Maybe it's the end of the dollar carry trade (where speculators sell risk assets). Or maybe not. Whether that little thesis turns out to be correct we'll know in due time.

In the meantime, there are some other things we might learn this week. First up is the TD Securities - Melbourne Institute Inflation Gauge. This will probably show that except for food, fuel, energy, healthcare, and housing, prices in the economy are stable and inflation is contained.

One quick note about this: there is obviously plenty of inflation in the prices you pay every day. But most consumer price indices are rigged to understate inflation, as our colleague David Evans pointed out yesterday in Canberra at the Gold Standard Institute conference in Canberra. Trimmed medians...hedonic adjustments...there's quite a bit of statistical hocus pocus going on.

Inflation is evident if you just follow the money. The returns on wealth (rent, capital gains, income from bonds) are accruing to that group that's benefitted the most from low rates. Dr. Michael Hudson called them the 'financial oligarchy' in his recent trip to Australia. This group has benefitted from inflation in the form of higher asset prices. And meanwhile, the Fed and other central banks have been able to say their policies are not inflationary because consumer prices and, more importantly, wages, aren't moving up.

Duh.

Is it really a surprise that there's no inflation in wages in a world where tens of millions of workers in emerging market economies are willing to do the same work as those in Western economies, but at much lower prices? Wage deflation is the order of the decade. Maybe the century. You generally won't find inflation in consumer prices or wages. But that doesn't mean it isn't there.

So what will the Fed and the Reserve Bank do this week? The RBA meets tomorrow and everyone is expecting another rate rise. The Aussie dollar has all but priced it in. The RBA also puts out its commodity price index week and its always exciting quarterly statement on monetary policy which we just can't wait to pore over for signs of continued credit and debt growth in the Australian economy.

Westpac will also post results this week. If it follows the lead of NAB and ANZ, it will report higher-than-expected bad debts, but claim the bad debt cycle has peaked. Don't be so sure, though. And why not?

Well, over the weekend, CIT Group Inc. (NYSE:CIT), with US$71 billion in assets, filed for the fifth-largest bankruptcy in American history. CIT is the latest victim of the credit crunch, which obviously still isn't over. It's a commercial lender to small businesses that's been unable to refinance its debt. As a non-deposit taking bank holding company, it has to finance asset growth through securitisation and borrowing, both of which are still pretty hard to do these days.

CIT's Chapter 11 allows it to restructure under the protection of the courts. Bondholders might make out okay. The U.S. Treasury, though, has already lost $2.3 billion in TARP money it put into the firm. And the biggest losers are the small businesses who will no longer have financing. That's bad news for the real economy.

As deposit taking institutions, the Big Four Aussie banks are not nearly as vulnerable to this kind of crisis as CIT obviously was. But as we showed last week, Aussie banks still rely on quite a bit of short-term borrowing in the wholesale funds market abroad, borrowing money from foreigners to financing lending here. That's always going to be a weakness.

Hold everything!

Last week we warned that a result of the Fed's low rates is that U.S. banks have stocked up on U.S. Treasury bonds and notes to stabilise their balance sheets. We warned that this could put the banks at risk again, IF the value of those bonds was slashed by market forces. You'd get another bank collateral wipe-out which could, if large enough, wipe out equity. Insolvency becomes an issue again.

But don't underestimate the ability of the bond bubble to go on longer than anyone thinks. The Feds meet this week and will probably not change a thing. Its formal program to buy Treasury bonds and mortgage backed securities with newly created central bank reserves (quantitative easing) can always be extended. So should bond bears like your editor (who agrees that U.S. Treasury bonds are a great short) be wary?

Yes!

The reason is a new regulation passed by Britain's Financial Services Authority which lays out new liquidity rules for bank assets. Rolfe Winkler has the story in his blog. The short version is that the FSA may require banks to own a certain percentage of assets that can quickly be liquidated to raise cash if need be. Lower credit quality assets (junk bonds or lower rated corporate bonds) might not qualify.

What that means - if you read between the lines - is that the only assets which would meet the new liquidity requirements from the FSA are sovereign government bonds. Now maybe this does make bank assets more liquid. But we wouldn't say owning more government bonds makes bank assets any safer, or improves the capital position of the financial sector.

What it DOES do is give the government a way to force new bond issues down the throats of banks. Rather than having to find creditors among the high-saving emerging market nations, governments in the UK and the US would have a captive market in their own financial sector. The banks would gradually gorge themselves on sovereign government debt, provided Moody's or Fitch or Standard and Poor's didn't downgrade the credit ratings of the US and the UK.

It sure looks like another move toward the nationalisation of the financial sector, although in a very clever way. And the banks probably don't mind that much right now. Trading government bonds with new Fed money was a virtually risk-free trade that propped up bank profits in the first half of the year. It's a good trade.

But in the bigger picture, as Nial Ferguson and Ken Rogoff mentioned this weekend, this means that the financial crisis may soon become a sovereign debt crisis. So far, the liabilities of financial firms have been transferred to the public sector balance sheet. But this has not solved the problem. It's merely moved it to a larger stage on which it must play out.

As we mentioned in our remarks yesterday at the gold show, we believe this marks the beginning of the end of the Super Cycle in paper money. A sovereign debt crisis is the same as saying that the funding model for the fiscal welfare state is broken. Only in this case, there is no organisation large enough to bail out the fiscal welfare state. What does that mean? More on the consequences, and the opportunities tomorrow.

"This is the first time I've been in Canberra," we began our remarks yesterday. "I spent most of last night trying to figure out what it reminded me of. And then it came to me. It reminded me of Washington D.C., and not in a good way. I spent four years in college living in DC. Both cities make you feel like you've stepped onto a very orderly and sterile brothel."

Dan Denning
for The Daily Reckoning Australia

• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Hyperinflation and the Dollar’s Monetary Destiny
• Everyone We Know Expects a Fairly Quick Up-move in Inflation
• The Asian Banks Have Finally Been Heard From
• Australia to Borrow as Much as $300 billion

"Okay."

"Why so serious? I mean, all you do every day is write about the worst-case scenario. It's depressing. Who died and made you the harbinger of financial doom? How about something positive for a change?"

"Is that code for, 'buy me another beer?'"

"No, seriously. It's not all bad all the time is it?"

We'll tell you how we answered our friend's question below. But first up, the markets. It was another red day in New York, with Dow stocks down over one percent. Tech stocks on the Nasdaq - the ones enjoying a bit of euphoria renaissance - were down 2.67%. September new home sales in the U.S. fell 3.6% from the month before. The Aussie dollar shed 1.44% against the greenback.

Is that all just noise? Or is there a melody building in the markets? The chorus chanted by Ken Henry, Wayne Swann, and most of the media is that the strong Aussie dollar, the strong market, and the strong(ish) economy are all factors of Australia's great policymaking and unique relationship to the China boom.

But the alternative tune - the one which we've been humming - is that most of the rally in stocks since March and most of the 30% rise in the Aussie dollar is a result of the carry trade. Yes, Aussie assets are relatively more attractive when the cost of capital in the U.S. is zero. But this can change in a flash when foreign speculators change their trading minds.

That's just what happened last year. Only then, it was both a dollar and yen carry trade that led to a rise in Aussie assets. Once the credit crisis set in, the yen carry got dropped and investors fled risk assets and piled right back into the greenback and U.S. Treasuries. Stocks fell, commodities fell, and the Aussie dollar plummeted to nearly 60 cents against the USD.

It doesn't have to happen that way now just because it happened that way then. But since our main job here is to question conventional wisdom and offer you an alternative explanation, that's the one we're offering you. Beware carry trades promising false permanent prosperity!

But what about today's earnings? ANZ followed up yesterday's bad debts bonanza from NAB with one of its own. ANZ reported an 11% fall in net profits (to $2.94 billion) and a 46% rise in bad debts to $3 billion. But both banks hinted that the end of the "bad debt cycle" is over and that things can only get better.

Let's take the other side of that trade. Again we'll focus on two risks: access to foreign funding and asset values on the balance sheet. ANZ sourced more of its funding from domestic savers and less from short-term whole sale funding, according to its report. Aussie savers funded 55% of ANZ new loans for the year (up from 50%) while the company reduced its reliance on short-term whole sale funding by 17% (now just 17% of all funding).

What does that mean? It means the company is making plenty of new loans (you'd want to, especially to the housing market, to prop up the value of your real estate portfolio). But it means the company is relying a lot less on short-term borrowed money from overseas in order to boost lending to Aussie homes and businesses.

Whether it is doing this by necessity or by choice is big question. But all we want to point out is that if your economy relies on imported capital to finance investment (or consumer spending, or new mortgage lending) you're vulnerable if that capital is not forthcoming. It's great when the dollar is high and capital is flowing. But if those capital flows reverse, the banks may find themselves in a jam that even a government guarantee makes it hard to escape.

It's not just us saying this, by the way. "We need to figure out how we can become less dependent on wholesale funding to finance our economic growth," said Commonwealth Bank of Australia chairman John Schubert in last Friday's Australian Financial Review. "It is not assured that we will get the funding into the future."

No foreign funding, no continued housing boom. In fact, we'd be willing to say that a cut off from short-term wholesale foreign funding is just the sort of thing that could lead to a major correction in Aussie house values. Naturally, the government here would step into the mortgage finance market in a big way, and not just for non-bank lenders, as it's done with the Australian Office of Financial Management buying securitised residential mortgage backed securities.

The U.S. government has done everything it can to keep the mortgage credit flowing and household net worth from imploding. Australia would do the same if it had to. But like in the U.S., this means more government borrowing to prop up the property market. More debt, higher interest payments, less capital available for lending to the rest of the economy.

But let's assume for now the public sector does not enlarge again to Depression-era levels of debt. Let's assume that Aussie banks have access to overseas credit. There is still the issue of asset values. ANZ says it is leveraged about 17 to 1. With $476 billion assets, that leaves it with about $28 billion in equity (according to how it calculates both assets and equity). And like yesterday, it's fair to say that a few billion in loan losses and bad debts are hardly the sort of thing to wipe out that much equity.

That's not where the real risk is, though. The real risk is to the asset portfolio. Twenty eight billion in equity capital is just under 6% of total assets. Or, put another way, a 6% loss in assets wipes out the equity.

A six percent loss in assets? Is that possible? The IMF and APRA have stress tested Aussie banks for scenarios in which large chunks of homeowners can't pay their mortgages. They chuck in large corporate bond default rates just to make things more stressful. And after all that, they've concluded that most of the banks' assets are solid and safe and unlikely to incur mammoth losses that would jeopardise the equity capital (solvency).

And maybe they are right. But we're just saying...in a world dominated by massive credit write downs...where we have just seen six months of re-leveraging...and where house values here in Australia have managed (thus far) to escape massive deflation...is a six percent loss on assets totally unimaginable?

We can imagine it, although we don't relish it. Either way, we wouldn't buy the banks just now.

But if you're looking for the most over-valued asset class in the world - the one worth a punt for going short - it has to be U.S. government bonds. Paolo Pelligrini, the man who helped John Paulson make a mint shorting the U.S. housing market, told Bloomberg that shorting long-term U.S. debt is the "only attractive bet" going at the moment.

"I always like to think about assets that are likely to experience a breakdown; the only thing I'm pretty comfortable with right now is U.S. Treasury securities and U.S. agency mortgage-backed securities...I think that those are overpriced so they are attractive shorts."

If you're not going to short the U.S. long-term bond market any time soon, the take away from this is to look for assets that go up when U.S. bond prices fall. If U.S. bond prices fall it means U.S. interest rates go up. That might, for a bit anyway, lead to a stronger USD and a weaker AUD.

For a trader - other than cash and gold - we'd look to see which of those Aussie stocks hammered by the stronger Aussie dollar have been beaten down the most. They might be due for a quick rebound - although they will be fighting the general trend in the market. We'll ask Murray what he thinks and get back to you.

So what did we tell our drunk friend when he asked us why were so critical, sceptical, negative, and gloomy all the time?

"Relax dude. It's my job to plan for the worst case scenario. It makes me happy to have a purpose in life. If you want the best case, turn the TV on and turn your brain off. And I object to your overly negative characterisation of my work."

"Huh?"

"My work isn't negative. It only seems that way because we live in a period of wealth destruction. I wish it were a world of wealth creation. But in a world of wealth destruction, you have to focus on preserving your wealth and maybe, when you can, growing it if you've got the big picture sorted out correctly."

"But you make it sound like the end of the world every day."

"It is the end of the world every day. But it starts all over the next day. And it is just the end of the financial world as we know it. Not the end of the world world...Besides, it's a lot less scary when you face up to what is really going on and make a plan for it. Uncertainty is scarier than risk because with uncertainty, you have no idea what to expect. Risk you can at least manage."

"But how can you be so sure you're right about the big picture? Everyone else I talk to says there's no way the dollar is going down as a reserve currency and that only kooks believe that. Are you a kook?"

"Certified. But that doesn't mean I'm wrong. You can't keep adding debt forever to fund your way of life. Debts have to be repaid. And interest has to be paid on the money you've borrowed. The politicians in America keep making new promises they aim to keep with borrowed money. This borrowed money is massively interest rate sensitive. And it's in addition to a huge amount of money they've already borrowed. It's the end-game for the whole financial/fiscal/political model."

"But so what? Isn't everyone else doing the same thing?"

"Well yeah. All fiat money is a scam. It's a way for the government to run perpetual debts and steal savings through inflation. It's an immoral living arrangement in that respect. But more importantly, from a financial perspective, it's a way of funding a political arrangement. And that way of funding it - borrowing more and raising taxes on a small productive class to pay for a larger public sector - is every bit as dead as the funding model for investment banks."

"But the government bailed out the investment banks. Who is going to bail out the government?"

"No one. Nothing. It will try inflation. But that doesn't work. Printing more money to pay off your debts just destroys wealth. That's where we're headed. That's what you should plan for. Sooner, not later."

"I would like to begin my plan with another beer, if it's all the same to you."

"No worries."

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• IMF Report Concludes Aussie Banks are “Very Sound”…
• A National Mortgage Bubble
• Fed Now the Middle Man in Interbank Lending Market
• Corporate Debt is Just One Aspect of the National Debt Problem

If you want to attend the presentations and discussions over the next four days, you can still do so. But you should contact conference organiser Marcus Matthews today. You can reach him via email at feketeaustralia@gmail.com. And if you're there on Sunday, be sure to say hello.

Yesterday we promised to show you how the funding model for the fiscal welfare state is blowing up. But this is going to have to wait at least another day. Don't worry though. It's not going anywhere.

Today, there is a banking story to cover. You recall that yesterday we were worried about the next banking crisis. But the lingering effects of the last one are still with us. National Australia Bank reported a 43% fall in net profit yesterday. Ouch.

Don't feel too bad for NAB. Net profit fell from $4.54 billion to $2.56 billion. But the bad and doubtful debts charge for the year grew by 53% from $2.49 billion to $3.82 billion. With $654 billion in assets and $616 billion in liabilities, the bank is sitting on $37.8 in equity. A few billion in bad debts and loan losses won't wipe out that amount of equity.

But it's worth noting that NAB's total assets are 17.3x times equity. This isn't as high as some leverage ratios in the U.S. just prior to the banking crisis in 2008. But it's not far off where NAB was at the time. And there are two further risks worth mentioning.

First, as the IMF paper on Aussie banks concluded earlier this year, Aussie banks are probably strong enough to withstand a normal shock to the balance sheet. That is, the IMF stress-tested Aussie banks for losses on their two largest loan portfolios - corporate loans and mortgages. The IMF concluded the banks were adequately capitalised to survive the shocks it tested for, but that, "The above shocks do not constitute a rigorous stress test and the results are only indicative of the health of the banking sector."

If we've learned one thing in the last two years, it's that bankers and analysts have consistently underestimated the frequency and magnitude of systemic shocks. That doesn't mean the IMF conclusions aren't to be trusted. But it means in the event of another more severe shock, the banks could face larger asset writedowns and losses than the IMF has modelled.

This brings us to the second risk worth mentioning. A bank facing bigger loan losses takes fewer risks. It reduces lending. This is how the credit crisis was transmitted from America's housing market to Australia's economy. The Aussie banks had to tighten up to prepare for losses on overseas assets.

Next time around, though, we reckon the losses - when they come - will be on domestic real estate assets. And with so much exposure to domestic real estate (mortgage loans), the assets could face a world of hurt. But even if bank asset quality doesn't crash (housing prices don't crash), an external shock affects Aussie bank liabilities.

The IMF report says that, "On the liabilities side, however, banks had sizable short-term external debt obligations, and access to offshore wholesale markets was disrupted by the Lehman Brothers collapse in September 2008." Of course the government's wholesale funding guarantee eased the pain of this shock, which is one reason why that guarantee may become permanent in all but name.

But the IMF wrote that, "A key remaining vulnerability is the roll-over risk associated with sizable short-term external debt. Banks' wholesale funding (domestic and offshore) accounts for about 50 percent of total funding, of which about 60 percent is offshore. Financial institutions short-term external debt (on a residual maturity basis) is estimated by staff at about $A 400 billion (35 percent of GDP) in March 2009."

Maybe the short-term external debt levels have improved in the last six months. We haven't checked yet. But in simple terms, it means a lot of domestic lending is funding from external funding, borrowing abroad to loan at home. If American banks again blow up on the destruction of their remaining collateral (mortgage loans and U.S. Treasury bonds) we'd predict another ice age in global credit markets.

Needless to say, as a capital importer, this would put Australia in an awfully uncomfortable spot. But hey! No one is worried about that at the moment. The Aussie dollar is being inflated by the U.S. dollar carry trade. It's a shame that the strong Aussie is going to devastate local industry and manufacturing with higher costs, but at least it obscures for now the risk that Aussie banks are reliant on foreign borrowing.

In the bigger picture, this means the investment needs of the economy can't be met by household savings alone. But that's an even bigger problem than we can address today. So we won't!

More cow bell!

And what about our theory that a U.S. dollar rally will trigger a correction in gold, oil, and stock markets and lead to a mini-rally in U.S. Treasury bonds? Bond fund king Bill Gross agrees. Writing on Pimco's website, Gross concedes, "Rage, rage, against this conclusion if you wish, but the six-month rally in risk assets -- while still continuously supported by Fed and Treasury policy makers -- is likely at its pinnacle."

Dr. Doom himself, analyst Nouriel Roubini, called the present market "The mother of all carry trades." "This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals," Roubini said via satellite to a conference in Cape Town, South Africa. "The risk is that we are planting the seeds of the next financial crisis."

With the S&P up nearly 65% since touching 666 in March (seriously), we'd say the seeds are already bearing fruit. But maybe it's poisoned fruit. After all, the rally has been worldwide and extremely impressive by historical standards. But it's fully consistent with previous bear market rallies. If anything, it's happened faster.

What nobody yet knows is if it IS a bear market rally...or a garden variety stock market rally that precedes a recovery in the economy. You know what we think.

There IS one notable difference between 2008 and today, though. Yesterday we mentioned that U.S. banks have loaded up on a whole other kind of super-dodgy collateral; U.S. Treasury notes and bonds. Demand for those securities may go up with a U.S. dollar rally and a reversal of the dollar carry trade. But in the longer-term, we think the banks have invited another toxic house guest on to the balance sheet.

But where did the previous smelly houseguest go? You know, all those mortgage backed securities and subprime loans? Where does that risk now reside? And what happens if it comes home to roost?

According to this report by the San Francisco Federal Reserve, over 95% of all new residential mortgage lending in the U.S. is now being backed directly by the U.S. government. With the banks unable or unwilling to lend, Uncle Sam has become the sugar daddy of the U.S. mortgage market. See the chart below.

The Fed supports this market by purchasing the securitised mortgages issued by Fannie and Freddie. The Congress funds the agencies which make the loans available. But no matter how you slice it, the U.S. government is supporting the housing market. It will continue to do so as a political imperative.

But by taking on this massive liability - not that it doesn't already have its hands full - the Fed is further consigning the dollar to the scrapheap of history. Do you think foreign creditors will not realise that the U.S. is borrowing money to keep house prices elevated? Will they not notice that the U.S. is printing money to do this? And what will happen to the dollar then? And gold?

The truth is that creditors already do know this. Today's Australian Financial Review reports that overseas Chinese investment is "surging." Chinese policy makers are trying to trade dollars for tangible assets or equity in resource shares as quickly as possible. "China reported a 190% jump in overseas investment by its companies for the third quarter."

"Policymakers might be encouraging Chinese firms to invest abroad, in part to help counter pressure for the nation's currency," the article continued. "Investors are betting on the yuan to appreciate as China's growth accelerates from its weakest pace in a year."

Most currencies that are not the U.S. dollar could appreciate in the coming years. Australia's currency has already done so. Brazil is considering a tax on capital flows into the country in order to prevent investors from speculating on a further rise in its currency by buying Brazilian assets. And of course speculators have tried for years to find a way to position themselves for an appreciation in China's currency. China's capital markets are not friendly in this regard, although Hong Kong stocks remain a popular option.

The fact that countries like Australia, China, and Brazil are trying to limit currency appreciation versus the greenback shows you how unbalanced the world economy still is, how unprepared it is for the reality that America's deleveraging will take place for years. Households and businesses must save and repair balance sheets. Some other country is going to have to consume what the world produces.

In the interim, the U.S. government will increase deficit spending to make up the difference. It is the stupidity of Keynesianism to support aggregate demand when what everyone needs is a correction and a recovery. But all the Feds will succeed in doing is blowing up the balance sheet of the U.S. government in spectacular fashion. Go gold.

Mind you we still think the short-term move is a dollar rally and some profit-taking on the dollar carry trade. We asked Slipstream Trader Murray Dawes what he sees when looking at the U.S. dollar index. Murray spends most of his time finding trading opportunities in Aussie stocks. But he also knows that Aussie markets (and capital flows) are still massively affected by what's going on in America.

Murray wrote that, "If we look at this chart of the US Dollar index going back to 1985, you can see quite clearly that the 10 week moving average crossing over the 35 week moving average has been a very good indicator of the trend. There are only a few instances over that whole time period where this indicator gave a false signal."

Click to enlarge

"Therefore," Murray continues, "we should be keeping an eye on this indicator going forward to tell us whether the US Dollar index has turned back up and is ready for a counter trend rally. The short US Dollar trade is getting pretty full, as I have mentioned in the past. And there is a high correlation between the direction of the dollar and the direction of gold, oil and stocks.

"The US Dollar has taken over the Yens role of funding the carry trade and this will be the situation for as long as the Fed remains too scared to raise rates, which seems to be for the foreseeable future. So we can probably expect the dollar to weaken further over the long term, but a counter trend rally (short squeeze) may be closer than people think and this would lead to weakness in commodities and stocks.

"When should we trade this move? Well have a look at the chart again. Notice the false breaks that keep occurring when the all time lows get breached (denoted by the numbers 1,2,3). With the trend still strongly down we can expect to see either a false break of the lows around 71 reached last year or if that doesn't occur then a crossover of the 10 week/35 week moving average to confirm that the trend has changed. Trading the move before either of these are confirmed would be jumping the gun."

Murray is tracking which Aussie stocks will move if and when we see the dollar index break out. We'll keep you posted.

Dan Denning
for The Daily Reckoning Australia

• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• IMF Report Concludes Aussie Banks are “Very Sound”…
• A National Mortgage Bubble
• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• How Did Australia Get Caught Up Losing Money in Commercial U.S. Real Estate?

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

Lesson? There's always an unseen or unforseen consequence to any action. In this case, the good news for NAB is that it's rebuilding its balance sheet with equity capital. That's a good alternative when the global cost of capital is going up (mostly because government bond auctions are hoovering up so much private capital).

The bad news is that existing shareholders took a hit on their shares when NAB discounted the offering to the current share price. It probably had to do this to incentivise buyers. But that was the hidden cost, and it was born by existing shareholders. And in any event, we're still not convinced that capital raised to buffer against further loan losses is the kind of event a shareholder would be bullish about.

Did you know there are already entrepreneurs who plan to build the infrastructure to recharge electric cars in Australia? Maybe it's wacky. Maybe it's ahead of its time. Maybe it's creative destruction at work!

Yesterday's Age reports that, "Shai Agassi is the charismatic entrepreneur, electric-car evangelist and founder of Better Place, a US-based company that plans to roll out the infrastructure necessary to recharge electric cars at home, at work and at battery-swap roadside stations.

"Speaking in Melbourne, he said Australia could become the modern equivalent of oil-rich Saudi Arabia if it quickly switched to manufacturing electric vehicles and lithium batteries. 'A billion electric car batteries will need to be made - that is the biggest industrial opportunity in the world today,' he said while giving the inaugural Deakins 2009 Eco-Innovation lecture. 'Australia can pick whether to be an exporter of iron ore, phosphate and lithium, or of kilometres [in the form of batteries].'"

An exporter of kilometres? Hmm. It does sound wacky. But having recently written on an Aussie lithium producer in Diggers and Drillers, we'd agree with Agassi that a lot of electric car batteries are going to be built in China and Japan in the next twenty years. And they're going to need a lot of lithium carbonate.

By the way, if you're going to recharge an electric car battery, you're going to need electricity to do it. Ziggy Switkowski says the wind and solar industry is a "cottage industry" that cannot meet the energy requirements of an industrial economy like Australia's. "There is no other alternative but to go nuclear," he says.

To be fair, Switkowski (like everyone) is talking his own book. He's the head of the Australian Nuclear Science and Technology Organisation. His job is to talk up nuclear. But we think he raises a fair point that hasn't really been debated in earnest in Australia: will renewable sources deliver the Australian economy the energy it needs to grow or do you need nuclear energy in the mix too?

Here's a shocker: there is no inflation in Australia because men's underwear is cheap.

We somehow missed that story in the papers earlier in the week. But sure enough, Thursday's Age reports that, "Sharp falls in the prices of men's underwear, fruit, vegetables, milk and bank charges helped offset big rises in the prices of women's underwear, hospital services, real estate and petrol."

The data, courtesy of the Australian Bureau of Statistics-suggest that if you wear jocks, eat apples and drink milk, your cost of living is going down, even if you get sick, buy property, drive a car, and sometimes wear women's underwear. That's probably good news for somebody out there. But is the cost of living in Australia really doing down?

Not if you ask the RBA! The Reserve Bank of Australia publishes regular inflation data. That data includes the "trimmed mean" measure of inflation. This measure (defined below) excludes volatile changes in certain consumer prices to "smooth out" the noise in the data set. The ABS also publishes this data, which you can find here on page 27 (analytical series 10).

What both data sets show is that underlying inflation in Australia is up about 3.6% in the last twelve months. That's outside the RBA's comfort zone of annual inflation/systematic erosion of your savings and purchasing power of between 2-3%. So are the statistics lying?

Well, we wouldn't go so far as to suggest that government statistics may be deliberately understating the rate of inflation. That could never happen. But it does show you that statistics can often be abused to contradict common sense.

Common sense tells you the cost of living is going up, despite the really great deals you can get on men's underwear. This is why there's such a large difference between the headline rate of inflation-which measures consumer price growth across around 70 different categories-and underlying core inflation-which measures price growth in core consumer purchases and weights them accordingly.

It does have the feel of statistical hocus pocus about it sometimes. RBA man Tony Richards explained the methodology here in 2006. The key part of his speech was this: "[Trimmed means} 'trimmed' means in the sense that they are the mean or average price change for the CPI basket after taking away, or 'trimming', the more extreme price changes in any period."

He added that, "Trimmed mean measures exclude - or more correctly down-weight - the impact of items based on whether or not they appear to be outliers in the period in question. These measures represent an attempt to estimate the central part of the distribution of price changes, and provide a measure of inflation that is not excessively affected by large price changes - either increases or decreases - in individual items."

It's a little weird to measure inflation by excluding the things that are actually changing in price. You'd think that would be important. But the RBA is trying to weigh which price increase matter more: underwear or petrol. It's probably best to keep it simple and say that when money and credit growth increase and bank reserves grow, the money supply growth (inflation) leads to rising prices.

We move on to superannuation and a pretty significant discussion of a change in corporate cash flows and how investors value them. Some financial planners and folks in the super industry have written in this week saying that we're being unfair to the industry by claiming the interests of planners and funs are not aligned with the interest of investors.

Suit yourself. We never said there weren't honest financial planners there. And by definition, not all actively managed funds are average. Some are better! Some are worse!

The point that's worth debating is whether there is a bias in the funds industry toward putting Aussie investors in common stocks no matter what's going on in the market-and especially into products that financial planners get paid commissions on, whether they suit the needs, goals, and risk tolerance of their clients.

This probably sounds stupid. The purpose of the funds management industry IS to put people into common stocks. But we think this reveals the divergence of interests between investors and the funds industry. There are certain times in financial markets where you need to ask yourself if you should be buying what they are selling-or at least remember that they are always selling.

This thought was prompted by a study quoted in yesterday's Australian Financial Review that shows the average balanced retirement fund was down by 13% in the year ended in June. It was the worst annual performance on record, according to research house Chant West. That performance is pictured below.

The upside-according to the data-is that over the last fifteen years, the median annualised return for growth funds was 6.9%. It peaked around 13% early 2000 and late 2007 before declining to around four percent each time. Chant reckons annual CPI increased by 4.2% over the same period. So all up, even after the shocker of last year, the investor who got into super fifteen years ago is still beating inflation and in the black.

This, of course, argues for buying and holding stocks and allocating the bulk of your assets (despite your age) to growth or balanced growth. That puts 40-60% of your assets in growth stocks. And THAT is the figure we think super investors should be asking themselves about.

If it's a bear market in stocks as an asset class, then being that heavily weighted in common stocks for your crucial capital-accumulating/income-producing years is going to be a big mistake. Remember that upwards of 90% of your total return in any investment comes from being in the right asset class, not single stock selection.

The question of how you allocate your assets in super, then, is what we're banging on about. Kris Sayce is banging on about it too. And in fact, he's banging on about it so much we've decided to publish a new newsletter on the subject of superannuation, income generation, and controlling your risk. Look for an announcement on that in your inbox later today!

For now, we just think it's a question you should be actively asking. Whether or not you actively manage your investments is up to you. But even in the equity market, we think it's well worth examining the old saw that you should just buy and hold over time because stocks go up in the long run it's too hard to time the market.

We have our resident Frenchman and technical analyst Gabriel Andre hard at work beta testing a system based on technical variables and charting. The goal of the system is to see if you can increase your returns in Blue Chip stocks by selling when they break technical support and buying back when the indicators suggest.

Granted, this is not the sort of thing for everyone. But in its latest monthly update, the ASX indicated that while volatility (as measured by the VIX) died down in June on the S&P 500, it stayed elevated in Australia. The average share market swing was 1.2% in the month.

That kind of volatility comes when there's uncertainty. And that kind of uncertainty comes when there's a changing in the structure of how large export commodities are priced (iron ore) and when investors aren't sure how strong demand for Aussie resources will be in the next few years. Throw in lingering doubts over how well-capitalised the banking sector is and how much capital the country may have to import and you have a scenario where market volatility could remain much higher for a lot longer.

Or, if you want to put super returns and share market volatility in perspective, you could argue that volatility is going to remain high in stocks because there's a huge debate over whether the historic equity premium in stocks is collapsing.

The equity premium is the extra return from stocks compared to bonds or cash that investors are willing to pay for. They take on a bit more risk. But in exchange for that they get extra return, the equity premium.

The argument for a collapse in the equity premium is made by some folks we quoted a few weeks back regarding the historic importance of dividends to the total return of your stock portfolio. The book is called Triumph of the Optimists by Elroy Dimson, Paul Marsh and Mike Staunton. And in it, the authors argue that over the last 100 years, corporate cash flows have grown faster in the last fifty years than in the previous fifty years.

As a result of the visible and tantalisingly large corporate cash flows, investors have been happy to bid up stocks (the rising equity premium) in order to capture a piece of those future cash flows. Hence rising P/E ratios (especially during the tech boom) and falling average dividend yields for stocks.

But if the authors are right and corporate cash flows revert to trend in the next fifty years, then investors are already paying too much for earnings that won't materialise. Presto. Change-o. You can expect a falling equity premium as corporate cash flows revert to the mean growth rate.

And why would corporate cash flows revert to the growth rate they had in the first half of the 20th century? Why the credit depression of course! That is, you could argue (quite successfully we think) that the increase in corporate cash flows over the second half of the twentieth century was largely influenced by the growth in global money supply.

Low interest rates and money and credit growth (first in the Western world and lately in China) generated a ton of economic activity. Some of it was legitimate, as the global population grew in size and per capita wealth. It made led first to huge profit margins for American manufacturers. But later, it led to the migration of productive capacity to Asia and a structural decline in Western wages.

What's more, some of the economic activity generated in the modern world of fiat money-particularly in inflationary periods-was of a lot more dubious value. It wasted capital in the sense that it did not produce incoming producing assets for the future that investors could own or capitalise.

But ALL the economic activity generated by money and credit growth found its way into higher corporate cash flows, at least for a pretty long period. Investors then bid up the value of those cash flows, resulting in the equity premium blowing out relative to bonds and cash.

If all that is changing now, it is a very big change and has serious consequences for your wealth-management and retirement plans. One obvious question is if the equity premium returns to trend, does that favour cash or bonds? Will investors prefer those assets more as they prefer stock less?

Our answer is a definite maybe! For many reasons, we would not shift into bonds, especially government bonds. We reckon either inflation or devaluation will eat way your capital there. On the other hand, you know what we think about gold!

But regarding stocks, we reckon switched-on investors will begin demanding stocks that do pay dividends over and above the interest rate on government bonds. Of course for a company to do that its cash flow has to be predictable and growing and not overly-leveraged or capital intensive. Finding those companies is what Kris is up to in his new letter.

But it's also possible that outside the stock market you may simply see the formation a tangible asset premium or a "commodities premium." As cash flows dry up for heavily leveraged business models in the financial economy, they will begin flowing for producers of tangible assets that play a part in the industrial growth of the developing world. Investors who can value those cash flows and time their entry into the stocks-accounting for volatility in commodity prices-may do very well.

That's the idea anyway. And if that idea is correct, it means you may be able to profit in the coming years from a share portfolio made up of companies with growing cash flows from the resource-intensive growth of China. While cash-flows shrink at Macquarie, they may increase at Rio, BHP, and a whole universe of smaller Aussie miners.

But this is such an theoretical discussion-and so far removed from the cliché of buy and hold investing in your super-that we'd expect to see a great deal of volatility in shares as this debate progresses. The volatility is really a result of people not knowing what the future holds, and valuing the present value of future cash flows very differently.

And it could last awhile. The bull market in stocks lasted twenty years. The bear market has already lasted eight. It could last another ten-especially if the authorities actively prevent the liquidation of bad debts and write offs in bank collateral. It will be a long, drawn-out, Zombie-like, Japanese demise. And it means regular volatility on share markets.

We found some support for this observation here. It was a study published in the Journal of Financial Research in 2004 called, "Analysing stock market volatility using extreme-day measures." The study's author Jack Wilson says that the study finds argues that:

Volatility is higher during bear markets. The intuition is that periods of increased uncertainty influence the market in two ways. First, equity value declines reflect higher risk associated with increased uncertainty. Second, increased uncertainty is associated with increased volatility as the market receives information. Veronsi (1999) provides a model that explains how rational investors react to news more quickly in times of greater uncertainty, which increases stock price volatility. Our evidence supports this view.

We'd argue that rational investors are a figment of the scientist's imagination. But it does make sense that in periods of increased uncertainty - and a historic change in the equity premium would definitely produce a lot of uncertainty - investors are going to behave in a highly unpredictable way.

At the very least, this suggests that more active management of your investments and your asset allocation is a good idea. We probably could have just wrote that and left it and that. But most people are reluctant to get more involved in managing their own money. It could cost them in the coming years.

On the other hand, it doesn't take much to improve your results if you have someone doing your thinking and researching alongside you-someone who's interests are aligned with yours. And that's why we have Kris on the case!

Dan Denning
for The Daily Reckoning Australia

• Equity Premium Will Be Replaced With a Tangible Asset Premium
• More Money in Cash Right Now Than Equity in U.S. Companies
• Stocks Better than Bonds When Inflation is a Big Threat
• The Price of Oil Explained by ‘Astrology’
• The Cash Flows Are Coming

You don't need to own subprime loans to take loan losses in a credit depression. Smith said the area that concerned him most was the surge in small and mid-size businesses simply closing up shop unexpectedly. "In the real economy," he said, "there is no evidence that the world economy is yet bottoming." Commercial property looms as the big threat to the Aussie banks this year.

The bad banking result may be enough to sink shares today. But not if they follow Wall Street's lead. Both the Dow and S&P closed up over two percent. It was a strange reaction to a do-nothing statement by the Federal Reserve.

The Fed merely reaffirmed that it would be dishing out US$1.75 trillion to buy mortgage backed securities, agency debt, and U.S. Treasury bonds, bills, and notes. What it did not say is that it would be increasing its purchases of U.S. Treasury bonds and notes. This may explain part of the rally in stocks. Why?

Well, bond prices fell after the Fed said it would do nothing. The yield on the ten-year note went as high as 3.12%. That's as high as it's been since the Fed telegraphed its intention to buy Treasuries and try and force mortgage rates down. If investors can surf higher bond prices in the Fed's wake, perhaps they are happy to rotate into stocks for a bit.

The rally certainly isn't explained by the GDP figures released yesterday in the U.S. Those showed that the economy shrank at a 6.1% annualised pace in the first quarter. That was a slight improvement on the 6.4% shrinkage in the fourth quarter. But is it the sort of thing-along with yesterday's improving consumer confidence number-that hints of a recovery? More on that in a moment.

Before we forget, we're taking applications here at the Old Hat Factory. We have several new products in development and are on the hunt for a full time commodities and resource stock analyst. Experience in the industry (mining or energy) is preferred. But if you're on the financial side of things and know your way around a balance sheet and cash flow statement and are handy with spread sheets, drop us a line at dan@dailyreckoning.com.au Serious inquires only please. Now, back to the markets...

The copper market seemed to interpret the Fed's statement that things were getting less bad as a sign that things are getting better. Copper prices were up 4.5% in New York. Copper is generally a leading indicator of economic growth because of its use in new construction (housing and commercial property).

Dr. Faber might be in agreement with Dr. Copper (as copper is sometimes called for its ability to 'diagnose' the economic conditions). Dr. Marc Faber's latest letter landed in the mailbox yesterday. There were some real gems in this month's Gloom, Boom, and Doom Report. One was this quote from Charles Kettering, "Success is getting what you want, happiness is wanting what you get."

Got it?

Dr. Faber also has quite a bit to say about whether the large rallies in global stock markets since March (and earlier in some cases) constitute a recovery in the economy or just a "bear market rally." He says that, "At least in nominal terms, the global printing presses being run by the world's central banks and fiscal deficits have begun to impact asset prices positively."

This is a concession that the big quantitative easing efforts of the Fed have found their way into bond prices and certain other sectors. Also, by trashing cash the Fed has made stocks look relatively more attractive. Dr. Faber also thinks that, "In the case of resource and mining stocks, as well as Asian equities (and, for that matter, most emerging and other stock markets around the globe), the lows that were reached between October and March of this year are likely to hold-that is, for now."

And what about Australia specifically? He did not single the country out. But he did say that, "The markets that have the highest probability of having made major longer-term lows are resource-related equities, emerging markets, and Japan."

"Conversely," he writes, "the asset market that has the highest probability of having a made a secular high (such as Japan in 1989, or the NASDAQ in March 2000) is the U.S. long-term government bond market. Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside."

Dr. Faber appears to be right. And we have the chart to prove it. The chart tracks the yield on 30-year U.S. bonds over the last year. We've included two moving averages (MA), a shorter-term 50-day MA and a longer-term MA of 100days. So what story does this chart tell?

Click to enlarge

Source: www.bigcharts.com

For one, you can see that when the Fed first announced its intention to buy mortgage backed securities in November of last year, it sent the 30-year yield cliff diving. And remember, because bond prices move inversely to yields, this sent 30-year bond prices up (which would have been good if you were a large holder and eager seller of those bonds like, say, China).

But at the turn of the year when the stock market swooned, thirty-year yields started creeping up again. Bond investors began doubting the Fed's resolve (or ability) to keep rates low with regular purchases (quantitative easing). The really interesting point on the chart is in Mid-March.

That's when the Fed said it would buy up to $300 billion in Treasuries. Yet from a technical perspective, this is exactly the point the short-term moving average (50 days) crossed over the longer-term moving average (100 days). In other words, when the Fed announced it would be coming into the market to buy bonds, 30-year yields experienced a bit of a technical breakout.

Now weather people began selling bonds because they thought stocks were a better bet, or for some other reason, we can't say. What we can say is that this chart may indicate the Fed's basic inability to control interest rates even with quantitative easing.

If ten-year yields keep rising too, the Fed is going to have to come back to the market with something even more jaw dropping. But will the market believe it? Or is Dr. Faber right? Has the secular bear market in long-term bonds begun at just the moment the Fed stepped in to support bond prices and try to force yields down?

We think the question is important because there is a lot of cash on the sidelines at the moment. Higher yields may suck in some cash looking for safety. But we reckon higher bond yields could just as easily trigger a bigger move into stocks. This would get a lot of people who are sitting on the fence back into the market. The rally would go even higher. And then?

That depends on the economy. And on that score, yesterday's GDP figures also revealed two important numbers. Residential investment (housing) declined at a 38% annualised pace in the first quarter of the year. It's been falling for 13 consecutive months, but this latest performance was by far the worst of the lot.

The other number that shocked was the huge decline in business investment. Business investment in equipment and software fell at a 33.8% annualised investment. Investment in non-residential structures fell 44.2%. Why does it shock?

If businesses are not investing now, where will GDP and wage growth come from later this year? We have a possible answer. But before we get to it, let's look at another chart. The chart from the excellent bloggers at www.calculatedriskblog.com shows the respective contributions of residential and business investment to U.S. GDP. So what story does this chart tell?

Click to enlarge

This chart is telling us that previous recessions, residential investment tends to recover ahead of business investment. In other words, it's telling us that households begin to spend again before businesses do. We can't quite work out why that might be (if it's actually correct, that is). It could be that at the low point of a recession, interest rates decline low enough to finally stimulate new demand for mortgages. The rates suck households in and the new housing activity stimulates the rest of the economy.

We're not saying we buy that theory. But the chart is indicating a bounce in residential investment. Our suspicion is that the bounce is re-financing activity at lower interest rates or foreclosure sales (which are doing a ripping business in California). In other words, most of the activity in the housing market is coming from market-clearing prices being reached in the most over-priced markets.

The big question is if the up-tick in home sales (and residential investment) actually stabilises house prices. If those keep falling, there could be a whole new wave of defaults and foreclosures that sweeps the U.S. market. This would have follow-on effects for the banks (more stress, loan losses, capital raisings) and for the job market (thus the economy).

It's also possible more people lose their houses anyway, even if prices stabilise. How? The economy. If the unemployment rate keeps going up, you can expect more Americans to lose their homes.

So it's a bit of chicken and an egg situation isn't it? Will housing investment lead to an economic recovery? Or will higher unemployment blow out the housing investment rebound and send us all into wave two of the Great Credit Depression?

This brings us back to the question of wage and GDP growth this year. If it's not going to come from the corporate world (still busy cutting costs and shedding jobs), is it really possible for housing to lead the American economy out of recession in 2009?

The only way we can see that happening is if the Fed is even more massively involved in supporting the mortgage backed securities market than it already is. It's committed $1.25 trillion to the market already. This backing could make it possible for millions of homeowners to refinance into new fixed rate 30-year loans this year. And if that happens, then you might see that housing-led recovery.

Don't hold your breath. Goldman Sachs reckons the U.S. government will have to raise $3.25 trillion in the debt markets this year to make up for the Federal budget deficit of $1.75 trillion and to fund the Fed's various credit-easing operations. And if the Treasury can't raise the money for the Fed on favourable terms, what do you think the Fed will do?

More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• The Credit Depression
• Global Credit Shortage is Over According to European Central Bank
• 40 Years of Inflation, 80 Years of Dow/Gold
• Fed Willing to Print Money to Buy More Bonds to Keep U.S. Interest Low
• Life After the Credit Depression

National Australia Bank (ASX: NAB) dumped the news on investors Friday morning. No-one told shareholders National Australia Bank was coming. That heightened the impact.

Specifically...NAB boss John Stewart set aside an additional provision for credit risk. An additional provision of AU$830 million. That was the part where the leapt dove into the sleepy-eyed market's midriff. An extra credit provision tells us all that there may be more subprime losses to come. Oooff.

But get an eyeful of this:

"This is the bottom for us for housing in the U.S. because we are now cleared out."  - John Stewart, NAB boss.

That's quite a statement. Especially seeing as Stewart considers the US to be less than half-way through this crisis. Total losses equal US$450 million. John Stewart sees the total topping US$1 trillion.

Of course, if the bank has cleared the table of those rotting subprime assets, it must be at the bottom. That would imply the bottom for share prices. In fact, if you're an efficient market fan, that would imply the bottom for share prices at some time in the past. The market likes to pre-empt things like this.

Well, the bottom isn't here. Not the way we see it.

It's useful to think of the credit industry as a web. There isn't one direct line between each Australian bank and "subprime". There are thousands of different mortgages, sliced and manufactured into more different securities, split between thousands of different institutions. Each firm is connected to many of the threads.

What National Australia Bank is talking about here are ten collateralized debt obligations (CDOs). Each CDO is a blend of different types of assets...packaged as one security. They aren't all 100% subprime. But they all contain subprime exposure.

That's one thread NAB has woven between itself and the subprime industry. It's direct exposure. But that's the very reason why the pain isn't over. Direct exposure isn't the only exposure.

NAB and banks like it have thousands of different loans spreading out in different directions. They provide exposure to other institutions that have exposure to subprime. They provide exposure to institutions that have exposure to institutions that have exposure to subprime.

It sounds a little pedantic. But all of it adds up. One financial firm drops a bit, and it tugs on the credit quality of thousands of others.

This means more credit pressure on big banks. If you need some tangible evidence, Standard and Poors lowered its credit rating on NAB Friday too. Please refrain from jumping on investors' beds in the morning.

So don't look at this at the bottom. National Australia Bank shares probably haven't finished the longer slide. And other banks? Well, if one is at risk, so are the rest. ANZ put out a statement today. Its EPS is likely to be
down 20-25% this year, thanks to larger provisions for credit losses.

Avoid the dip in financials. The bottom for National Australia Bank looks like one of the best ways to lose money in the market today.

Bank earnings, as you can see, aren't giving the market much inspiration. In fact, despite a good lead from Wall Street on Friday, they'll probably help push the market lower.

Aside from Earnings, there are two other market-moving Es to keep track of: Energy and the Economy.

But the Aussie economy isn't giving away any clues this week. Don't camp out for any big announcements. Not in Australia anyway.

Over in the US though, house prices and unemployment numbers come through on Wednesday and Friday. They might be good or bad.

Actually, scratch that. They will be bad.

But the Dow Jones doesn't care about quality...it only really gives a hoot or two if numbers surprise analysts. Be prepared for a chain reaction if that happens. A worse-than expected economy equals falling US stocks. Falling US stocks are, in the absence of anything important happening here, a bad omen for the ASX.

The All Ordinaries is sitting just above a key support line. That makes any big event more important than usual.

So we'd rather just watch the market this week. It doesn't quite have a clear direction yet. And those US releases have the potential to louse things up again.

Al Robinson
The Daily Reckoning Australia

• Funny Business at the Banks
• A National Mortgage Bubble
• This Reflation is Not Yet a Monster Hyper-inflation
• One in Four US banks Announce Unprofitable Quarter
• Twenty-Five Standard Deviations in a Blue Moon

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