no fancy computer model can accurately predict, and that?s human behaviour.

When people are put under stressful conditions they may do and act in ways that no-one could possibly imagine. I mean, even in non-stressful conditions people do things that defy logic.

But there?s something else which we dare say the brain-bods at Fitch haven?t considered. And that?s the Ponzi nature of the banking system.

Banks exist on the basis that the supply of money into its vaults will constantly increase. As long as more money is created it means more money will be deposited and therefore it can use that as capital to create even more money.

The problem arises when the flow and creation of new money stops ? deflation.

If a bank such as the CBA has lost several billion dollars on mortgages, it has to cover that money from its own pockets to make sure depositors are made whole on their deposits.

And, if property prices have just fallen 40%, even if there are people who are prepared to borrow, they?re going to need to borrow less as property is cheaper.

And of course, not forgetting all those defaulters ? 8% of borrowers ? who are no longer credit-worthy. Ask any business what the impact on their revenues would be if 8% of their customers were suddenly not in a position to buy from them anymore.

We doubt that they?d just shrug their shoulders and not worry about it.

That?s why it?s important to consider how banks really work. This is where we get back to fractional reserve banking.

Remember how people swarmed the banks in the UK and the US to withdraw their deposits as soon as there was a whiff of trouble at the banks. Well, take a look at the latest Commonwealth Bank annual report.

The CBA records in its balance sheet that it holds $374 billion of ?deposits and other public borrowings.?

Yet, if you look in the Assets column you?ll see the bank holds just $10.1 billion of cash and liquid assets. And if you drill down further you?ll see that the CBA holds just $3.09 billion in ?Notes, coins and cash at banks? in its Australian vaults.

In other words, it tells its customers that their cash is available when they want it, yet less than one cent on the dollar is sitting in the CBA?s vaults.

So, run it past me again. If Australia?s property market collapses by 40%, according to Fitch, this will only have a negligible impact on the banking system.

Yeah right.

In the Utopian world of the ratings agencies they seem to believe that individuals will just grin and bear it. That there won?t be a run on the banks, people will continue taking out new mortgages to buy up all the cheap properties, and the government won?t need to put taxpayer dollars on the line again to bail out the banks.

As we said at the start, that?s utter hogwash. You saw the panic that consumed the bankers, the government and the bureaucrats in 2008.

And you saw how individuals reacted both here and overseas ? they panicked too.

We wrote yesterday about Black Swan events. Events that are unpredictable.

Well, it?s likely that the housing market will collapse as a result of an unpredictable event. Whether that?s something that causes a rise in unemployment or something else ? we don?t know.

But what we do know is that an analysis of the Australian banking system and its exposure to the housing market can?t be analysed in isolation. The housing and banking collapse will have a major impact on other sectors of the economy and that in turn will feedback to impact the housing and banking markets.

As much as the pointy-headed graduates who fill the corridors of the ratings agencies, the banks and government bureaucracy believe that they can model for and avoid a collapse of the banking industry, the fact is they can?t.

The very structure of the Australian housing and banking system means that it is ultimately destined for collapse. Reports such as the one from Fitch, only succeed in spinning the tired and stale old yarn about Australia being different.

It isn?t. It?s exactly the same as everywhere else. The only difference is that most people haven?t figure that out yet.

Cheers.
Kris Sayce