Getting stressed out

- Stress testing 60% drop in home prices – negative for banks "Media reported that the Chinese banking regulator has required banks to stress test for 60% property price drop. While the magnitude of correction sounds quite unlikely, it has nonetheless caused lots of concerns and confusion among investors. People are asking “why another round of stress test”, “why 60%”, and “what is the outcome”. In our view, either from a political posturing or real earnings impact perspective, this is negative for the banks. It reinforced our cautious stance on the bank sector this year."
- Our interpretation of regulators’ intention "1. Signaling continued tightening: the regulators are determined to deflate the property price bubble. In light of the market speculation of policy loosening, PBOC recently reiterated the differentiated mortgage policies, and CBRC Beijing also banned mortgages to 3rd homes again. This may be another political posture. 2. A real concern: regulators may believe the tightening policies so far have been ineffective. Second hand market prices are higher than April levels in many cases, and mortgage loan volume remained strong in June. Regulators may see the property prices bubble lasting longer than expected, and are truly concerned that the correction, when it comes, will be deeper than expected. 3. An excuse to push for more provisions: LGFV and property are the top two concerns for CBRC. The regulators have been pushing banks to “front-load the pains”, downgrade loans, and increase provisions, but have encountered strong resistance from banks. This may be another effort to raise the sense of urgency for provisioning and “counter-cycle management” while earnings growth is strong."
- Why 60%? – it’s needed for a true “stress” scenario "Mortgage loan-value ratio is around 60% at sector level (without MTM), based on our estimation, and ~50% at large banks, according to management. Thus, most loans are still in positive equity when the price drop 30%. Banks only expect ~2.2ppt rise in property NPLs in such a scenario, even taking into consideration 108bp of rate hikes. However, as we highlighted in the May report, “the rise in property loan NPL will be exponential as property prices fall”. To find out a true “stress” scenario, a >50% correction is warranted."
- The result and impact on banks "We would downplay any outcome of such stress tests, because: 1) there is no precedence to refer to, and 2) default is influenced by a lot of "soft" factors other than the home prices (eg confidence in job security, confidence in long term property prices, the “cost” of default, etc). We reiterate our view that any sharp correction in property prices may lead to significant earnings hit on banks, but the impact on balance sheet and book value is limited (unless it turns into a broadbased economic crisis). Among the H-share banks, CMB and MSB are more vulnerable due to their relatively high exposure to mortgage and developer loans."

Merrill Lynch Banks China 20100805

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