The news that’s all the rage today is Westpac’s $19 billion bid for St. George. It would create the biggest bank, by assets, in Australia. So… should we care? Big five? Big four? Big deal!

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, 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 from 2.22% to 2.17%, NAB’s 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
http://www.rba.gov.au/Statistics/Bulletin/index.html

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?

Goldman Sachs says so. It expects so “global credit losses” of $1.2trn. Nouriel Roubini said so some time back and notes his view has become fashionable since. “$1trn is the new size 6!” though the final tally could be higher still. And now, the International Monetary Fund says so. Losses from the US mortgage crisis may amount to the best part of a $1trn blunder ($945bn) they reported yesterday in what the FT dubbed “an Instability Report”.

This puts it ‘at least on a similar order of magnitude in dollar terms’ with the 1990s Japan crisis, though there are differences say the IMF.

This time it’s not just the banks of a single country that are left holding the bag, as happened with the Japanese banks in the 1990s. The age of the internet and globalisation has increased the reach of the financial muck spreader to cast its manure around the planet to such an extent that most subprime losses have landed on non-US plates. European bank subprime losses expected to total $120bn, will be only $20bn shy of those expected in the US.

Another difference between Japan in the 1990s and the US today is the relative sizes of their economies. Japanese losses amounted to 15% of GDP reports the FT against about 7% of the US economy – making it about half the hit in GDP terms. And the third distinction says the IMF is again one of dispersion. Not only are subprime assets held around the world. They are held by a broad array of financial businesses. In 1990s Japan this was not the case. The Japanese banks bore the brunt of the losses. This time it’s not only the world’s banks, it’s the insurance companies, pension funds and hedge funds.

Commentary has alluded to the risk of the US following Japan into a deflationary slump. Do these distinctions make that less likely? We’re up to the question but regrettably not to the answer though it must help. As too should the cultural difference where loss of face in the West is not what it is in the East. History may show eventually that Bear Stearns was the bottom of the crisis but with some $230bn of losses revealed to date the credit squeeze is far from over. News abounds of its tightening grip around the necks of consumers who went too easy on EZ credit in pre-crunch days. Discrimination is making a comeback among the lending community as they look more closely at those credit reports.

Back to the IMF’s “Instability Report” for a moment. Comments from the IMF’s Head of monetary affairs and capital markets Jaime Caruana gives some insights.
- Since October “systemic risks have increased sharply” as has the potential domino effect if a large financial institution going bust.
- The Bear Stearns rescue “helped to reduce the possibility of a tail event in the financial system”. A what? The FT explains: ‘it made a truly catastrophic event less likely.’
- “Funding strains remain high and balance sheet pressures on financial institutions continue.”
- There has been a “collective failure to appreciate the extent of leverage in the financial system”.

Ah the old rogue steals centre stage in all the best financial crises. Borrowed money… Borrowed money to the max. You can amass the best brains, the best contacts and the best technology but still go bust. Long-Term Capital Management proved that in some style a decade ago now. Of the $129bn of assets it boasted at the time, $124.5bn had been purchased with borrowed money. Even a team that included joint economics Nobel prize winners Myron Scholes and Robert Merton couldn’t find a mathematical formula to save the ship when its mountainous debt hit an immovable object in the form of a Russian debt default inspired market panic. More recent examples of highly leveraged hedgies to have come unstuck in the current credit squeeze include Peloton Partners and Carlyle Capital.

As to the prospects for UK plc., the IMF is gloomy. It expects growth to be 1.6% this year and next. Okay I think we’ve all registered this is a slowdown for the UK. Here we’re just picking over how slow do we go. Alistair Darling is more optimistic. We’ll do better than that says he – 1.75% this year and 2.25% next. The metaphor of arranging deckchairs on a sinking Titanic comes to mind and we’re left hoping it is just that and ‘the further downside risks’ muttered darkly by some analysts don’t show up.

News on jobs and wage inflation provides some encouragement this morning. Permanent job placements picked up in March and wage inflation eased according to the Recruitment and Employment Federation/KPMG but the tone is cautious. Alan Nolan, a director of KPMG tells Reuters:
“No matter what sector, employers are becoming increasingly cautious about the outlook.”

It’s hard not to be cautious when even Sky News is headlining house price crash as its topic du jour and Gordon Brown is looking for scapegoats. As to that subject, we’ll give it a rest and let it our fevered brow cool for a while. That said it’s interesting to note HSBC is throwing UK homeowners a lifeline and possibly a support to the wider market. 1.4m mortgage holders face a rude awakening when they come off low fixed rate deals this year and start discovering the cost of money has gone up somewhat from the heady days prevailing a couple of years ago. But maybe this is an awakening postponed…

HSBC is offering to match homeowners’ existing deals – some as low as 4.54% – in what the FT calls “an audacious offer”. And quite possibly a shrewd one too for a UK bank with sufficient clout to take a view on the UK mortgage business. HSBC has 3% of the market and are building in a comfort zone on deals they will accept by demanding at least 20% property equity. Given there are 11.8m mortgages in the UK according to the Council of Mortgage Lenders, if HSBC captures even a quarter of this market segment it stands to at least double its market share at a time when weakened competitors are licking their wounds.

Whilst mentioning the Council of Mortgage Lenders, their press release yesterday is a timely reminder of the housing wealth held in Britain today. For all the angst, UK homeowners are collectively sitting on £2.5trn of housing wealth in hock to no one.

Over in the markets, European stocks are higher this morning with the FTSE 100 ten points clear of the 6,000 level. Mining giant BHP Billiton, currently bidding for Rio Tinto, is itself being stalked according to a report that broke in the Australian press. It was up nearly 5% yesterday on rumours that China’s Baoshan Iron and Steel is planning to pick up 9% of the company. Another Chinese entity Chinalco, has a 9% stake in Rio Tinto. It’s that West to East thing. Gold is lower at $908. Oil is $108. UK interbank lending rates are lower too, at 5.93%. The pound is worth $1.97 to the dollar and €1.25 to the euro.

Finally, today and tomorrow we are without Bill as he is somewhere in the Argentinean hinterland either travelling to or from his remote estancia in the foot hills of the Andes. Satellite communications permitting, he will return on Friday when we expect an update on the livestock included within his market reckonings. As a consequence, we run rather less verbose Reckonings today and tomorrow than is our habit.

Regards,
Rob Mackrill
The Daily Reckoning

Stocks on Wall Street took a beating yesterday, but on the other side of the Earth, the Shanghai exchange soared… up nearly 5%.

Rumors suggest the Chinese government may enable gamblers worldwide to trade futures on the Shanghai Composite. And up she went.

If you haven’t been paying attention, the mainland Chinese market has been witnessing some serious bloodletting for the past five months. The Shanghai Composite is down 40% from its all-time high set in October 2007.

In the last month alone, the SSE has suffered a textbook 10% correction:

After putting U.S. markets to shame in 2007, Chinese stocks are looking less attractive by the day in 2008. If you’ve got the cajones to trade futures on that market, more power to you.

Also of concern in the Far East, rice prices skyrocketed overnight. Since we mentioned the rising cost two weeks ago, rice has risen as much as 30%.

Yesterday alone, traders goosed the price double digits after Egypt — a leading rice producer — announced a ban on rice exports. Global stockpiles have dropped to levels not seen since Carter entered the Oval Office.

Following Egypt’s decree, the Philippines announced a massive purchasing plan to shore up reserves. India installed additional restrictions on rice exportation. Vietnam officials vowed to cut exports, and Cambodia followed suit.

China, as we’ve come to expect, added its own twist. The government promised to pay farmers more than market price for their rice in order to grow stockpiles. They’ll need extras supplies for the Olympic hordes they’re pining to impress.

Thus, the price of Thai rice, the global benchmark, has doubled since January.

Rice trades a bit differently in the U.S. But a quick look at futures in Chicago and we think you’ll get the idea:

The price has doubled, to $19 per 100-pound contract, in a little over 15 months. At this pace, you’ll see blood in the streets in many of the world’s poorest nations before the end of the year.

The U.S. stock market resumed its losing ways yesterday. The Dow and S&P 500 both fell around 1%. In keeping with the trend, a down day for the Dow spelled an even worse day for the Nasdaq. The tech index fell nearly 2% on a Google downgrade and poor earnings guidance from Oracle.

J.P. Morgan released its 2008 Global Internet Snapshot this morning. It paints a surprisingly optimistic future for global “tech.” Here are some highlights:

Cell phones: For every 100 U.S. citizens, 77 have a cell phone calling plan. In Italy and Hong Kong, there are 135 mobile subscriptions for every 100 people. The global average? Only 41 out of every 100 citizens subscribe to cell phone service.

Mobile phone users are growing at an annual rate of 27%… Indian cell phone users grew by 84% last year alone. Computers: For every 100 Americans, there are 80 PCs. Global PC ownership is a humble 13 for every 100.

Internet: 1.3 billion people now have reliable access to the Internet, thanks to an annual growth rate of over 20% during the last eight years. Yet global Internet advertisers spent only $40 billion last year, 6% of the total estimated worldwide advertising expenditure.

If the global economy doesn’t melt down completely, cell phones and computers still look like a long-term growth opportunity. The trick is finding the right players.

Former Bear Stearns bridge champion and part-time CEO Jimmy Cayne sold every last one of his BSC shares yesterday. Cayne unloaded some 5.7 million shares at $10 a pop for a net “profit” of $61 million.

In a shocking twist, Bear stock fell about 4.5% in aftermarket trading.

Two years ago, Cayne became the first Wall Street CEO to own a $1 billion stake in his own company. Now that he’s cashed out and the stock has ticked down… what are the odds of J.P. Morgan continuing to woo the failing bank above $10 per share?

The Fed took on $75 billion worth of mortgage-related securities in exchange for U.S. Treasuries yesterday.

In its first and much hyped TSLF, our lender of last resort allowed banks and brokerage houses to unload their toxic mortgage-related investments for government debt… for a mere 0.3% rate of interest. We’re sure our grandchildren will thank you for the effort when they get the chance.