Friday, August 6, 2010

Housing price drop stress tests.......proactive risk management or false comfort?

In less than 48 hours of China regulators instruction to banks to conduct stress tests assessing the impact of home prices dropping 50-60% in the worst case scenario, Taiwan follows suits but with less stringent test scenarios. Are these proactive risk management or breding more hubris or over-confidence thinking everything is/will be okay?

I am not an expert in these areas but as an investor, I certainly need to think about this issue so that I will not be caught with my pants down. After following the financial crisis stories for a while, I think there were a few thinkings out there trying to explain why we had 2008 financial crisis.

1. Slow reaction of Fed to raise interest rate creating excessive liquidity finding its way into housing bubble.

2. Over-saving Asian countries are funding over-consuming American because they have no place to recycle their money. This self-reinforcing loop created the global imbalances.

3. Market knows best will sort out all the problems by itself. Government should stay out of the market. Long lives MARKET FUNDAMENTALISM!

4. Like all bubbles, the party has to come to an end. When natural cleansing process set in to correct all excesses - house prices began to collapse.

5. Complex and lack of monitoring of complex financial derivatives finding it difficult to value its securities that were rarely traded. Lack of price discovery mechanism triggered fire sale that keep bringing down the value to, almost ZERO???.

6. Over-leveraged and under-capitalized banks just could not withstand shocks when these proverbial stuffs hitting the fan.

7. The global financial markets coupling much more stronger than we thought it was -- de-coupled.

Back to the issue of China and Taiwan's stress tests. I am sure with them staffed with 100 of PHDs, they will be able to keep the mechanism in place to fight the property bubbles that at its infancy. Chances of their conclusion will be okay at this point of price level.

However, what they must recognize is this, price is not static but dynamic. It could go up another 1,000% before they collapse(just an over-exaggeration here). The prescription will certainly has to be modified. The amount of capital adequacy needed by banks could be very different.

What if the obvious housing bubble was not the problem. What if bubbles find its way into some other asset classes? What if Sovereign Funds chasing after few other classes creating other bubbles? What if developed countries continue to drop money from helicopters? Well, they should be thinking of black swans --- thinking things are less obvious and unthinkable.

They must go back to the root of the problem - fight that damn liquidity. My bet is they are afraid to tighten it too quickly fearing choking the recovery process. There is no way they can time it right, regulators have been wrong as frequent as weather forecaster's' call. Did I raise the correct big picture questions? Well stop worry things that I can't control.

As an investor, I should remember this day and night. Be fearful when others are greedy, be greedy when others are fearful. At some point of time, I'll keep my money under the mattress. But at this point of time, people have not been too greedy yet.

(Bloomberg)Taiwan regulators asked lenders to conduct stress tests to gauge the impact of a 25 percent drop in home prices amid concern speculators have driven the market too high, said Johnson Chung, head of mortgages at Ta Chong Bank Co.

“The regulator is doing the stress test because the government is concerned about banks’ exposure to the property market,” Chung said in a telephone interview today. He said officials are also concerned that “hot money” may create a bubble in asset prices.

China's stress tests
China’s stress tests of banks will assess the risk that a possible slump in property prices may strain developers’ finances and cause homebuyers to default, a person with knowledge of the matter said this week.

The banking regulator told lenders to include worst-case scenarios of prices dropping 50 percent to 60 percent in cities where they have risen excessively, the person said, declining to be identified because the regulator’s requirement hasn’t been publicly announced. Previous stress tests carried out in this year assumed home-price declines of as much as 30 percent.

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