But here is where the world of super collides with the world of the credit crunch. Aussie corporate bond issuance has increased as access to foreign bank loans tightened up in the last two years. Domestic savings (in the banks) may be inadequate to fund the country's credit requirements. But if borrowers could siphon off a bit of the super money...that would be the ticket.

It's this whole issue of Australia still being a net importer of capital. It's a major economic vulnerability. And there are some bankers who are already looking for a way around it. In today's Age we read that, "Commonwealth Bank of Australia Ltd (CBA) group treasurer Lyn Cobley said there was a place for the government to mandate more superannuation savings to stay in Australia to fund some of the lending that was now funded from offshore."

Let us deconstruct. Super is compulsory. Now CBA (or one of its officers) has broached the idea that compulsory super money be compelled to invest in corporate bonds." Not much choice there for you, is there? Your money being taken away and being made to invest in assets not of your choosing.

All of that as a solution to the worst two years of super performance in memory? In today's essay, Kris Sayce shows why now is not the time to be complacent about super. Even if this year's rally has erased some of the sting from the last two years, there are a lot of good reasons to fundamentally reconsider your relationship to super.

Or you could take up Texas Hold 'Em poker. Joe Cada, a 21-year old college dropout from Detroit won the World Series of Poker (and $8.5 million) yesterday...with a pair of nines! A pair of nines?!

Cada's story is a great American vignette. News reports say he is the son of an out of work auto-parts design engineer. His mother deals black jack at the Motor City Casino in Detroit. Cada is the youngest winner in the history of the tournament, and beat a logger from Maryland and a Frenchman in a fourteen and a half hour final session. He went all in on the last hand.

It's great for Cada. It sounds like he's a pretty good poker player. But it may not be so great for America that the only way a young man from Detroit can make it big in the United States is to win a poker tournament in Las Vegas.

Dan Denning
for The Daily Reckoning Australia

• Your Average Australian Super Fund
• Is Kevin Rudd Planning to Steal Your Superannuation and Bankrupt Your Retirement?
• A Look at Debt and Super
• Actively Managed Superannuation Funds Have Not Had a Stellar Few Years
• Attention Dr. Ken Henry: Government Could Make Employee Voluntary Contributions Compulsory

Before we forget, drinks are confirmed for Tuesday, December 9th at the BLVD Bar, located at 6 Queensbridge Square on Southbank in Melbourne, from 6:30pm until (perhaps) midnight. Finger food will provided, and the first drink is on the DR. But after that, you're on your own for food and beverages. Quite a few readers are eager to toast in the New Year, or say goodbye to the old one. Either way, see you then!

On to the markets. Australia's biggest mortgage lender says its bad doubts could double this year. Commonwealth Bank said loans it made to now-defunct firms Lehman Brothers and Allco. Bad debts at CBA were nearly A$930 million in 2008, compared to $496 million the year before. Ouch.

The bad loans are still a small percentage of the total loan portfolio. You can see, though, that Aussie banks are trying to beef up their core capital to provide for future loan losses. NAB's $3 billion institutional raise endeared it to investors. CBA may have to raise new capital as well, if only so its Tier 1 capital ratio matches that of its peers.

Huh?

Tier 1 capital is a bank's core capital-the amount of equity it has to withstand losses. It's actually a ratio of core capital to risk-weighted assets. You might be surprised that, according to the Australian Prudential Regulatory Authority (APRA, or the agency that regulates Aussie banks), the minimum capital adequacy ratio for Aussie banks is just 4%.

They prefer it to be much higher, though, around 8%. And you can see why. Unusually large and unplanned losses in a bank's asset portfolio could wipe it out if it didn't have sufficient high quality capital on the balance sheet. This, by the way, is the reason the Paulson TARP plan in the U.S. morphed from a plan to buy bad mortgage assets on bank balance sheets into a direct inject of capital. It was meant to bolster the core capital positions of banks with troubled assets (cross fingers, hope asset quality improves.

Australian banks-at least the big four-do not appear to require any of the major capital injections taking place in Europe in the U.S. The banks appear to have parked a lot of their residential mortgage backed securities with the RBA, though (for safekeeping of course). It goes to show you, though, that banking is an inherently risky business.

Meanwhile, on Wall Street, the Dow fell by nearly five percent and the Nasdaq broke its 2003 low. It's likely that stocks all over the world are going to test the 2003 lows again, and probably crash right through them. But we honestly thought that wouldn't come until the first or second quarter of next year, and would be preceded by a significantly rally in shares.

That's still possible. But the drumbeat of hideous economic news is pulverising investor sentiment. What's so alarming about this market is that the popping of the credit bubble is not just forcing all asset classes much lower. It's bringing the government into play as the key economic actor of the next five years (or much longer, perhaps). It's like a giant global Red Dawn. Yikes.

Yesterday we promised to talk more about Aussie resource juniors. We're running out of space today, so we'll save it tomorrow. However, picture a world in which your great grandchildren have no idea what a petrol station is...because there aren't any. It's a world where petroleum is a construction material, not a fuel for internal combustion engines. And it's a world where the most valuable resource isn't paper capital...but energy.

Some reader mail?

Dear Dan,

As always, a well-written and thought-provoking article. But no Bill of Rights for me thanks . The problem with such a Bill is that unelected Judges can have an absolute birthday... at our expense. I do not want Activist Judges to dictate my life. While parliaments can be composed of a bunch of boofheads... at least we can vote the bastards out. Activist Judges are far more frightening than an absence of a Bill of Rights. Besides, we appear to have got along pretty well without a Bill of Rights.

Regards

Bob M.

Ahh yes. What to do with the boofheads? Vote them out!

From what we can gather, the worry about a Bill of Rights is that it becomes a specific list of things which you as a citizen may not do. Or worse, it becomes a laundry list of so-called rights the government extends to special interest groups. It becomes a list of particular laws rather than general principles.

That doesn't sound like a Bill of Rights we'd want either. But then, as we understand it, a Bill of Rights is a very general list of negative rights. Negative rights specify what the government is NOT permitted to do. Positive rights, like the ones a lot of readers seem to hear, specify what YOU are permitted to do.

You'd want a Bill of Rights that negates the government's power to make laws to tell you what you can and can't do. The whole point is to remove critical freedoms like freedom of speech and freedom of the press from courtrooms and legislatures and put them, in a constitutional sense, above judicial or legislative deliberation. The government can't touch them because they are off legal limits.

Of course other countries have had Bills of Rights that didn't succeed at all in guaranteeing liberty. Weimar Germany is a great example. But if you'll forgive us for being a barbaric American, we'd suggest that one reason these Bills of Rights didn't help in the practical defence of liberty is that they did not include the right of the people to keep and bear arms.

The founders realised that having rights-freedom of speech, of the press, or religion-was no good if you didn't also have the right to defend yourself from people who would deprive you of those right unjustly, including the government. What good is it having rights that can't be taken away if you aren't able to defend yourself from people who want to take them away?

Of course in a civilised and free society, a man wouldn't generally have to worry about the State's monopoly on violence infringing on his rights. None of us spend much time defending our rights to worship and speak freely because we enjoy them without challenge. For now.

Keep in mind the second amendment to the U.S. constitution-which clarifies that a man has the natural right to defend himself with arms-has its origin in British common law and not the violence of the American frontier, as is often suggested by people opposed to self-defence.

The 1689 English Declaration of Rights recognised the right of British people (although only Protestants) to bear arms in their own defence. A similar right to bear arms was introduced to the U.S. House of Representatives by James Madison with two big changes. One, it applied to everyone, not just Protestants. And two, it was not an Act of Parliament but an amendment to the Constitution.

That means it was not a right that could simply be taken away by a future Act of Parliament. To modify or eliminate a Constitutional right requires a specific and fairly difficult process. But remember, we're not talking about "rights" like health care, education, or other socially desirable outcomes.

Parliaments of elected men and women are free to pursue those policies inasmuch as they represent what people want their government to do with their tax dollars. That's consensual government, after all. But a clearly defined bill of negative rights simply tells the government what it cannot do with respect to individual liberty. That seems pretty handy.

• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• Bank Stress Test Not Stressful Enough
• Aussie House Prices Face “Perfect Storm”
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• Americans Behind On Mortgage Payments

The earnings growth rate was the slowest in four years, according to Bloomberg. You knew it was going to be hard to grow earnings in the middle of a credit crunch. But the more disturbing number is the near doubling of bad debts.

Bad debts rang in at $496 million last year. This year, they came it just under a billion dollars, at $930 million for the fiscal year. Bad debts as a portion of total loans went from 0.14 last year to 0.26 this year. Commonwealth Bank shares are down about two percent as we write.

You can see that bad debts as a percentage of the total loan portfolio are still pretty low. That's good. But they are rising. That's not good.

There are some interesting nuggets in the consolidated balance sheet and cash flow statements, though. For instance, banking income grew just eight percent, reflecting the higher cost of wholesale borrowing. Commonwealth Bank made nearly $300 million from the Visa IPO in America. Meanwhile, funds management income was up 23%.

Here's a thought. If the Federal government lifts the required contribution to Super from 9% to 12% (or even 15%) you can see that funds management income going even higher, can't you? What a great racket. Free money for the funds management business, courtesy of the Parliament. No performance required!

Funds management fees aside, the banks are still going to have find new ways to make money if demand for loans goes down. With consumer and business confidence low and interest rates still high, the banks will lean on fee income...unless they get into the credit card business more aggressively, as one colleague suggests they might.

Dan Denning
The Daily Reckoning Australia

• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• Buying and Holding a Bad Strategy if Bank Earnings Remain Unpredictable
• RBA Buys $780 Million in Residential Mortgage-Backed Securities
• You Can Never Be Sure How Fabricated Income and Earnings Are These Days
• CBA Sees More Bad Loans

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

• Banks or BHP?
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• In Europe, Banks Borrow Money and Lend it Back to the Government
• Big Australian Resource Stocks Up 24% in 2008
• One in Four US banks Announce Unprofitable Quarter

Jesus wept.

It may be determined to be different, but Commonwealth Bank is facing the same margin squeezing credit crunch as all the other Aussie banks. "The net interest margin, a measure of lending profitability, narrowed 5 basis points to 2.17 percent as funding costs increased A$100 million amid tighter global credit markets. Provisions for bad debts jumped A$138 million as interest rates rose," reports Stuart Kelly at Bloomberg.

No one will have much sympathy for Commonwealth Bank. It raised interest rates on variable home loans by 30 basis points after the Reserve Bank's last quarter point rise. On top of the 10 basis point preemptive raise in January, Australia's largest home lender now charges 8.97% for its variable rate mortgage loans.

By the way, this is still one basis point lower than NAB's variable rate and lower than ANZ's variable rate of 9.02%. But all the banks are in the same neighborhood, aren't they?

And are they a buy? We looked at the chart for Macquarie Bank (ASX: MQG) yesterday and suggested that the stock might have at least some technical support at $60. But a line on a chart can only tell you so much. What is the business really worth today?

"In our view," writes our friend Greg Canavan at Fat Prophets, "the market does not believe the earnings forecasts for the sector. Neither do we. As we have stated in previous reports, we believe bank sector earnings have peaked and profitability is likely to decline as the cycle turns down."

"The chart below from the Reserve Bank of Australia shows the long term profit growth performance from the major Australian banks. Since Australia's last recession in the early 1990's, the banks have produced exceptional profit growth. However it is unrealistic to expect anything like this to continue. We are entering a bear market in credit, and we believe the Australian banking sector is in a bear market too.

"This may seem an alarmist statement considering credit growth is running at the highest annual rate since 1989. But that is just the point, 1989 proved to be the last cyclical peak and we believe credit growth is peaking again. And given the comments coming from the RBA, interest rates are set to remain relatively high and credit is therefore expected to remain expensive.

"Credit growth is important for banks because it translates into growth in banks' assets. If an individual borrows $250k from a bank, it is a liability on the individuals' balance sheet but an asset on the bank's. One man's debt is another man's asset. Banks earn a margin on their assets based on the difference between their cost of borrowing and what they charge the borrower. So all else being equal, asset expansion translates into profit growth.

"In recent years, banks have fuelled their profit growth by securitising assets (mortgages for example). This is a process whereby assets are packaged and sold to a third party. Removing assets from the balance sheet in this way frees up capital to make additional loans. It is fair to say that this game is over for the banks for the time being."

Dan Denning
The Daily Reckoning Australia

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