More on all that in a moment. First up today is this little pearler from Bloomberg, "Australian banks, including Westpac Banking Corp. and Commonwealth Bank of Australia, risk more loan defaults as the government unwinds economic stimulus and the central bank raises interest rates, according to Fitch Ratings."

Fitch says it's the small and medium size businesses that are starting to show "signs of stress." The $42 billion in stimulus money - to the extent it went to these businesses - is all spent with little multiplying effect. The government (bearing down on an election) can't give more money away. And with rates rising, businesses are feeling the pinch of higher loan costs.

Fitch reckons all of this will add up to higher bad debt charges for Aussie banks. It says the threat of "large corporate collapses" has receded, though. And the banks themselves don't seem too terribly fussed. They say even the chance of higher mortgage defaults in Australia is "manageable."

Frankly, the banks and the media and the financial industry are incredibly blasé about the risks to the economy and the financial system. We're not two years removed from a major systemic crisis, and most financial professionals are treating it like it was an anomalous "near miss" and not a sign of a more fundamental rot in the very DNA of the financial system.

That rot, we would contend, is the attitude towards debt and leverage. It's a series of embedded assumptions about how to use borrowed money and what to expect (in terms of risk and performance) from asset markets over time. The financial world is using 20th century assumptions for a 21st century world in which the basic premises (the cost and availability of capital) have radically changed.

Take the Commonwealth Bank and its mortgage fund Colonial First State. It has again halted withdrawals from its $850 million mortgage fund after "being caught out by a spike in lending losses," according to Eric Johnston in today's Sydney Morning Herald.

"With rising interest rates likely to spur further mortgage stress, Colonial First State's move suggests the nation's troubled mortgage fund market could face a fresh round of problems after the $30 billion sector was hit by the introduction of the bank deposit guarantee about 14 months ago."

There are three issues here and each gets to the heart of the modern problem with debt, investing, and banks. First is asset quality. The mortgage funds are pools of mortgages or mortgaged backed securities. Colonial First's has a reputation for being conservative. Right.

But in a note to clients yesterday it reported that, "Since the withdrawal offer opened on November 25th, 2009, we have identified a small number of mortgages in the fund's portfolio that have the potential to become bad bets...We have commenced a review of the fund's assets to fully assess these loans and determine the impact on the fund and investors."

We'll take the fund at face value on these comments, although that is generous these days. The withdrawal offer, by the way, is the fund allowing withdrawals as of November 25th. They had previously been halted. That limited lifting seemed to be a sign of normal times.

But these are not normal investments. Any time a security is backed by a pool of mortgages - no matter how vigilant the underwriting standards - asset quality is going to be an issue. Asset values are variable, and funds made up of variable assets are generally not as safe and sound and their prospectuses make them out to be. Keep an eye on the default rates in prime U.S. mortages and you'll see what we mean.

The second issue with the mortgage gunds is that government bank deposit guarantee that came into effect last year. Talk about unintended consequences. When the Rudd government slapped a government guarantee on bank deposits last year, it may have done the Big Four a favour by driving scared depositors into their arms. But it hit the mortgage funds especially hard.

Investors treat those mortgage funds like a high interest bank account that produces a steady, reliable, and secure income. Fixed income with a high yield! But minus a government guarantee, the $30 billion fund industry with over 150,000 investors saw so many redemptions that it had to halt them and freeze investors out from getting their cash.

Reminder: your money isn't really yours unless it's in your hot little hand.

The funding model for the funds industry was seriously strained by the outflows. As we understand it, the funds have three sources of funding: deposits, bank credit facilities, and the mortgage payments it receives from mortgagees (commercial and residential). The bank credit facilities are exercised either to make new mortgage loans or pay out withdrawals that exceed what the fund takes in via mortgage payments.

You can see this train wreck coming. If bank credit tightens up, asset quality declines, and withdrawals (for any reason) accelerate, the model gets stretched. Not to the breaking point. But to the point where you look at the model and reach the conclusion that this is not a safe, steady, reliable way of generating income.

But then there is a whole funds industry in Australia (and the world) built on turning debt into an income-paying asset. Often that debt is collateralised by a real asset (like a house, or a toll road). Just to be clear, however, there is no Income Fairy that makes sure you always get paid in these investments. They only work if the funding pipeline is clear and asset quality doesn't deteriorate.

The trouble in a credit bubble, though, is that plenty of assets get built and valued and prices far above their ability to pay themselves off AND generate returns for investors. What's more, sometimes the assets fail to generate an income stream capable of sustaining the debt service costs. The inevitable result is falling valuations or insolvency. For investors in these schemes, the result is a loss.

The last point worth making about this story is about the idea of income investing itself. We were yapping with our colleague Kris Sayce about the issue the other day. Kris was looking at high-yield listed investments in Australia and examining how they produced the payouts made to investors. Some of them would make Rube Goldberg, Ken Lay, and Bernie Madoff envious with their ingenuity.

The point?

Not all dividend yields are created equal. There is an assumption among today's investors, bred by complacency, that higher yield is always available if you're prepared to take the risk. But the way some of those income streams are manufactured, and the way the funds are structured, is, if not misleading, certainly not safe.

Not that you're going to retire rich on bank interest. But be wary of funds promising safe yields with no risk. It doesn't exist. In fact, we'd be wary of nearly the entire universe of financial investments at the moment. We'll tell you why tomorrow.

You can't blame investors for chasing yield. With real incomes falling in the Western World - as a result of a corporatist policy to off-shore high-wage jobs - the only way most people can achieve a standard of living that matches cultural expectations is to borrow money from the bank. Debt is just a means to an end. And that end is social respectability.

Perhaps that is why bankers have become so blasé about how they risk shareholder money. We're referring to the response of former banker Saul Eslake to the news, commented on by Terry Barnes in the Age on the 13th, that Australian households have $1.2 trillion in debt - or 112% of GDP according to the ABS. That's $56,000 for every man, woman, and little nipper in the country.

In today's Age, Eslake says debt won't "roon" us and that the debt-to-GDP numbers don't convey anything significant. The important numbers, he says, are the debt-to-asset ratio and the debt payment as a percentage of disposable income. By both measures, Eslake says there's nothing much to worry about.

To prove his point, he uses a hypothetical example where a customer walks into the bank with $100,000 in cash, annual after tax income of $100,000 and a request to the bank manager to borrow $200,000 for the purchase of $300,000 home. Elsake says, "The manager would not reject the customer's request for a loan on the grounds that he or she would then have a debt-to-income ratio of 200 percent."

"Rather, the manger would look at the customer's debt-to-assets ratio, which in this hypothetical example would be 67 percent [a $200k mortgage as % of a $300k house]. Banks will normally lend for owner occupied housing up to 80 per cent of the value of the property (or up to 90 per cent with mortgage insurance. No problem there."

No problem there?

We can think of at least one. The main one is the point we made before: the value of the property. The assumption embedded in Eslake's risk assessment is that that the loan-to-value ratio can be that high because house prices generally go up. The borrower is getting an appreciating asset in exchange for his debt. That's a good trade as long as asset prices rise.

It's just worth pointing out the nonchalant assumption. Of course if house prices don't rise, or if they fall, the debt-to-asset ratio would get closer to parity. In practical terms, the mortgagee has a debt that doesn't change and an asset whose value does. During certain phases of the real estate and credit cycle, that is a formula for indentured servitude to the bank.

But what about the ability to service the debt? Eslake says that, "The manager would also consider the customer's capacity to service the loan out of his or her income. Assuming a mortgage rate of, say 7 per cent, interest payments would be absorbing 14 per cent of his or her disposable income, plus a little more for principal repayment. Banks will typically lend amounts requiring up to 25 or even 30 per cent of a customer's disposable income before becoming seriously concerned about his capacity to service the mortgage."

What's left unsaid here is just as important as what's assumed. What's left unsaid because it's assumed is that the borrower will have an income. That's a basic assumption, it's true. But is full time employment over the life of the loan something you can take for granted in an economy like this? Perhaps these kinds of assumptions explain the track record of global bankers in making good loan decisions over the last ten years.

But what's left unsaid is that the bank is obviously happy for the borrower to maximise the amount of his income that goes to service the loan. After all, the bank is getting paid. What does it care how much stress it puts on the borrower? For the bank, the borrower and his stressed out mortgage payments are just as much an asset as the collateral itself, the house.

For the bank, the borrower is a kind of fixed income investment. Mortgagees are literally a cash crop to be planted, farmed, rotated, and reaped cyclically. The bank only really risks a loss if the cost of servicing the loan breaks the back of the borrower. The banks allow for that in their loan loss and bad debt provisions. But generally, if you break your financial back it's your problem, not the banks.

We're not bashing on the banks, mind you. They sell money. It's a valuable service. But we are showing that if the underlying assumptions behind their lending practices are faulty, or not in your interests, you should be very cautious when they tell you it's okay to go into debt. They're in the business of selling you debt. What else would you expect them to say?

Eslake adds, that "Not only would the customer's request be approved more or less on the spot, but mindful of the 'cross-selling' targets, the manger would have had, he or she would have probably also offered a further $100,000 loan for a geared investment in the share market."

To give him the benefit of the doubt, we detect a note of irony in Eslake's telling of this anecdote. He's not endorsing or approving of the scenario. But we think he is saying that under common practices, this is how a bank would behave and that this behaviour is reasonable, prudent, and ultimately, wildly profitable for the bank.

That tells you a lot about the banking sector. It shows you why the financial services industry has every incentive to load you up with debt so you can buy houses and stocks. And in boom times, that strategy appears to make people richer. But when the cost of capital goes up and debt deflation sets in, both banks and their borrowers will regret the debt.

And not just in a financial way, which is bad enough. Debt is not inherently evil. But it is a burden. And a society that loads itself up with obligations it strains to pay the interest on, much less the principal, is a very unhappy, heavily burdened society.

There was a lot more we meant to get today, including cyclical attitudes toward debt. But we've gone on too long already. More on why you should retire now and other financial taboos in Friday's episode. Until then!

Dan Denning
for The Daily Reckoning Australia

• An Insider’s View of the Real Estate Train Wreck, Part II
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• The Problem With a Well-Diversified Portfolio
• How Did Australia Get Caught Up Losing Money in Commercial U.S. Real Estate?
• Equity Asset Allocation and Portfolio Rebalancing Left Out of Superannuation Review

Greece was last night downgraded by ratings agency Fitch from A- to BBB+ and was placed on negative credit watch. That means there could be more downgrades to come.

The Greek budget deficit is currently 12% of GDP. And that makes a mockery of the stability and growth pact of the Euro Zone which requires member nations to have a 3% deficit limit. What a farce.

Not only that, but the Greek government debt will reach 130% of GDP next year.

But the really interesting thing about this situation is to understand what the repercussions of the downgrade are.

The Greek banks have been playing the carry trade by borrowing from the European Central Bank (ECB) and then investing in Greek government bonds. This is a fun game where you borrow low and lend high and then laugh all the way to the bank.

Well, actually they are the bank. So they just laugh.

This is a merry old dance until someone does something really unfair like downgrade the bonds that you're buying! In the last month 10-year Greek government bonds have sold off from 137 basis points over 10 year German bunds (German bonds) to 220 points over German bunds.

The wider the spread, the greater the perceived risk. That's nearly a full percentage point in a month.

When interest rates go up the value of the bond naturally goes down. A full percentage point sell off in yields corresponds to a large fall in the value of the bonds. And Greek banks are full to the eyeballs with Greek bonds.

Now suddenly, the fun game of making free money doesn't seem like so much fun. Because they're losing money instead. Poor banks.

Now let me think, is there anywhere else in the world where banks are borrowing money from their central bank at really low interest rates? Is there anywhere else where they're using that money to load up on long term government debt?

And is there anywhere else where government's interest rates are kept low by all of this buying by the banks?

Hmmm. How about America? The land of the free... lunch... for banks.

This is the most enormous carry trade. The government gets what they want by keeping their interest rates low at a time when they need to borrow a huge amount of money.

The Chinese aren't buying as many bonds as they used to because they're not selling as much stuff to the Yanks. Plus they don't trust the Americans not to turn their currency into little more than toilet paper.

Not only that but the price of oil is a lot lower than it was a few years ago so the Middle East isn't recycling as many petro dollars into US bonds either. Therefore the banks have been enticed into buying US bonds by lending them money for nothing so that they can make the difference in the yield.

The only problem with this game is that the banks are loading up on bonds at a time when interest rates are at their lowest in a generation. Which way do you think yields are going to go from here over the next few years?

Especially since last night we were told that both the UK and the US are at risk of having their AAA credit rating downgraded as well!

Oh dear. Suddenly it's starting to look a lot like Greece. Except 1,000 times larger.

What appears to be free money for US banks now, could end up being a noose around their neck before long. Who's going to bail them out then?

That's led to the markets taking a battering on the back of the news about Greece.

The main point to take out of this is that Dubai has been found to have no clothes on, and now the Greeks a few weeks later. Who else is swimming naked?

Credit default swaps on sovereign debt around the world have been going higher and higher in the past few months. The term "treasury yields" has become an oxymoron because there is no yield and stock markets are resting near their highs after rallying 60% in less than a year.

Something has to give before long.

The free money from the Fed is coming face to face with the reality of economics.

It's for that reason I've positioned Slipstream Trader subscribers to be as market neutral as possible.

We're short one of the Australian banks, a transport stock and an oil stock. But we're also exposed to upside from new technology in the energy sector and to the recovery in fertiliser stocks next year.

There's also some exposure to the cyclical recovery in the Steel sector.

The philosophy I'm using is to take some money off the table as quickly as possible. That way I can lower the risk profile of the trade. In effect it turns the trade into a free call option.

As the positions are sitting now, there's the potential to swipe some decent short term profits, and then leave the rest of the position to pick up some longer term gains.

As any trader will tell you, it's important to be nimble in responding to any signs of a sustained pullback in prices. Because I've no doubt that when the music stops on this rally, the sell off could be vicious and quick.

Memories of last year remain fresh in many people's mind. They won't need too much prodding to press the panic button.

Murray Dawes
Editor, Slipstream Trader
for The Daily Reckoning Australia

• U.S. Bonds Better than Greek or Other Sovereign Bonds
• The Single Best Trade for 2010
• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• E-mail Update for Paid-up Subscribers Only
• Is It Really the End of the Dollar Carry Trade?

But there are some strange and perplexing crumbs to collect from news reports this morning. Yesterday we learned that for the first time in 70 years, yields on 90-day U.S. government securities were briefly negative. Investors - if you can call them that - were happy to loan money to the U.S. government for 90 days - and lose money.

Normally, the only thing that could explain such an unusual preference for liquidity at the expense of return is abject terror of equities. But stocks have been moving on up nicely. The plunge in short-term yields can't be explained in terms of "risk aversion." So what's behind it?

It's a pretty interesting question if you simply phrase it: what kind of investor is happy to lose money over 90 days? Is the move to the short-end of the U.S. yield curve part of a broader shift out of longer-dated maturities (10 year notes and 30-year bonds).

Even the New York Times is starting to freak out about the amount of U.S. debt that must be rolled over in the next four years. The times article points out what we pointed out at the beginning of the month: U.S. debt is far more interest rate sensitive than ever before, which makes it potentially far more expensive to service if interest rates spike.

But that doesn't get us any closer to explaining the near-zero short-term yields. Granted, they were low to begin with. Maybe they are only unusual because they descended from such a low base to begin with. But is there another explanation that sheds light on what's going on in the markets?

One possibility, and we admit we are speculating here, is that banks are beefing up on liquid assets to bolster their capital positions. Whether this action corresponds with the end of the year or some other force, well, we have no idea. But without a corresponding fall in some other asset, the fall in short-term bond yields must represent a preference by institutions for T-bills and notes right now.

Our colleague Kris Sayce thinks institutions might be using T-Bills as collateral for other loans, pyramiding their way up to new balance sheet growth. It's possible. It's also possible that banks are buffering their capital positions in anticipation of...turbulence.

In today's Age, Eric Johnston begins his story with the headline, "Australian banks fail new capital test." Gee, that sounds familiar! "Ratings agency Standard & Poor's has warned that nearly all the world's big banks - including Australia's major lenders - have insufficient funds to cover their lending exposures and risk a ratings downgrade unless they move to bolster their balance sheets over the next 18 months.'

That might sound odd, considering that Aussie banks tapped equity markets for $20 billion in new equity last year. But did the new money actually bolster the balance sheet? Johnston reports that, "While Australian banks benefited from having a large exposure to low-risk residential mortgages, S&P said a narrow geographic and business base counted as a negative. It also noted that the capital raisings by the local banks had been used mainly to fund acquisitions or balance sheet growth."

More home lending baby!

It's probably a stretch - given we have no evidence whatsoever - to suggest that global banks (Australia's included) are bolstering capital by moving into short-term U.S. debt. It's also arguable that U.S. debt - even short-term near cash bills and notes - are a quality asset to be adding to your capital mix. But it's a lead and we're chasing it down.

Why does it matter? Well, the last time yields went negative like this was in 1938. That preceded a collapse in the stock market and the onset of the "Great" part of the U.S. Depression. Of course in 1938 the Fed began tightening up monetary policy again (prematurely, some argue). It won't do that today.

Meanwhile, some other troubling pieces of information from the bond market. Bloomberg reports that Telstra, "scrapped a domestic bond sale plan after it couldn't reach an agreement with investors on the terms of the securities. " Apparently bondholders "wanted the 10-year debt to include assurances compensating them if Telstra's credit rating gets downgraded."

Geez. Creditors are getting pretty choosy these days, aren't they?

There are other stories we'd like to have a closer look at today. For instance, a Brazilian steel-maker has plans to buy 16.5% of coal explorer Riversdale Mining for $190 million. This fits the pattern we described earlier this week of major international companies seeking to buy independent junior miners in order to guarantee resource supply. We'll have to ask Dr. Cowie what he thinks.

Time to board the plane now and cross the Tasman. We'll report tomorrow from the east coast of the North Island. Until then.

Dan Denning
for The Daily Reckoning Australia

• Surge in Chinese Bank Lending in 2009 Leads to Fall in Bank Capital
• U.S. Bonds Better than Greek or Other Sovereign Bonds
• If Unemployment Numbers Get Better So Will the Economy
• Fed Willing to Print Money to Buy More Bonds to Keep U.S. Interest Low
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis

The $2.5 billion listing of Myer is expected this week. And what better way to celebrate a six-month reality-defying rally than the listing of a consumer-driven business? Happy days are here again!

Not that we have anything against Myer. It's a good store. We recently bought a sweater there to get us through Melbourne's Antarctic spring. But you know our position here at the Daily Reckoning.

You don't wash out twenty years of mis-allocated credit with a mild recession and then return to the glory days of the stock market. We are still in the middle of a large deflation in credit-backed financial assets. The Myer listing may give the index a boost. But it's not going to change the big picture.

The big picture is that across the Western world consumers are dialing back the spending and turning up the caution. A sea change in attitudes about the future is taking place. For example, the U.S. Commerce Department reported that durable goods orders fell in August by 2.4%. Take away government subsidies for new cars and households are not buying big ticket items.

And then there's housing. Existing home sales fell by 2.4%, the first decline in five months. Here's a warning: watch out for a second massive wave of foreclosures in U.S. housing. U.S. banks, thanks to a relaxation of mark to market accounting rules, have been able to put off the day of reckoning on what to do with millions of non-performing loans. That day, though, is coming.

There are other looming issues like commercial real estate. But we know you must be tired of hearing all that. After all, that is America, not Australia. It would be much easier if we quoted the impossibly smug Kevin Rudd that the government has saved the day. But that just ain't the case.

By our reckoning, the second dip of the global downturn is upon us. Government policy (monetary and fiscal) has merely lured people into believing there is no real cost for decades of bad investments. But the truth is that a lot of stock analysts and economists have simply miscalculated the magnitude and severity of what happens to the real economy when the world's largest ever credit bubble bursts.

Of course we could be wrong. Nobody knows what's going to happen. You hedge your bets and continue to plan for the future. But we're about to find out if we've been living through a modern version of 1930, when a false recovery in the economy was the prelude to the "Great" part of the "Great Depression."

Maybe this will sound like a bunch of whining by the end of the week. After all, three of the big four Aussie banks will report results this week. There will be billion dollar cash profit figures tossed around. But as we said last week, the earnings performance of financial firms in the last six months is a sham.

Cost cutting, government loan guarantees, and an infusion of central bank credit allowed all the big financial players to trade their way to profits for a few quarters. What we don't expect to see is that the Australian banks are suddenly keen to expand their loan books or that their underlying businesses are fundamentally better now than they were twelve months ago. A simple question: just where will the profits come from now?

In the meantime, keep an eye on oil. Sometimes the oil price is driven by speculators. Sometimes it's driven by expectations for the economy. And sometimes it's driven by flat out geopolitical fear. We think now could be one of those times were geopolitics drives crude. Why?

We got a note from a commodities trader in Chicago over the weekend. Up at three a.m. as we're getting over our jet leg we read, "In the big geopolitical dance that has dominated recent headlines there remains one player that all the action seems to swirl around. That player is Iran.

"President Obama's announcement of the discovery of a second 'secret' uranium processing facility with shouting distance of the Shiite holy city of Qum has raised the stakes in what is quickly becoming a very dangerous game. If you read between the lines, nearly all of the geopolitical maneuvering over the past few months has been about the same thing.

"Obama dumps Bush's land-based missile system for a sea-based one that poses far less threat to Russia. Russia - without admitting it, of course - then becomes more accommodating to sanctions against Iran. Israeli Prime Minister Netanyahu goes to Russia without telling anybody and gets caught doing it. Why?

"Certainly not to talk about the weather. We believe Netanyahu was there for a specific purpose: to warn Russia what would happen if Iran did not stop producing bomb-grade uranium. We also believe Obama's controversial move was designed to give Russia political cover to pressure Iran to do just that. Now that a second uranium-producing facility has been found, the stakes have risen again.

"If some sort of political solution to the Iran crisis is not found within the next few months, Israel will strike - with or without the 'permission' of the United States and the price of oil will react accordingly. The global slowdown is currently focusing all the attention on demand, but the biggest bullish factor out there is ultimately, supply. Remove Iranian oil from the market and the old highs of $147 per barrel could be tested quickly.

"Is this going to happen? We hope not. However, our read of the geopolitical events of the past few months makes us think it could be a distinct possibility.

Dan Denning
for The Daily Reckoning Australia

• Iran Suffering from Own Version of Peak Oil
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• Are Farm Prices Destined to Rise as More People Compete for Food?
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Are Australian banks going to be able to sustain their dividends? Over the last ten years, bank fee income has become a big driver of bank profitability (and the source of the dividends paid by banks). The credit crunch has crunched the amount of money banks make lending money. The net interest margin - the difference between what Aussie banks pay to borrow from overseas and what they make lending domestically - has been shrinking.

Here's a question then...if the bank's cut their fees, are they cutting off their own heads? For example, NAB is axing its penalty fees for overdrawn accounts. A Reserve Bank study published in May showed that so-called "exception fees" resulted in $1.2 billion in fee charges to Aussie households - or 10.34% of total bank fee income for the year.

Total domestic bank fee income for Aussie banks was up 8% last year to $11.6 billion. You can see from the chart below that fee income has been growing by about 11% the last few years. But keep in mind that aggregate profits of the Big Four banks last year were $15.9 billion. That means fees accounted for nearly 73% of total bank profits, according to our back-of-the-envelope math.

This actually shows you how bad a business banking typically should be. You can only make money lending money by taking more risk (both as a borrower on international capital markets and a lender on the domestic residential real estate market). If you take less risk, you have to make up for the fall in income by raising fees, which infuriates customers and law makers. Banking isn't a low margin business. But maybe it's headed that way.

Speaking of cash, should BHP sending more cash to share holders? That's the question some investors are beginning to ask, according to Bloomberg. Our co-Melbourne based commodity giant told investors that its record of seven consecutive profit results has ended. Underlying full-year profit for 2009 was down 30% to $12.8 billion on the back of lower commodity prices and demand in the fiscal year.

But the company left its dividend in line with the second half of last year at US 41 cents per share. It did not increase the dividend. However that dividend is 17.1% larger than the year before. So why not give back more cash to investors?

Mining is a capital-intensive business. BHP has been around the commodity block a few times. It knows that to expand production when commodity demand picks up requires cash. You have to keep that cash around for a rainy day for when the cycle turns.

Or, conversely, if the cycle turns down again - as it might if the global recession takes a second, depressionary dip - the cash is a bulwark against weak demand. It's also nice to have a war-chest to buy out asset-rich, cash-poor firms that cannot ride out a sustained drought in earnings when production is shuttered. BHP remains in a better capital position than nearly all its global rivals.

But if you don't want to put your capital risk in common stock, why not have a look at the new inflation-indexed bonds being issued by the Federal government for the first time in six years? Yesterday's Age reports that the Australian Office of Financial Management plans to introduce the bonds back to the market in September or October of next year.

Finding assets that deliver a return greater than the rate of inflation is going to be the big challenge in the years ahead. Inflation-indexed bonds are one strategy. Small cap growth stocks are another (especially precious metals and energy stocks leveraged to higher gold and oil prices). Emerging markets are a third. We'll ask the Australian Wealth Gameplan editor what he thinks of these bonds and get back to you tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• Note to Australia: Buy Resources, Not Banks
• Aussie Banks Addicted to Foreign Borrowing
• One in Four US banks Announce Unprofitable Quarter

Let's begin with BHP. The company announced yesterday it was cutting six thousand jobs globally. It will shut down the nickel operation at the Ravensthorpe mine indefinitely and reducing production at the Mt. Keith Nickel mine. What's more, it will reduce coking coal production by 15% in Queensland and lay off 1,000 workers. BHP is the world's largest producer of coking coal, so this tell you how much the global demand for steel has fallen off.

For its, troubles BHP is taking a $1.6 billion charge against earnings. But if you had any doubt, this is clear evidence that an organic contraction is now firmly under way in the global mining sector. With the leverage gone from futures markets and the credit gone from lending markets, the mining industry is behaving more or less as it has in past cycles.

What should you do? It is hard to make an argument for base metals and industrial commodities when you have a full blown recession in global industrial production. The saving grace for the resource sector is that market economics (cycles) are still in force. Production will contract and many firms will be swallowed up or disappear.

Then, after the liquidation of non-productive investment, and when demand begins to grow again, it will eclipse reduced supply. But that is not likely to happen this year. It's hard to see a recovery in either earnings or final demand this year. Or perhaps even next year.

That doesn't rule out AGMOIL , though. Yesterday, we mentioned that there are three major resource sectors that DO look like they have the chance to increase earnings through scarcity/higher prices this year: agriculture, precious metals, and oil and energy.

As for agriculture, our U.S. colleague Chris Mayer writes on the subject in today's essay. You've read about gold here before, so we won't repeat it. And oil and energy stocks are the topic of this month's Diggers and Drillers. You can read more about them in the January issue, or in next week's Daily Reckoning.

One further point on this. If you take the simple Permanent Portfolio strategy we outlined yesterday, it is not hard to fit the AGMOIL ideas into it. For example, investors with a higher tolerance for risk who want more money in equities and less in cash might choose to put more money into energy stocks.

Or, if you like a little leverage in your 25% allocations, there are leveraged ETFs for currencies, indexes, and precious metals. One might go long the Swiss Franc with the Swiss Franc Currency Shares ETF (NYSE:FXF). Or one might buy put options on the British Pound Sterling Currency ETF (NYSE:FXB), although you'd have to careful on that as volumes look a little light for the puts.

Why those two currencies? The Swiss Franc has a reputation for being better managed than other paper currencies. Jim Rogers likes it. Jim is not as fond of the Pound Sterling, which he says is, "finished." "I would urge you to sell any sterling you might have," Rogers told Bloomberg. "It's finished. I hate to say it, but I would not put any money in the U.K."

By the way, a word of warning. ETFs are no sure bet as a way to profit from currency moves. The chart above shows that the Swiss Franc ETF and the Gold ETF (NYSE:GLD) have both outperformed the S&P 500 on a relative basis over the last six months. But yesterday, State Street (NYSE: STT), which is one of Wall Street's leading custodians (it holds securities in safekeeping for investors) reported a 71% drop in Q4 earnings related to losses in its bond portfolio.

Investors punished the stock, sending it down over 60%. But the investors were more worried about further unrealised losses that could, ahem, "impair" its capital. We're not sure how the ETFs run by State Street would be affected by more...impairment. We'll look into it. And we're not saying ETFs can't be a handy tool to use in various Permanent Portfolio Models that have different levels of risk.

It's just a good reminder that in an age of asset deflation, everything in the equity market has risk, even if it's a security designed to correlate to an asset (like gold or oil), or double the downside performance of the S&P (the Rydex family of funds). The ETF managers use leverage and management to achieve their returns. And that is certainly not without risk these days.

But hey, isn't the stock market all about risk? Entrepreneurs take risks. And the investors who back winning entrepreneurs are rewarded. It's pretty straight forward. That's why Harry Browne had an allocation of 25% to growth stocks in his Permanent Portfolio, designed to prepare for the coming devaluation. You want an investment that grows at a much faster rate than the rate of inflation (which comes after asset deflation has hammered financial assets).

Kris Sayce thinks he's found just such an investment. Or investments! "I've been telling Australian Small Cap Investigator subscribers that they should only be considering two types of share market investment at the moment. One is stocks that are paying a sustainable dividend at a decent yield. The other is growth stocks - but only in the small cap sector.

"In a market like this we don't know which companies are going to be around tomorrow morning let alone in six months. And that goes for any company - big or small. So, in a high risk environment like today you want to be looking at a high potential return for your growth stocks. Buying blue chip growth to get a 10-15% return over 12 months isn't worth it. But if you have even just 10%-25% of your portfolio in a number of small cap stocks you could be looking at returns of 50%, 100% or 200% in 12 months."

"And if the stock market continues to go down? Well, hopefully your dividend payers will continue to pay, and your downside on the small caps is not likely to be much greater than if you were in blue chips, and you have put at risk a much smaller allocation of your portfolio. Small cap growth and any-cap income are the two best plays for 2009."

Hear hear ! And now hear this! Great Britain could be headed for bankruptcy, according to an article in yesterday's Telegraph. The article reports that London is in danger of becoming Reykjavik on the Thames.

Brown writes that in Britain, "The possibility of national bankruptcy is not unrealistic." "It is finally dawning on the Government," he adds, "that the liabilities of the British banks grew to be so vast in the boom years that they now eclipse the entire economy. Unfortunately, the Treasury is pledged to honour those liabilities because it has guaranteed not to let a British bank go down."

Now you begin to see why Rogers is so bearish on the Pound. The British government may not have the resources to honour the liabilities of British banks, at least not without raising taxes or printing a great deal of money. Raising taxes drives away wealth producers. This is what happens when you turn your economy into a leveraged hedge fund that takes massive risks. So what do you think the Bank of England will do?

Start the presses! Here come da money printing.

Not that that dealing with the Credit Depression is exclusively a British problem. The Brits face national insolvency. Here in Australia, it's a lack of lending. Enter the Rudd.

"The federal Government could soon become lender of last resort to Australian businesses, with the creation of a multi-billion-dollar scheme partly funded through the sale of commonwealth bonds," reports today's Australian. This is not the same as money printing, mind you. But it does show you how quickly the nationalisation of lending is being accomplished (or embraced) in Anglo-Saxon countries.

And a quick follow up to yesterday's discussion of technically vulnerable Australian bank stocks. ASIC has extended the short-selling ban on stocks by another six weeks, as of last night. You can bet that the extension was directly related to the carnage in American and British banking stocks the day before. But we're not so sure it'll work. Here's why...

Current shareholders of commercial banks in both America and Australia realise that if asset values are falling and capital must be replenished, it's going to have to come from somewhere. That somewhere is likely the government or the Central Bank.

For example, in America, the six large banks (Citigroup, Bank of America, Wells Fargo, JP Morgan, Morgan Stanley, and Goldman Sachs) have combined assets of $8.6 trillion and combined liabilities of around $8.5 trillion. Does the U.S. government even have the resources to guarantee those liabilities or provide for losses in those assets?

Maybe it does. Maybe it doesn't. Either way, current shareholders realise that nationalisation or help from the government is going to come with conditions. In other words, current shareholders will get diluted if the Feds get involved. Or it will come with some kind of condition on mandatory lending to business and households (not something banks want to do at the moment).

That's why shareholders in North American and Europe said "Sayonara!" to bank stocks on Tuesday. They're getting out before the government gets in. They're probably also realising that in a Credit Depression it's pretty hard for banks to grow earnings. There's not much a shorting ban can do to prevent existing shareholders from heading for the exits.

What's next? A ban on all selling?

Yesterday we promised a discussion about fair value versus mark-to-market accounting. It will have to wait. How to repair financial sector balance sheets is suddenly the urgent question of the new Obama Administration. But the subject is too complicated for today.

Instead, a note on breathing to help you through your day. In "The Art of Learning," former chess prodigy Josh Waitzkin (Searching for Bobby Fischer) writes about how to learn. Waitzkin was a world chess champion at a young age, and later taught himself the art of Tai Chi push hands and one won a world title at that too. It turns out breathing is important to everything!

"A large obstacle to a calm, healthy, present existence," he writes, "is the constant interruption of our natural breathing patterns. A thought or ringing phone or honking car interrupts an out-breath and so we stop and begin to inhale. Then we have another thought and stop before exhaling."

"The result is shallow breathing and deficient flushing of carbon dioxide from our systems, so our cells never have as much pure oxygen as they could. Tai Chi meditation is, among other things, a haven of unimpaired oxygenation."

All life is oxidation. So don't just inhale. Exhale too! Happy breathing until tomorrow.

Dan Denning
for The Daily Reckoning Australia

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Is it a big deal if you're an investor? That depends on whether you believe the banks are a buy. If one bank is buying another bank, then at least one bank thinks banks are a buy. But why? And is what's good for one bank good for the investor?

The question, as always, is where earnings growth is going to come from? In that light, the Westpac move is all about growing the loan book through acquisition. Growing the loan book means putting more Australian in debt. We'll get that in a minute. But let's take a quick look at the details first.

First, if you exclude non-recurring items, cash profits at Australia's big five banks grew by just 1.1% in the first half of 2008 compared to the year before. During the biggest credit crunch of the last thirty years, that's not awful. But it's not good either. By the way, all the data that follows, unless otherwise indicated, is taken from the KPMG survey "Major Banks: Half Year 2007/08." It's an excellent read. Seriously.

Aussie banks didn't face massive losses from bad housing loans (although at least one bank, ANZ (ASX: ANZ), took big losses on loans to stock brokers). So what ate into profitability? The "net interest margin" declined for all five banks in the first half of '08. The interest margin is the difference between what Aussie banks pay to borrow and what they pay out interest on deposits.

The credit crunch has raised the cost of "wholesale borrowing." ANZ's interest margin decline from 2.24% to 1.99%, Commonwealth Bank's (ASX: CBA) from 2.22% to 2.17%, NAB's (ASX: NAB) from 2.33% to 2.18%, Westpac's from 2.25% to 2.05%, and St. George's from 2.07% to 1.92%.

So here's the question, dear reader: if you're making less money lending money because the cost of money has gone up, how do you make more money? You make it up on volume.

Despite the decline in net interest margins, total net interest income actually increased by 9.8% in the first half to $17.6 billion. The banks managed that by growing assets by 19.9% in the first half compared to '07. Growing assets by that much is an accomplishment during a bear market in credit. How did the banks do it?

The banks grew their lending portfolios by 16.1% in the last twelve months ended March. Consumer lending (housing, credit cards, personal loans) grew by 11.2%. Business lending grew by 24.5%. Total bank assets in Australia now exceed $2 trillion.

Now THAT's how you grow your way out of a credit crisis. You lend more. It could, of course, be troublesome if you look at bank assets as other people's liabilities. Debt levels are already high at the household level. For banks to grow assets, household debt levels would have to grow even more and business borrowings would have to rise as well.

The trouble with growing your assets to drive your earnings is that you take increased credit risks to do it. This was the problem for the Government Sponsored Enterprises in the States and led to massive blow outs in their balance sheets (the regulators came in late to restrict the growth in balance sheet assets).

Eager to drive earnings and please shareholders (and make some money on stock options tied to earnings growth) bank managers in the States grew the balance sheet with little to no regard for asset quality. That is one simple explanation for how a mortgage lending bubble gets started.

Here in Australia, if banks are going to continue growing assets, the housing boom will have to keep booming. This is problematic too, with housing already so unaffordable. For example, the Australian Bureau of Statistics reported today that the number of home-loan approvals fell by 6.1% in March.

Higher interest rates are discouraging demand for housing loans. Yet the banks have to loan more to make up for declining margins. But the more they loan, the bigger the risk they take that the loans will be non-or under-performing.

Is there any way out for the banks? Well, they could hope for an increase in net interest margins. This would lead to a decline in the cost of borrowing money. The banks could leave the interest rates they pay on deposits fixed, and benefit from the lower cost of funding. An end to the global bear market in credit would help, then.

Of course, there's another way banks can grow earning without growing loan volumes. You know it well! Fees!

If profitability on loans is declining (and it is), the banks could make it up charging you more fees (not that they would ever do that). The growth rate in bank fees has actually declined, if you peruse the data from the Reserve Bank. But bank fees, as you can see from the chart below, contributed nearly ten billion to bank's income in 2008-basically half of a full year's profit.

Source: Reserve Bank Statistical Tables, Domestic Banking Fee Income, Table F6

There's consolation in that massive income from fees if you're a bank shareholder getting a dividend and some capital appreciation. But if the worldwide model of growing asset values through debt is under massive attack in the U.K. and the U.S., then why would it be terribly different in Australia?

Unless margins improve, banks will either have to raise fees to continue earnings growth, or expand the loan book. With rising interest rates, expanding the loan book is going to be hard to do, even if that's what you want to do. Westpac must know this and decided to take a short cut to balance sheet expansion: acquisition. Does this mean organic growth is dead? Hmmn.

Dan Denning
The Daily Reckoning Australia

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