Can we expect anything like this here? To some degree we’ve already seen it with Allco [ASX:AFG], Babcock & Brown [ASX:BNB], Opes Prime, Tricom and MFS [ASX:OCV]. But they mainly peripheral players. Merrill Lynch, Lehman Brothers and Bear Stearns were not on the periphery in US markets.

The next phase is to see if any of our major banks get caught in the wash-up. Could an Australian bank or major brokerage firm fall to the same fate? ANZ Bank [ASX:ANZ] and National Australia Bank [ASX:NAB] have been touted as the riskiest of the four major banks. As for the broking firms, only those with proprietary trading desks, deal heavily in debt securities or who have unsustainable loan books, are candidates for trouble.

We have said it for a while now. We are content to stay away from the finance sector. We may miss out on some of the upside when the market turns, but we are prepared to take that chance.

This morning The Australian newspaper tells us that “NAB, ANZ most at risk, investment bank Citi warns,” – it probably isn’t the best constructed headline the world has ever seen, but it does get the message across… just.

We have to admit that we do always find it entertaining when one bank is passing judgement on another. It almost seems as though they are reluctantly breaking some secret covenant if they criticize the competition. Although their biggest fear is highlighting something in another bank which others may think is also the case in their bank.

For a start it seems odd that none of the banking analysts were able to pick up potential problems in the credit markets, despite these analysts having an in-depth knowledge of how these complex products work.

44 Pages You DON’T Want to Read
Despite this warning by Citi, the bank has still decided that both NAB and ANZ make a worthwhile investment and have upgraded both companies to Hold. After glancing at the 44 pages of charts, tables, ratios and acronyms we will just have to take their word for it! We try to be briefer with our research at the Australian Small Cap Investigator.

But perhaps this is the very reason the analysts missed all the warnings that were soon due to explode onto credit markets. They just couldn’t see the woods for the trees.

And maybe, just maybe they didn’t understand how complex products such as Collateralised Debt Obligations (CDOs) worked. They can’t take all the blame though, as they were ably assisted by credit ratings agencies (Standard & Poor’s, Moody’s, Fitch) who allowed their ratings to be manipulated and distorted to such an extent that the genuine meaning of a AAA credit rating went out of the window.

All You Need to Know About CDOs
How so? We don’t have the space to go into it in any great detail, so here’s the thirty second version. A Triple A credit rating is normally reserved for those companies or governments that are deemed by the rating agency to be so financially reliable – beyond almost any doubt – that they will have no problem in repaying their debts. For example the Australian government has a AAA credit rating.

The less the expectation is that a company or government can repay its debt the lower the credit rating, eg. AA, B, B-, C, etc… Bonds with a rating of less than B are typically termed as being “Junk Bonds.”

Needless to say, the greater the credit quality, the lower the interest rate as there is perceived to be lower risk. The lower the credit quality the higher the interest rate in order to compensate for the higher risk.

The problems with CDOs is that the investment banks would take a bunch of mortgages for example and split them into tranches. The tranches may be exactly the same ‘quality’ however, they had a different order of priority that would effectively subject the first tranche to any defaults first up to a certain level. Once that level was breached then the second tranche would be subjected to any defaults, and so on until finally the last tranche would start to be allocated any defaults.

When is Triple A Not Triple A?
You’ve guessed it, this last tranche was deemed to be Triple A rated debt by the ratings agencies. To investors it was placed on the same risk level as major corporations and governments despite the fact that it was just a big pool of home mortgages.

Did the likes of NAB and ANZ know this? You would have thought so, but based on the ANZ report into its securities lending business where it claimed that staff didn’t know what they were doing, then perhaps it didn’t.

The latest bank to release its annual results is Suncorp [ASX:SUN]. The bank announced profits for its banking, insurance and wealth management business units.

However, the net profit was down by a reasonably large 47.7% compared to the previous financial year. The banking division performed the best, increasing profit by 11%, but insurance profits were down by 63% and wealth management profits decreased by 86%.

With net profit totaling just $556 million, down from just over $1 billion the previous year, Suncorp has maintained its dividend payment at $1.07, which means that it has a dividend payout ratio of 183%. Further to that, the board are expecting to maintain at least the dividend payment at the same level for next year.

On that basis Suncorp is yielding 8.74% in dividends plus any capital growth. This all depends on their ability to increase profits back to where it was last year at a minimum. If not, and if it has to cut the dividend you could reasonably expect Suncorp shares to fall further.

Government Profit Set to Increase
You can imagine how pleased we were to read on page 3 of today’s Australian Financial Review (AFR) that the Australian government is forecast to make a profit of $5 billion more than expected to come in at around $25 billion.

Every year the public servants in Canberra seem to grossly underestimate what they call a surplus, but what any other business would call a profit. A profit which is at the expense of taxpayers.

Will the Danes Save Tricom’s Bacon?
Bell Financial Group tried to buy it, didn’t like what they saw and left. According to the CEO of Tricom, Lance Rosenberg, he doesn’t know why. Before that, ANZ Bank were not prepared to give Tricom cash instead of stock back in January when Tricom failed to settle trades with the ASX. Again, Rosenberg doesn’t know why ANZ wouldn’t cough up.

Now it turns out, as reported over the weekend by The Australian that Tricom’s saviour, Danish firm Saxo Bank has also seen the light after taking a look at the audited books and deciding that it would rather not proceed.

Is the deal really off, or is Saxo merely being opportunistic in taking advantage of the mess that Tricom’s financiers, ANZ Bank and Babcock & Brown are both in to renegotiate the terms of the deal? With everything we’ve seen over the past couple of weeks ANZ, B&B and Tricom need Saxo more than Saxo needs them.

ANZ in Denial
Rule 1. When taking over as CEO of a company make sure that you shift the blame for all the bad stuff on the previous mob.
Rule 2. Keep quiet about the good stuff until you’ve been in the job for at least 6 months so you can claim the new “culture” has resulted in an improved performance.

Last week the ANZ [ASX:ANZ] released its ‘Securities Lending Review’ which was commissioned by the new CEO, Mike Smith. Right on the first page of the document the review states “It is clear now that the difference between Equity Finance and other types of Securities Lending were not fully understood and appreciated by most staff involved in those products.”

“Most staff” – that’s a worry. Especially considering that as a bare minimum all staff had to do was go to the website of the Australian Securities Lending Association (ASLA) and they could have learned all about the history of securities lending, how it works, the risks, and they could also have seen that the ANZ Bank was in fact a member of ASLA.

We also question whether it really is possible that senior bank management really didn’t know anything about securities lending, Opes Prime, nor what the real exposure was.

It seems as though everyone was happy enough taking in the revenue but was too lazy to learn anything about it.

The market is up 24, below futures expectations - SFE Futures were up 72 this morning. Financials strong – up 1.9% after strong rise in US financials on Friday. Resources down 2.1% following falls in BHP and RIO in the US. The property sector is up 1.7%. Results season going OK– United Group up 4.5% on results. Crane Group up 3.2% on results, Bendigo & Adelaide Bank up 3.16% on results. Profits warning –Babcock & Brown have issued a profits warning this morning and fallen 9.41%.

Dow up 302. Up 329 at best. Down 43 at worst. Main factors behind the rise in the Dow on Friday include falling oil prices and a rapidly appreciating USD (A$ down to $88.85). Dow up 3.6% for the week – S&P up 2.9% and the Nasdaq up 4.5%. Oil down 4% on Friday - down 8% for the week – still up 20% year-to-date. Energy sector fell 0.6% on falling oil and rising USD. Resources and metal prices sold off as USD rose (makes commodities more expensive and reduces demand). Euro weak on European Economic growth concerns. Financials up 3.5% although Fannie Mae posted a wider-than-expected 2Q loss – down 9%. Homebuilders and retailers well up – 7% and 4.3%. 2Q unit labour costs were up just 1.3% - easing inflation concerns and boosting bonds.

• Both BHP and RIO down in ADR form on Friday, 1.83% and 3% respectively. BHP down 49c to 3666c. RIO down 333c to 11265c.
• Metals all down on Friday – Nickel down 3.59%, Zinc down 3.46% and Copper 3.67%. Aluminium down 2.41%. Oz Minerals down 3% or 6c to 178c.
• Oil price down $4.42 to $115.42 despite concerns of a sabotaged oil pipeline in Turkey. Woodside down 7c to 5143c.
• Gold down $13.10 to $860.70. Newcrest down 178c to 2461c.
• US Bonds down with the 10 year yield up to 3.95% from 3.93%.

RBA impending rate cuts, falling oil prices and weaker AUD lifting consumer and industrial sectors– up about 2% each – DJS up 5.0%, ANN up 4.4%, WOW up 2.1%, HVN up 3.9%. Healthcare flying– CSL up 4.7% ahead of results this week, SHL up 5.1% and COH up 2.9%. Big industrials benefiting from lower oil price – exporters benefiting from lower AUD – WES up 2.0%, BXB up 2.1%, QAN up 2.4%. TOL up 2.4%. Nickel stocks falling over on a fall in the nickel price – WSA down 1.3%, MRE down 9.1%, PAN down 7.1%, and MCR down 5.6%.

RBA’s Statement on Monetary Policy is out– Main message: Inflation in Australia still high - in other words the same message as last week’s statement….interest rates have peaked and cuts are on the way.

NAB comment on the oil price – “markets are in for one of the most amazing turnarounds ever seen…entire commodity boom looks like busting… this is just the start of a pullback. It is very feasible to get downside targets into the $70-$65 zone”.

• Bendigo and Adelaide Bank(BEN) up 5.1% on results roughly in-line with consensus.
• United Group (UGL) up 4.3% on full year profit. Described as a strong underlying result. 
• Crane Group (CRG) up 3.8% on solid result - net profit in line with expectations and guidance.
• Babcock and Brown (BNB) down 7.8% early on profit warning – says interim net profit to be down 25-40% below that of $250m 2007 interim result.
• Felix Resources (FLX) down 7.36% after putting construction on hold at its key Moolarben thermal coal project while awaiting NSW court of appeal who Friday upheld Xstrata’s case about the validity of the two mining leases.
• Macquarie Airports (MAP) down 6% as Sydney Airport approach banks to refinance $762m of debt, probably at much higher rates than current levels.
• Credit Suisse tip Cochlear (COH) to post FY08 net profit tomorrow in middle of analyst’s consensus range – up 2.63%.
• JP Morgan predicting Bluescope Steel (BSL) to post FY08 normalised earnings up 22% on FY07 and 4% above consensus and BSL’s guidance. Despite that the price is down 5.13%.
• AGL Energy (AGK) up 2.07% as UBS cut AGK’s target to 1590 from 1640 due to the fall in Queensland Gas price in which it has a 28% stake.
• UBS have cut their target price on nickel stock Minara (MRE) by 50% from 370c to 185c and their recommendation to NEUTRAL from BUY – down 7.3%.

We await CBA results on Wednesday– a bellwether for the bank sector. Hard to believe they won’t be good….otherwise why haven’t they let us know in the wake of the NAB and ANZ profit warnings. Telstra results also on Wednesday. Guidance of 6-8% growth…consensus is 9.5% growth.

 Problem with Bank

Boom. The second of the four pillars went down yesterday.

When the dust settled at the end of trade, 11% of ANZ’s (ASX:ANZ) share price was missing. Its weakness was the same one that crushed 15% of National Australia Bank on Friday. The falling and uncertain value of CDOs.

Collateralised Debt Obligations are pot-luck assets. Investment banks basically take a bunch of different ingredients – high-risk mortgages and low-risk mortgages, for example – and stir them together into one product. Then they sell these off to whoever wants them.

The CDO units with mortgage assets encased inside them are crumbling. Any businesses built with CDO bricks are crumbling now too. But because they’re a mish-mosh of assets, no-one really knows how much their CDOs are worth.

So far, we know that other Aussie banks have CDOs built into them somewhere too. You’d probably like to know how many CDO bricks there are. The banks are keeping their mouths shut on that one.

Westpac (ASX:WBC) has said it hasn’t suffered any losses on its CDO portfolio. It owns a “small, high quality CDO portfolio”. Commonwealth has said it has no unhedged CDOs or CLOs (Collateralised Loan Obligations), but a “small portfolio” that is “fully hedged”.

Seeing as none of the banks plan to divulge exactly how much CDO or CLO exposure they have…the nearest thing the market has to go on is total derivative exposure. So here it is. These are the figures from the banks most recent balance sheets. Most of them reported in March.

NAB and ANZ have probably built the most bricks into their businesses. St George probably has the least. But all the banks have fallen in double figures since Thursday’s close, before the funeral procession began.

Ordinarily, we might look at this as a trade. Commonwealth, for example, has about half the derivative exposure as ANZ. Plus it has hedged those assets. But it’s still down 11%.

The problem with this CDO mess is that analysts and financiers are having trouble valuing the assets. Plus they can, and probably will, fall further. NAB boss John Stewart noted on Friday that America has about as many spare homes as Australia has people.

If there’s still more bad news to come, we don’t see any compelling reason to look at the banks yet. The market seems to agree. The big banks are down another 2-5% again today.

Wall Street Sends All Ords Lower

But that probably has a lot to do with Wall Street’s performance last night. The Dow Jones fell 2% after regulators closed two small regional banks. The smallest ones are the first to go.

Expect more of this. It may seem like financials will never heal. They will eventually. We don’t know what the industry will look like then. Probably a lot more conservative…until the next big fad loads up balance sheets with debt until it all climaxes in another bubble.

Meanwhile, iron ore and coal stocks are still in high demand…

For the second time in two trading days Australian stockmarket investors, and investors in the country’s big banks, have been battered by another example of bank management incompetence and boardroom ineptitude. On Friday it was the National Australia Bank which stunned the market with a $830 million write-down on credit securities written over US housing mortgages and yesterday it was the turn of its fellow Melbourne rival, the ANZ, to reveal a sharp rise in bad debt provisions for the second half of the year and more worrying, a 20% to 25% drop in cash earnings. The ANZ’s news reflects badly on former management and board members, some of whom are still there. The ANZ forecast the biggest full-year profit drop since the last recession in 1992 when it was crippled by bad debts to property and stockmarket players. This time it’s those, plus previously disclosed loans and investments in the US and an association with a monoline insurer that has gone bad and continues to hurt the bank. An d rising provisions for credit losses because of the slowing economy. The shares had their sharpest fall in 21 years as they plunged by more than 13% at one stage. They ended down 11% at $15.81, a fall of $1.94 on the day. The bank said cash earnings per share (which excluded income from derivatives trading) will fall 20% to 25% in the year to September 30, as the company tripled provisions for bad loans to more than $2.1 billion, compared with 2007’s figure. In the wake of the NAB’s shock announcement last Friday, Australia’s five biggest banks have lost a combined $27.4 billion in market value. The NAB fell 76c yesterday to $25.80, Westpac dropped $1.76 or 8% to $20.33; the Commonwealth shed $2.15 or 5% to $41.10 and St George fell 8.4% or $2.41 to $26.20. ANZ shares are now around half the value of their high in October last year of $31.55. ANZ’s second half provision came on top of first half credit write downs of $980 million, bringing the full year potential loss to close to $2.2 billion. But in contrast to NAB, ANZ has attributed its likely losses to local clients rather than any exposure to the troubled US property market, although some of the first half losses were due to the involvement with the downgraded monoline insurers. ANZ revealed it had made a further provision of $160 million related to its exposure to those monoline insurers, in addition to the $226 million booked in the first half. Chief executive Mike Smith said the second half collective provision charge had been raised to $376 million, or around 1% of credit risk weight assets. He explained in a statement to the ASX  that the decision was a response to both the deteriorating global credit environment and the softening domestic economies in New Zealand and Australia. ANZ’s individual provisions charge is now expected to be around $850 million in the second half compared to $604 million in the first half.

Those likely losses flow from ANZ’s lending to a number of previously identified corporate failures, including payment firm Bill Express and securities lender Primebroker. Both companies are now in administration.

The ANZ had an involvement with the messy and failed margin lender Opes Prime and another failed broker, and helped financed Tricom, a third troubled margin lending business.

But the individual provisions also cover a number of commercial property clients the bank refused to identify although they are known to include Centro Properties Group and US-based mortgage lender Countrywide which has been taken over by Bank of America.

Earlier this year brokers estimated that ANZ had a $500 million unsecured exposure to Centro, a $700 million secured exposure and a $150 million exposure to Countrywide.

In a phone briefing , Mr Smith made it clear he wasn’t impressed:

“Having to announce these sort of provisions is beyond disappointing,” he said.

“What is really irritating is that we having to spend so much time on remedial action, so much time and money on addressing legacy issues when I know there is real growth potential available to the business.”

The bank made it clear in its statement that it had enough capital to fund that growth, having completed its 2008 term funding and with $32 billion in liquid assets and that there would be no cut to the full year dividend of $1.36 a share.

ANZ said its 2008 cash profit was likely to be over $3 billion. It said that while its underlying business was performing well, particularly its personal banking and Asia businesses, significantly higher mortgage interest rates and higher food and petrol prices were weighing down heavily on consumers and business.

”While losses are being contained, individual provisions are likely to be around three times the low levels experienced in 2007. Losses on commercial and corporate lending have also increased,” the bank said.

The bank said it had no direct exposure to US subprime mortgages, and no direct exposure to subprime collateralised debt obligations (CDO). Mr Smith made it clear the ANZ had no exposure to the sort of securities which caused NAB’s write-down last week.

ANZ said its commercial property exposure was about $26 billion, or 8% of its total loan book.

Mortgage and credit card arrears in Australia had risen “only modestly” Mr Smith said.

“But we do need to take a conservative view as the economy slows further. I think it’s is entirely unrealistic to assume that the position can maintained.”

New Zealand’s economy was now contracting and the growth in provisions for bad credit there was expected to push profit down by 10%.

The bank said its institutional division’s after-tax profit will be weighed by ‘’substantially higher credit provisions and valuation adjustments”. The institutional division’s annual profit is expected to be about half 2007’s result of $1.44 billion.

The ANZ’s news means the long reign of former CEO, John McFarlane and chairman Charles Goode took a second knock, after the first one with the surprise write-downs earlier in the year, just as the reputation of the NAB’s current CEO, John Stewart, was damaged by Friday’s announcement.

SHARES in ANZ fell 11 per cent in early trade after the bank flagged a $1.2 billion second half credit provision and said its annual profit could fall by up to a quarter.

At 10.18am (AEST), ANZ (anz.ASX:Quote,News) shares had fallen $1.89, or 10.65 per cent, to $15.86 after dropping as low as $15.40.  By noon its shares were down $1.80, or 10.14 per cent, at $15.95.

ANZ fell about 9 per cent on Friday after banking stocks were dragged down by National Australia Bank (nab.ASX:Quote,News) announcing a $830 million additional write-down linked to investments in US mortgage debt.

ANZ’s expected $1.2 billion second half provision adds to a $980 million provision booked in the first half.

The bank said today the the losses were expected to drive its annual cash earnings per share down by between 20 and 25 per cent. The bank said its 2008 cash profit was likely to be over $3 billion and it expected to maintain its full-year dividend at 136 cents per share.

Provisions are ’sensible’ move

Federal Treasurer Wayne Swan said it was sensible of ANZ to make provisions for potential losses, adding he was satisfied with the level of disclosure.

“These potential losses come from decisions, investment decisions, poor investment decisions taken over a period of years, as well as the fallout from the global financial market events.”

He said it’s important for chief executives and boards of banks to accept responsibility for their circumstances.

“From day one, this Government has said that it is important that financial institutions declare their positions.

“That sort of transparency is very important and that’s what we’re seeing today.”

He said the fact major banks were making extra credit provisions shows Australia is not immune to developments in global financial markets, but added the local banking system was robust.

“I think we shouldn’t lose sight of the fact that we do have a strong, well-regulated banking sector which is capable of withstanding the fallout from these international developments.”

NAB fell $1.11, or 4.18 per cent, to $25.45, Commonwealth Bank of Australia fell $2.25, or 5.2 per cent, to $41.00 and Westpac fell $1.19 or 5.39 per cent, to $20.90.

The ANZ bank this morning warned the market its looking at a 25% drop in earnings because of dodgy and bad loans. In a statement to the ASX the bank joined its Melbourne rival, the National Australia Bank, in softening up shareholders for the worst. The ANZ said 2008 cash earnings per share were likely to fall between 20% and 25% on the previous year due to a rise in credit impairment costs. ANZ said its provisions in the second half were likely to be around $1.2 billion as a result of the ongoing deterioration in global credit markets. It made provisions of $980 million in the first half. The ANZ forecast that 2008 annual profit before provisions to rise by around 8% and its annual cash profit would exceed $3 billion for the year to September 30. The second half collective provision charge is expected to be $375 million, from $376 million in the first half while for individual provisions, ANZ said known credit issues had deteriorated including ”certain commercial property clients, securities lending and Bill Express”. Second half individual provisions are expected to be around $850 million, from $604 million in the first half. ”ANZ’s underlying business is continuing to deliver a solid performance, and we expect a cash profit of over $3 billion in 2008,” chief executive Mike Smith said in the statement to the ASX. The news comes after credit rating agency, Standard & Poor’s revised its credit watch outlook for the National Australia Bank and its subsidiaries after the bank’s shock revelation on Friday that it had put aside an extra $830 million to cover provisional losses on dodgy housing loans in the US. S&P said it was changing the NAB’s outlook to negative from stable. The decision caused the market to drop 3% on Friday and the NAB almost 14% in the biggest drop in almost 21 years. Investors on Friday cut $7 billion from NAB’s market value. The $830 million provision adds to another charge booked earlier this year and takes the bank’s total exposure to $1.01 billion, meaning some 90% of the value of the CDOs has now been written down. The ratings agency said the additional provision was a significant amount, representing 40% of NAB’s pre-tax earnings for the first half of fiscal 2008. However, it has affirmed its current credit rating (AA/A-1+). Standard & Poor’s said the banks ratings were likely to be lowered if NAB were to suffer a further significant increase in credit costs, if some other significant unfavourable information was to emerge, or if NAB experienced adverse investor sentiment. “Although we expect the bank to remain profitable in the second half of fiscal 2008 and that the large provision is a one-off event, the negative outlook reflects the risk of further increases in credit costs in the next 12 months,” Standard & Poor’s credit analyst Sharad Jain said. “Apart from emphasising the potential for higher credit costs, today’s announcement highlights that NAB may face challenges in predicting future credit losses.

“Furthermore, such developments could reduce investor confidence, which would put pressure on the bank’s funding access and costs.”

Standard & Poor’s said it expected NAB would continue to “rigorously monitor and manage its credit exposures, funding, and liquidity amid the challenging conditions in the financial markets, and maintain its conservative capital profile”.

The NAB’s CEO, John Stewart said on ABC TV yesterday that “This is the bottom for us for housing in the US because we are now cleared out”.

Mr Stewart said NAB’s other business continued to do well and the company’s dividend would therefore be unaffected by the $830 million provision.

The bank late Friday revealed a further $4.5 billion in CDOs written on a mixture of corporate loans, infrastructure and commercial property assets in Australia, Europe and the US.

Mr Stewart said the situation for the US housing market would probably worsen.

“Things are going to get worse,” he said.

“There are more than 18 million vacant properties for sale in the United States just now. That’s more than the whole housing stock of Australia.”

He said it was a worrying time for the US economy and it would be some time before it recovered.

Mr Stewart said the National would not have to raise new equity to account for the provision.

“No, we don’t,” he said.

“That’s why we were so confident that we should take a big write-off here and not let it drip over the next few years,” he said.

It’s the biggest crisis for the bank since the foreign exchange options trading losses four years ago and it wouldn’t surprise if the key regulator, APRA, became involved.

Shares in NAB, the nation’s second largest bank, ended down $4.14 or 13.49% on Friday at $26.56.

The ASX200 index finished down 173.6 points, or 3.37%, to 4970.5 after hitting a low of 4939.8 in intra-day trade, while the All Ordinaries shed 157.4 points, or 3.03%, to 5031 after reaching a low of 5003.2 in early trade.

It was the biggest one-day fall since January 22, when the All Ords fell 7.3% and the S&P ASX 200 fell 7.1%. The futures had the local market opening up 24 points today after trading overnight Friday.

The Commonwealth Bank fell $3.14, or 6.77%, to $43.25, the ANZ shed $1.70, or 8.74%, to $17.75 and Westpac fell 71c, or 3.11%, to $22.09. St George Bank lost $1.04, or 3.51%, to $28.61.

Analysts said the NAB would suffer a $600 million blow to its annual net profit for the year to September 30 after the write-down.

The NAB also faces pressure on earnings from sluggish economies and lending in New Zealand and in Britain.