Commonwealth Bank reported its full-year results to the ASX earlier this morning. The highlight (or lowlight) was that second-half profit fell by 16% to $4.72 billion compared to the previous six-month period. This happened despite a 19% surge in home lending to $257 billion and a smaller 6% growth in business loans to $135 billion.

Does it look like the bank is doubling down its bet on Aussie houses?

For the full year, if you exclude the $612 million after-tax profit on the acquisition of BankWest, CBA's net profit after tax was down 9%. Cash earnings fell by 7%. CBA also took a $2.94 billion impairment charge for bad loans. It took a loss on notes in failed day-care provider ABC Learning Centres and noted, "Home loan arrears over 90 days and personal lending arrears have increased on the prior year with deterioration in the second half."

Trade the banks if you'd like. In fact, that's what Gabriel says you ought to do - trade the trends. But buying and holding may be a bad strategy if bank earnings and cash flows remain so unpredictable. And we reckon they WILL remain unpredictable.

If we're right, households have just begun reducing their debt loads. It will take years for the leverage in the system to be wound down. If you're buying bank stocks you're assuming credit and debt growth will resume once this recession is over. That's a big assumption. And probably stupid.

By the way, CBA also said - presumably because cash earnings are down - that it's cutting its second half dividend by 25% to $1.15 per share. That puts the full-year dividend at $2.28 per share.

It's not shabby. But remember, you still have your capital at risk. And as Kris Sayce has shown in his debut issue of the Australian Wealth Gameplan, there are other businesses in Australia with strong and regular cash flows that also pay you regular dividend income - arguably with a lot less risk to your capital.

In case you think we're just bashing Aussie banks, we'd suggest that the profit outlook for U.S. banks sucks too. U.S. stocks fell overnight. One big reason why is that JP Morgan came out with a shiny new report that said losses at bond insurer MBIA may wipe out capital at the firm. MBIA's shares fell by 13%.

Wait! Haven't we seen this film before? Is it possible that the recovery in earnings everyone used to justify the recent rally was really just a bunch of second quarter cost cutting, and NOT a fundamental improvement in business conditions? Is it possible, as John Hussman suggests below, that the fundamentals that supported the previous bubble have vanished, making it more likely that corporate cash flows are headed lower for years to come?

Hold that thought. One of the factors that led to an increase in second quarter earnings was cost cutting. And officially, cost cutting - when it entails firing people - improves productivity. It does not, however, increase wealth.

There are two kinds of productivity. The first kind is where you produce more because you have new skills and you can do your job faster and better than before and produce something better. Your personal output rises and the aggregate output of the economy rises. That's the good kind of productivity. Everyone wins.

The other kind of productivity is where you end up doing the job of three people because two others have been fired. That is the bad kind of productivity. Your output rises. But your increased work load doesn't mean the economy is using resources more efficiently or producing more goods and services per person. You are also probably at least three times more miserable, stressed, and unhappy...having more than three martini lunches or whiskey breakfasts.

So what do you make of the fact that U.S. productivity grew by 6.4% in the second quarter according to the Bureau of Labour Statistics? It was definitely the second kind of productivity growth. Second quarter output actually fell by 1.7% according to the BLS. But total hours worked fell by 7.6%, raising the output per worker by the most since 2003.

Alan Greenspan started yammering about productivity growth in 2003, when it looked like the U.S had leveraged the tech boom into a huge structural increase in productivity. The argument at the time was that computers and modern telecommunications had led to a huge surge in productivity.

The jury is still out on that. There are some industries that would simply not exist (or exist at the same level) without computers and the Internet (ours being one of them). But whether or not modern technology has made people more or less productive is an open question. Does Facebook make people more productive? Does Twitter?

It also depends on what kind of output you're talking about. If by productive you mean, "make more stuff" or you mean "generate more work." Information technology has generated huge volumes of work - information, trading, transactions - in the financial sector. But is the economy any wealthier for it? Has the capital stock of the nation increased?

Say's Law says that supply creates its own demand. What Jean Baptiste meant by that is that you create your own purchasing power and future demand by producing goods that you can sell. Those goods generate your income and that income becomes the source of your consumption. But in that old-fashioned way of thinking about things, all economic prosperity comes from producing things of value and selling them.

We live in the dying days of an era where people think wealth comes from consumption. Why else would the government encourage consumption without production via cash hand outs? It reckons this money will stimulate production by stimulating demand. But demand comes from people having money to spend to begin with. And they can only do this if the economy and the job market are geared toward producing wealth, not spending it.

Speaking of producing wealth, Chinese firms have been busy this week chasing Aussie real assets. State-controlled Yanzhou Coal has made a $3.5 billion bid for Felix Resources (ASX:FLX). This would be China's biggest Aussie acquisition to date. It values Felix at $18 per share, which is about 10% above the closing price before Felix went into a trading halt on the announcement.

And in today's Age, Barry Fitzgerald reports that Hebei Mining - the State-owned mining company of China's Hebei province - has taken a 14.9% stake in unlisted Western Australia uranium explorer Raisama. Raisama issued Hebei 4.5 million new shares and sold it 2.5 million existing shares at 25 cents a piece.

Raisama also said that, "''The Hebei provincial Government currently has plans to build at least three nuclear reactors and is selectively securing strategic interests in uranium exploration companies internationally that it believes have the best potential to meet the province's growing need for uranium."

Despite (or because of) all the controversy over the arrest of and bribery charges leveled at Rio Tinto iron ore executives in China, Chinese firms are still busy buying Aussie resource real estate. This is happening for a couple of reasons. China has heaps of U.S. dollars it gained in trade that it would like to get rid of before America inflates the value of them away. China also has long-term resource needs.

But since we've covered both those subjects before, let's address a different part of this equation: the valuation. Is China paying too much, too little, or just enough for its stake in Aussie resource firms?

Not all assets are created equal, we mentioned yesterday. For example, Commonwealth Bank's chief assets are its loans to customers and its deposits. But the deposits are callable by customers and the loans are only worth what they're worth if people can pay them back.

With resource companies, the main asset on the balance sheet is a mine, an ore body, or a lease or a permit to drill and/or explore a prospect. Sure, mining companies are capital intensive and this capital equipment shows up (in depreciating fashion) on the balance sheet, along with cash.

But the chief asset of any resource company is the resource it hopes to produce. Just what that asset is worth depends on a number of factors. One big factor is the quality and quantity of the resource. You want to know whether it's a reserve - a clearly defined asset with reasonable projections about how much can be produced economically, given today's commodity prices - or a resource (a less defined estimate of how much of a given commodity might be underground).

Other factors are the capital spending required to produce the asset (including mine constructing and ore processing, in some cases) and the operating expenditure. For example open pit mines are cheaper to build and operate than underground mines, and projects far away from infrastructure (rail, port, roads) have much higher operating costs. Labour and raw materials are also variable costs that tend to rise in a commodity boom, as we all found out in 2007.

The great variable in all this is the price of the underlying commodity itself. That changes based on both supply (other producers) and demand (economic growth, or the variables that drive individual commodity prices, including investment demand and speculation). In the traditional commodity cycle, high prices attract more producers and low prices drive out all but the lowest-cost producers with the lowest cost ore bodies.

Judging by this week's activity, Chinese firms are happy to take a stake in existing producers with clearly defined reserves and resources. But they're also happy to pony up the capital and fund explorers who have big hopes but no production and no clearly defined asset. So what does that tell you?

Maybe China is speculating on real assets the way Australians speculate on house prices and Americans speculate on stock prices. And what does THAT tell you?

For now, it tells us that Aussie assets - both equities and real assets in the ground - are in demand. Frankly it's all sounding bullish isn't it? Will Chinese demand for Australian resources diminish if the People's Bank of China tightens monetary policy to prevent bubbles in property and the share market? More on that subject tomorrow, including the dreaded Fibonacci retracement on the S&P 500.

Dan Denning
for The Daily Reckoning Australia

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Big Aussie blue chips like Commonwealth Bank, Telstra, and BHP Billiton report their annual results this week. It is a contention of this version of the Daily Reckoning that corporate cash flows have been unusually high for the last fifty years - a combination of an explosion in credit and debt markets and the real economic activity the credit boom kicked off in the industrialised world and, lately, emerging nations like Brazil, China, and India.

The emergence of those economies as producers of capital goods and consumer goods puts pressure on prices for Western manufacturers. Meanwhile, legacy costs for Western firms (taxes, pension, healthcare etc) rise. All of this eats into cash flows, forcing them to revert to the mean (lower).

And let's not forget the credit boom has ended. Sure, global capital markets are not as broken down and frozen as they were last year. But trillions of dollars in capital has been wasted in speculation or sunk into bad investments (residential American real estate).

National governments are demanding a larger portion of global savings. Government welfare transfer schemes and bailouts have to be funded from borrowing (unless from money printing), which also makes capital harder for private companies to get. Corporate cash flows will revert to the mean in the absence of huge infusions of credit to finance the growth of the balance sheet.

So yes, the cash flows are coming, and in some cases, going. They will reveal which companies emerged from the last eighteen months of chaos with sound capital structures...and which are still vulnerable (not enough equity, too many dodgy assets not valued correctly). It may sound kind of boring. But for investors, taking a microscope to the balance sheet and income statement has never been more important.

Housing finance data for June is out tomorrow. That will be worth a look. Remember that the Reserve Bank has cut the cash rate by 425 basis points since last October. They remain at a 49-year low. By the way, what do you get when you cut rates by that much that fast? You get yourself a bit of a bubble in the housing market.

"Are we agreed that the proposal is crack-brained, absurd, could prove incalculably expensive, and violates every dictate of financial prudence?" writes Robertson Davies in "The Lyre of Orpheus." We picked up a copy in Fitzroy Street and ran into that line. It could apply to a great many things.

Speaking of crack-brained schemes, the Australian is reporting that credit unions are looking to the superannuation industry has a source of liquidity for making home loans. "If the fund gets the green light, it will give credit unions an important alternative source of funding to expand their market share in home lending, now at 7per cent," reports Adele Ferguson.

It's another example of forced speculation. The Big Four banks source their home loan funding from capital raisings (guaranteed by the government) both domestically and overseas. The borrowed money goes into commercial and residential property. Banks make a mint, and the liquidity drives prices up which drives more people into property, keeping up demand for more bank loans (and keeping stamp duty coffers full for state governments).

The credit unions want a piece of that action. And why wouldn't they? If the government, the banks, and the regulators rig the housing market so that it's the preferred destination for foreign capital, smaller competitors can't be blamed for wanting to get in the game. It's where the easy money is made.

Of course this could be the mother of all bad capital allocation decisions for Australia. You'll have a larger share of superannuation money going into the housing market. An increasingly large share of the nation's income will be tied up in residential housing. This confirms what Dr. Steve Keen said recently at our Debt Summit. "Americans traditionally speculate on stock prices. Australians speculate on houses," he said. (By the way, the transcript of the Summit should be available this week).

What made the housing boom so unusual in America, he pointed out, is that it was one of the first time's Americans speculated so wildly on houses. Prior to the last twenty years, house prices never went up much faster than the rate of inflation. They were consumption assets. Not financial assets.

The lowering of interest rates by the Fed and the explosion of non-traditional mortgage lenders changed the financial incentives just enough for Americans to abandon prudence and start gambling with houses. It ended - is still ending in fact - in what we once called the total destruction of the U.S. housing market.

As we told a Diggers and Drillers reader last week, "A report from Deutsche Bank reckons that by 2011, nearly half of all U.S. mortgages could be underwater with negative equity. Further price falls, the Bank reckons, will wipe out the little equity that large swathes of the market currently have. Once the equity in the house is gone, there's no reason for the borrower to hang on. In the States mortgages are non-recourse loans, which means the lender cannot chase up the borrower if the borrower decides to walk away."

"Why does this matter to junior resource stocks? It was the original fall in U.S. house prices that kicked of the credit crisis. The fall in home values wiped out bank collateral and rendered into junk a lot of the securities that were made up of subprime U.S. home loans. That episode brought the global financial system to the brink of ruin."

"The market is telling us that the system has recovered from its near-death experience. In fact the market is obviously pricing - in a robust recovery in earnings, which itself implies a return to normal economic life. No one, apparently, is considering the possibility that further losses in U.S. real estate could again trigger a capital collapse in global financial institutions. But it's a real threat!

"Australia's banks appear to have minimized their exposure to losses from U.S. real estate. But what did happen in the last year is that the capital crunch led Aussie banks to be a lot more conservative in their lending to the mining sector. The mining sector responded by tapping the equity markets directly and bypassing the banks. But some companies were left exposed an unable to fund their projects or roll over loans."

"That's exactly the situation that could happen again. At least it's something you have to consider. The supply of capital to the mining sector looks stronger. But Australia is a net importer of capital. Its strategic weakness has been exposed and not fully repaired."

Dan Denning
for The Daily Reckoning Australia

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Meanwhile, there is not much we can tell you that you don't already know about the global rout in stocks. Wall Street is at twelve- year lows. The FTSE is at six-year lows. And here in Australia the market has opened lower than its five-year low, as you'd expect after such a wretched overnight performance on global markets.

On a side note, a large cloud of brown plane tree leaves has just blown down the street across the way. We're watching from our perch on the second floor of the Old Hat Factory. Gale force winds are blowing through Victoria today.

Back to the markets and the banks. Moody's has said that the AA1 ratings on the Commonwealth Bank, ANZ, and Westpac are no longer secure. Moody's analyst Patrick Winsbury said the Aussie banks could survive the global collapse better than most,, but that "The negative outlook reflects the potential for the deepening global economic downturn to have a protracted impact on the banks' asset quality and earnings."

If the Aussie banks are re-rated by investors (downgraded), it's exactly the sort of thing that will lead to taking out the 2003 lows in the 2,700 range. That may sound severe-wiping out all the gains of an epic resource bull market. But keep in mind the S&P barely closed above 700 overnight and dipped under that level for the first time since 1996. The Dow crashed under 7,000-a place it hasn't seen since 1997.

The chart below reminds you how vulnerable the Aussie indices are to the big four banks and the big two miners. You can see that Rio and Macquarie Group (which we included as an example of how discredited the investment banking model is now) lead the charge lower.

But over the last year, the big four and BHP have managed to fight earnings gravity. If that changes for whatever reason-like seven of Australia's top ten trading partners being in a recession-the lows will be taken out. And probably sooner rather than later.

Click to enlarge
Source: www.google.com/finance

Plain and simple: All the gains in equities since Alan Greenspan uttered his famous words about irrational exuberance have been wiped out. All that remains to know now is how irrational the downside would be. The good news is that you're seeing signs of capitulation. Investors are giving up on stocks for the long-term.

For example, we got a text message this morning from a long-time bull. He always finds reasons to disagree with our analysis. He texted early this morning after watching Wall Street's depressed closing.

"It's over."

That's not quite a buy signal. But it's not a bad sign either.

Across the world the trouble is with the banks. HSBC will slash its dividend and do a US$17.7 billion rights issue to shore up its capital. Will shareholders pony up? In the U.S., AIG reported a US$61.7 billion loss. The company guaranteed some $450 billion in credit default swaps. European banks are its big counter parties, with some $300 billion in exposure outstanding.

You can see why the U.S. government is flushing money down AIG as fast as it can. If AIG is downgraded , it triggers more losses for European banks, which already have problems on their Eastern front to begin with.

In fact, the more we think about it, the more we agree with John Robb that this is not just a stress test of financial firms. It's a stress test for national governments. Banks and governments have co-evolved to get to this point where we are today in the modern world (where interconnectedness and complexity threaten to crash the system).

The "Cash Nexus" as historian Niall Ferguson calls it is the murky relationship between fractional reserve banking, perpetual government debt, and the fiscal warfare/welfare state. That is, governments would never have the money to build powerful military machines without modern bank financing and the bond market (where banks buy and sell government debt, bridging the gap between private capital and government borrowing).

Similarly, banks could never have gotten as large without the regulatory and legal framework set up to favour them. And of course it would favour them.

A few things have changed in the last ten years. The main one is that leaders have become looters, be they political or corporate. On the political side, instead of conventional armed conflict, which had diminishing marginal returns (in addition to being really unpopular in a culture addicted to leisure) governments have gotten into all sorts of other wars, mostly against their own people (War on Poverty, War on Drugs, War on This, War on That, War on Everything, War on You.)

And for their part, the banks and even non-bank lenders figured out that if the government was going to encourage home ownership for political reasons by discouraging rigorous lending standards, then the best way to deal with the increased risk was to sell it!

Alan Greenspan called this "disaggregation" of risk. But obviously securitisation did not lower systemic risk. It heightened it. But for a little while anyway, the banks and bankers made a mint off of the government's desire to gear the entire national economy towards the goal of home ownership. This happened in Ireland, the U.K., the U.S., and Australia to name few English-speaking companies.

You'll forgive us if we don't quite have our head wrapped around the idea yet. It's a work in progress. But yes, we are suggesting that the co-evolution of the modern welfare/warfare state and the financial system has been impacted by a financial meteorite of sorts.

The co-dependency has always required a little inflation to keep it going. But lately, the last one hundred years or so, it's turned into a lot of inflation. The expansion of global money supply through fiat money and widespread credit has created an inherently unstable scale of modern living. We have a living arrangement that uses resources too quickly and too inefficiently. And now we have bumped into that fact in a rather abrupt way.

A re-localisation of the economy would be something to think about and even plan for. If the centralisation of money and power has reached its useful limits, then you'd think we'd be moving away from it. Yet in Washington, Canberra, Paris, London, Tokyo, and Berlin everyone wants government to get bigger and spend more and take a larger role in the economy.

The response to the crisis has become activist and interventionist. This, ironically, echoes the ideological response of the Bush Administration in Iraq. Meet the new boss everybody! Making the exact same strategic mistake as the old boss, only a different theatre! We'll see how that works out...

Some reader mail...

Hi Dan & all at DR,

Whilst I enjoy reading your daily ramblings, sometimes your analogies are left wanting. A case in point is your analogy of the 27th February, of the "death of a star". Whilst super nova's do indeed produce enormous explosions of galactic proportion, remnants of the stars will continue to survive, all be it, in less than bright condition.

Further more, every element in the universe heavier than iron on the periodic table, and that includes gold which you seem to bang on about constantly (excuse the pun), owes its existence to past super nova explosions. Without these heavier elements, you, me and every living thing on the planet, (and perhaps elsewhere) would not get a chance at life and living it. So your analogy is perhaps, fatally flawed. Just thought I'd mention it. Keep up the polly bashing though, love it!!!

Kindest Regards

Simon A Blane

Undergraduate student, Edith Cowan University, Perth, Australia.

Sorry about that.

Hi Dan,

You really should be careful about what you wish for. In the modern Corporate Welfare State, the rich are the greatest beneficiaries of Welfare. The Rich pay almost no tax, and the taxes that are paid by the Poor are used to create an apparatus that protects the Rich from the very people paying the taxes. Without that apparatus your 'private goods' remain so only until someone takes them by force, which of course is feudalism.

So the extreme of capitalism is feudalism, and if that is the system you want for our society, then you better prepare yourself for everything that entails; bloodshed, disappearance of the middle class, culture death and endless warfare. I thought we as a society were over that phase, but apparently not. Sigh.

Ian

See above.

Dan Denning
for The Daily Reckoning Australia

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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

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• CBA Sees More Bad Loans

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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