Should the bank shares be rising as house prices fall?

I have seen numerous portfolios of clients who come to me with 40% and even 50% invested in Australian bank shares.

With house prices across the entire globe falling and bank shares (apart from the Aussie ones) having fallen 80% or 90% and numerous failures, why do Australians persist with the notion that investing almost half your capital in these grotesquely geared entities is considered a safe practice?

The above average intelligence guys at the Intelligent Investor wrote in the back of one of their recent newsletters that they believe a maximum allocation of 10% of a portfolio should be invested in the Australian banks. I completely agree. Although at Valor Private Wealth, we believe that the Australian banks have limited upside and potentially large downside and this is not the kind of investment we feel comfortable owning for our clients, so our current weighting to Australian banks is 0%.

The capital requirements of the banks are about to come under closer scrutiny over the coming months with Basel III. There is talk of some of the enormous off balance sheet derivatives being required to be brought onto the balance sheet. I have spent countless hours attempting to work through this issue, however as the reporting for these instruments is still quite opaque, any work done has limited application. When the derivatives listed in the banks are in the trillions for each bank, small movements  can have enormous affects. The vast majority of these instruments are simply hedges, however as seen with the JP Morgan losses of late, trading losses can be large.

One of the biggest concerns is the accounting of capital for the banks. With house prices rising over the last decade around Australia, there has not been any issues, however since October 2010, house prices have begun a gradual retreat and if this continues, the banks could prove to be swimming naked when the tide goes out. Westpac and Commonwealth have the highest proportion of residential mortgages at about 2/3 of their book, whilst ANZ and NAB are holding approximately 55% and 50% respectively. The ugly girl at the dance (NAB), who has been a stellar under performer may actually be the least worse bank!

So the latest reports of house prices continuing to fall why are the bank shares rising? Deep T from Macro Investor has highlighted the risks to the banks with continued house price falls. In reality, the banks are a levered bet on house prices in Australia. If the market was rational, then the bank shares should move at a greater rate than the house price falls or rises. This was definitely the case when house prices were going up, but there appears to be a disconnect with house prices falling 5% year on year nationally and bank shares rising approximately 15%.

In a situation of continued house price declines, it is the LMI (lenders mortgage insurance) insurers that are most at risk. QBE and Genworth could shoulder enormous losses, many times their current capital, if house prices fall in a similar fashion to what has happened around the globe. This is something I would suggest is not a negligible probability. Once again, there is very little data about the current LVR profile of these highly geared insurers. In the last QBE annual report, the word LMI only popped up twice. For what I see as one of their largest risks, mentioning the word twice is not what I call keeping investors up to date.