A housing bust's biggest loser Vulnerable ... Australia's housing market Photo: Paul Rovere Besides the Melbourne Cup and the footy finals, there are few things that set Australian pulses racing quite like arguments over house prices. The ingredients for a property downturn in Australia are in place. But rather than add to the abundance of analysis and opinion that's flooded the media recently, let's consider who has more to lose from a housing bust: Australia's largest insurer or the world's most expensive bank. In the Commonwealth Bank's annual results presentation, you'll find a reassuring slide that shows the predicted losses from a three-year stress test. Assuming property prices eventually fall 32 per cent, unemployment rises to 11.5 per cent and the official cash rate drops to 1 per cent, Commonwealth expects to lose only $1.9 billion from uninsured loans after collecting $2.1 billion of lenders' mortgage insurance, and that conservatively assumes that all loans 90 days in arrears trigger a claim. That's just $4 billion of losses on a $373 billion mortgage book, or just over 1 per cent, and half of that is insured. This seems a trivial amount for such a big economic dislocation, but let's look at the two largest players in lenders' mortgage insurance. In October 2008 QBE Insurance bought mortgage insurer LMI. QBE LMI reportedly has about 35 per cent of the mortgage insurance market, with Genworth controlling 50 per cent, according to ratings agency Standard & Poor's. In Australia, borrowers with deposits of less than 20 per cent of the purchase price of their new home are obliged to take out mortgage insurance, so if they default on their loan mortgage insurers such as QBE LMI are on the hook for any properties sold at a loss by lenders such as Commonwealth Bank. At this point shareholders of the big banks, who include virtually every Australian through their superannuation portfolios, will be feeling safe and secure. But there's a problem. Under the assumed conditions in Commonwealth's stress test, every other financial institution would be making claims as well. Let's say the total claim was $7 billion, though it could be far higher. Now compare that to the $2 billion of shareholders' equity that Genworth reportedly has, and the roughly $1 billion QBE has invested in LMI, which is itself obliged to meet certain regulatory capital requirements. Theoretically, the most QBE could lose is the $1 billion because LMI is ring-fenced to ensure that losses from QBE LMI never drag QBE down with it. Suddenly bank shareholders aren't sitting so pretty. If QBE LMI is only good for $1 billion and Genworth $2 billion (it also has $1 billion of unearned premiums) who is going to cover the remaining $4 billion or more? If QBE LMI and Genworth don't have adequate reinsurance policies, it seems losses would be higher than Commonwealth, for example, is anticipating. But who would be worse off? Even if Commonwealth suffered the full $4 billion ($1.9 billion + $2.1 billion) of losses, if that's as bad as things got, Commonwealth would get through the period relatively easily. But remember the government had to backstop the big banks' loans during the global financial crisis, even though there was no real trouble with bad debts. Perhaps the thought of large losses would cause foreign lenders to withdraw funding, triggering dilutive capital raisings and dividend cuts anyway. Though there's no guarantee that shareholders would emerge smiling, the big four banks would also probably receive help from the authorities if they got into real trouble. In contrast, the losses could devour QBE LMI - $1 billion of capital is a drop in the ocean of the $500 billion mortgage insurance market. If QBE chipped in more capital to maintain its reputation, QBE's already leveraged balance sheet would come into question and also probably trigger a capital raising and a further cut to dividends unless its reinsurance policies paid off. Bailouts were required during the financial crisis because losses from a US-style property collapse are virtually uninsurable. The ingredients for a property downturn in Australia are in place: high personal debt, too much reliance on China's unsustainable economic growth, and high property prices. But there's no telling how the situation will play out. Perhaps China will muddle through and income growth will one day catch up to the growth in property prices. Anything's possible but the message for investors is pretty clear. If you have a large direct exposure to property, either through your home, investment properties or superannuation, owning bank shares or QBE means all your eggs are in one basket. You can get access to a free trial to Share Adviser here and follow Share Advisor on Twitter at @value-investing.