“It’s all OK, nothing to see here”, seems to be the preliminary finding of the Australian banking “stress test” performed by ratings agency Fitch. News wires have reported Fitch’s preliminary findings that even if Australian house prices tumbled by 40%, such a drop would be manageable, and banks would lose only $9.9 billion. In a briefing to discuss the initial results, Fitch directors John Miles and John Birch claimed that “in the case of the banks, loan-loss reserves and pre-provision, pre-tax profits are more than adequate”.

Fitch was inspired into conducting the stress tests after international investors, including GMO’s Jeremy Grantham, suggested that Australian housing was a price bubble. The notion of a housing bubble is supported by house prices increasing at a far greater rate than inflation, rentals, economic growth and disposable income in the past decade, and the fact that mortgage debt (relative to GDP) has virtually tripled since 1998. Then there is the small problem that housing investment yields  2%-3% on a net basis — less than half the rate of a savings account.

Fitch hasn’t yet released detailed information about how it came to its conclusions, but its credibility remains somewhat damaged after it was one of the three leading ratings agencies (along with S&P and Moody’s) that played a large role in creating the sub-prime mortgage crisis in the United States. The New York Times stated that Fitch and the other ratings agencies were “a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more”.

During the bubble of the early 2000s, French-owned Fitch was making more than half of its earnings from rating structured finance instruments (such as collateralised debt obligations) leading to its share price tripling. Sadly for banks and other investors, most of the so called AAA-rated securities were actually the investing equivalent of toxic waste. In total, 93% of sub-prime instruments that were rated AAA between 2006-2010 by the ratings agencies have since been downgraded to “junk” status.

Fitch’s claims that a 40% collapse in house prices would cause such minimal effect on banks appears fanciful. The flow-on effect from a house price drop is likely to be substantial, as occurred in the United States and Ireland. Not only are directly jobs lost in industries such as construction and materials, but unemployment would increase and consumer spending fall. This will place pressure on government spending with the budget switching from surplus to deficit as tax receipts drop and social security spending rises. Not only will banks lose money on the hundreds of billions of dollars in housing loans sitting on their balance sheets, but they will also face massive losses on consumer loans and business loans.

Due to the fractional nature of banking, losses can mount quickly and have a massive impact on profitability and solvency. NAB lost a billion dollars in 2008 after writing down the value of their investment in United States debt securities. Those assets represented a fraction of NAB’s overall asset base. Similarly, NAB wrote off more than $3 billion in 2001 after a failed investment in US lender Homeside. Fitch is therefore suggesting that the entire Australian banking industry will lose only slightly more than NAB did after a bungled US investment a decade ago.

As a comparison, US losses as a result of the GFC have been forecast to eventually reach $US4 trillion (with direct banking losses already exceeding $US500 billion before the recent foreclosure issues).

Fitch’s confidence echoes a recent study by Australia’s largest home lender, the Commonwealth Bank, which claimed that even if unemployment rocketed to 10% and interest rates leapt to 14% and property prices dropped by 30%, losses of only 0.2% would result.

While not privy to the CBA’s calculations, its projections appear somewhat optimistic. But of course, CBA executives have good reason for their optimism — they are backed by government deposit guarantee and wholesale funding guarantees. It is in their interests to adopt a riskier profile because that increases short-term profitability and most importantly (for executives), their remuneration.

Whether one can trust a word uttered by the CBA is also questionable, after it was revealed that the bank’s presentation to investors about the housing market was deeply flawed and misleading. Money Morning commentator, the fantastic Kris Sayce, called the CBA presentation “the biggest case of deception since Harry Houdini was pulling rabbits out of hats”. This is because CBA’s main argument disputing a housing bubble was that the price to income ratio for Australian capital cities was below that of other international cities such as London, New York and San Francisco. (CBA also made a bunch of other fallacious arguments, which we discussed here).

However, CBA used two different sources for its presentation. For Australian cities, CBA used a UBS study, but for international cities, it used a study by Demographia. Had the Demographia study been used consistently, it would have shown that Sydney and Melbourne are far more “expensive” in relative terms than even New York or San Francisco. That makes the CBA either complete frauds or utter fools. (Incidentally, the same charge can be leveled at the CBA board, which pays its risk-taking executives tens of millions of dollars annually).

House buyers have two contrasting views. First, there is the view submitted by the likes of the misleading CBA, disgraced Fitch and a bunch of self-interested bodies such as the HIA and the Real Estate Institutes that claim housing isn’t a bubble. Or there is the view submitted by some of the world’s leading investors and economists, such as Gerald Minack, of Morgan Stanley, or Jeremy Grantham, who claim house prices are 40%- 50% over-priced.

The decision really isn’t that hard.