Wednesday, September 29, 2010

Fitch prepares the rubber stamp (Updated)

The market is apparently abuzz with heavens knows what pertaining to the banks and the Fitch Ratings announcement that they are
...probing the potential impact of a spike in mortgage defaults or drop in house prices on the portfolio of Australian residential mortgage-backed securities and banks it rates.

Over the last few months, Fitch has received numerous enquiries as to the sustainability of Australian residential property prices and the possible impacts of a correction,” said Ben McCarthy, managing director for Australia.

While over the short-to-medium term, a downturn is not Fitch's central expectation, the agency is performing its stress test exercise on ratings impact under the hypothesis of an imminent housing market correction.

This blogger could not welcome this announcement more. However, the excersise is doomed before it begins. The danger for Australian banks is not an "imminent housing correction". We are in the midst of a raging commodities boom. APRA has already stress tested a scenario worse than this in June this year with:

- A 3 per cent contraction in real GDP in the first year followed by a V-shaped recovery;
- A rise in the unemployment rate to 11 per cent;
- Chinese growth dropping as much other countries;
- Commodities getting pounded;
- A peak-to-trough fall in housing prices of 25 per cent; and
- A peak-to-trough fall in commercial property prices of 45 per cent.

As a few commentators noted at the time of the APRA tests, they looked pretty much like the 1990s recession, perhaps slightly worse. The banks passed with flying colours. None breached 4% tier one capital requirements.

So, what might Fitch do differently? It might apply the tighter Basel III capital requirements to stress bank capital more severely. The results would be interesting but it seems a long bow. Although APRA is working behind the scenes to push Australian banks toward the new requirements, the rules aren't yet official.

Nor is it the real problem. As the recent Goldman report makes clear, the danger is a crisis that signals the end of high commodity prices and the impact that has upon Australian bank liquidity. In that event, wholesale markets dry up and/or become chronically expensive and, as argued here several days ago, there is no effective government guarantee to bail them out. That is the real danger and it comes without a v-shaped recovery.

So, will Fitch stress test the Budget too? And given its dependence on Chinese demand for commodities, will it also stress test that market? No and no. It is testing for an "imminent" correction.

Perhaps it is an inflation/interest rate driven housing rout - which seems the more likely trigger this month - that Fitch wants to test.

Either way, it begs the question, if "....over the short-to-medium term, a downturn is not Fitch's central expectation" and that is factored into its current ratings then exactly how stringent can the test be? A bad result is going to undermine its own credibility.

If Fitch goes through the stress test, only to produce a report based upon limited scenarios for falling prices, it will likely reinforce the myth of Australian bank invulnerability. A result that can only serve to set us up for a greater fall when commodities ultimately flatline.

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