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Hong Kong Faces Subprime Puzzle

Conflicting data and statements create a challenge for investors seeking clarity.

While some see at least the beginning of the end of the U.S. subprime morass, Hong Kong investors find themselves mulling conflicting reports about whether subprime lending may be a bigger factor on their turf than they previously thought.

Last Thursday, Joseph Yam, CEO of the Hong Kong Monetary Authority, told local journalists that subprime woes may be more serious on the island than they realize. According to local newspapers, Yam told reporters "that the impact of the subprime crisis was serious and the worst was not over yet." Furthermore, he did not rule out the possibility that year-end results of local banks might decline in profit or even "go into the red" for 2007.

However, the Hong Kong Monetary Authority maintains that Yam also said that subprime posed no "systematic risk" to the banking sector in Hong Kong, and that he did not see any "big impact" of subprime on the local economy.

The reported comments, which were bearishly slanted by local journalists, have contributed to the sharp declines in valuations in financials on the island over the last week.

Since Thursday,

HSBC Holdings



Hang Seng Bank


has lost 6.1%, while shares in rival

Dah Sing

have plunged 8.4% as another competitor,

Wing Hang

, slipped 5.6%.

Whether Yam meant the comments as a negative may be significant, say market participants, because if they were misinterpreted, then the financials look cheap after the recent selloff.

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"It sounds a little bearish. I think he is perhaps referring to a couple of small banks that have confessed to a fair amount of exposure," says Brian Hunsaker, Asia ex-Japan research head at regional financial specialist Fox Pitt-Kelton. "Maybe he said something that he later regrets, or maybe he just exaggerated a bit. Either way, the comments don't match the economic reality."

For example, while shares in

Bank of China


have come off 7.3% in the last week, to HK$3.82, Fox Pitt-Kelton estimates that the stock will continue to surge and rates it an "outperform" on the belief subprime exposure is already factored into the now discounted price.

Subprime write-offs by banks in Hong Kong currently stand at 25% of the number in June, when the crisis began.

According to analysis by Fox Pitt-Kelton,

Sinopac Financial

, Bank of China and subsidiary

Bank of China Hong Kong

are the local banks with the highest subprime exposure. Still, assuming a worst-case scenario of 100% write-offs on 11.6% of Tier 1 subprime exposure in the three most exposed local banks, even then none would need to raise new equity to finance the losses, as has been the case with international giants like


(C) - Get Citigroup Inc. Report



(UBS) - Get UBS Group AG Report


Still, others such as Joel Naroff, president of Naroff Economic Advisors, agree with Yam and caution investors against making sure-fire predictions when it comes to writedowns.

"A lot of this

mortgage-backed paper was sold around the world, so we really haven't got a count on worldwide issues," Naroff says. "Hong Kong and Asian exposure is still totally unclear. It could be minimal, but it depends on what individuals and companies did with their investments."

Naroff says that it may take up to six months before investors know the full extent of the exposure to subprime mortgage-related losses that Asian banks will incur, because different credit instruments will default at different times, making absolute predictions practically impossible.

"The default process means it takes time to see all the things that happened, so you're not going to get a handle on this today, or in the next month, but months later when underlying securities reset," adds Naroff.

Other market participants argue that sharply declining volumes in Hong Kong trading are making the situation even more difficult to read, since it is unclear how much capital investors will allocate to financial stocks when they return to the market in 2008. A combination of severe losses, and lack of investor support, can become a double whammy for banks as they struggle to find liquidity to write down the losses.

But it remains essential to point to the fact that Hong Kong banks are different than their U.S. counterparts in that most of their cash is derived from deposits, rather than share-purchases.

To add further confusion to the debate, even those who have been outspokenly critical of high equity valuations in Hong Kong and China throughout this year are now unworried about further subprime-related losses.

"I think the worst of the news on subprime exposure has already been revealed -- the banks here have been very conservative in their assessments," says Sean Darby, chief Asia strategist at Nomura Bank in Hong Kong. Only six months ago, Darby was warning Nomura's clients that Asian equities would be liquidated heavily to offset losses in the credit crunch.

For now, most investors are waiting for January, to see the lending policy of Chinese banks, which are rumored to be decreasing loan growth to 12%, from 17% in the last two years, due to pressure from Beijing to cool the white-hot economy.

"It's the uncertainty that's the problem more than anything else, right now," says Naroff.

Daniel M. Harrison is a business journalist specialising in European and emerging markets, in particular Asia. He has an MBA from BI, Norway and a blog at

. He lives in New York.