We have climbed down from our soapbox today, in order to take a look at the banks. Or, more precisely, the dividends on bank shares.

Today’s Age reports that “Australian banks pressured to lower dividends.” It’s a touchy subject for the four major banks. If there are two things Australian income investors like it’s a nice juicy dividend and 100% franking.

With interest rates falling, investors will naturally be looking for other sources of income. And with bank share dividends offering yields of about 9% it is a pretty attractive investment.

For instance, take a look at the four major banks:

ANZ Bank - yields 9.7%
National Australia Bank - yields 10.2%
Commonwealth Bank - 8.1%
Westpac Bank - 8.5%

And Queensland based Suncorp can offer a dividend even better than that. It is yielding 11.7%.

Add in the franking credits and the yield gets another boost.

For those that rely on income streams from their investments, falling interest rates can make a big difference. Supposing an investor has $500k in their account to live on in retirement, a cut in interest rates from 6% to 5% results in an income reduction of $5,000 per year.

For that reason bank shares should look attractive. $500k could potentially provide an income of about $45,000, compared to only $25,000 if held in cash at 5%.

But it is a big, big risk. Especially for those in retirement. Many will have seen a drastic reduction in the value of their share portfolios. They would be the same people who assumed investing in the banks was safe and reliable. They would have convinced themselves that banks shares couldn’t fall - not by 50% anyway.

The big question for them is, has the market discounted the price of bank shares in the belief that dividends will be cut? You would think it has. So far the Australian banks have weathered the global credit problems quite well.

Not that they have got off completely. But unless something really bad comes out of the woodwork it seems likely that all the ‘bad debt’ risk is already built into the share price.

So it can only really mean that expectations are high for a dividend cut. As Bell Potter research director Peter Quinton points out in The Age article, “It’s increasingly untenable to be paying out 90% of profits as dividends when all banks around the world are rebuilding their capital.”

If we assume a reduction in the yield to about 7% then the banks are now trading around that level. That should reduce the chances of them falling much further in the event that dividends are cut.

Considering that if banks do reduce dividends there is little incentive for investors to jump in as they won’t benefit from the current yield anyway. Therefore it would seem probable that despite the appearance of being good value, bank shares will remain low until there is an indication on the next round of dividends.

Commonwealth Bank of Australia, the country’s largest home lender, says it is unable to guarantee matching any further reduction in official interest rates.

Financial markets are fully pricing a further quarter of a percentage point reduction in the Reserve Bank of Australia’s (RBA’s) cash rate when its board meets next month.

“We can’t be in a position to make any comment,” Commonwealth Bank of Australia’s James Sheffield told a parliamentary hearing in Canberra.

“The volatility in the market is huge at the moment,” he told parliament’s house economics committee which is conducting and inquiry of competition in the banking and non-banking sectors.

“You have got to wait for the theoreticals to become real and make a decision, balance out the interests of our customers, obviously pass on as much to our customers as we can afford, but you must also bear in mind we are on very turbulent waters at the moment.”

Retail banks did match the RBA’s rate cut earlier this month, the first reduction by the central bank in nearly seven years.

Greetings, reader. This weekend’s topic? Commonwealth Bank (ASX:CBA) and its annual results. We’ve stripped them down though. They’re not dressed up here like in the report itself. All those bothersome words and fancy graphs are gone. Here are the bare facts.

The headline numbers sounded decent. Revenues were up by 12%. Net profit was up 7%. The final dividend will be $1.53, taking the total annual dividend to $2.66 (a yield of over 6% at today’s price).

Of course, Commonwealth Bank was one of the banks bleating about the cost of credit and the squeeze on its interest margins. After all, isn’t that what forced it to increase lending interest rates independent of the Reserve Bank of Australia?

We aren’t in the habit of telling anyone how to run a business…least of all a $58 billion bank. We’ll leave that to politicians, welfare groups and the mainstream press as they all deem themselves suitably qualified. We prefer to let them tell us and then we can decide whether to believe them or not.

Instead, here, we’ll restrict ourselves to just observing.

In the 2008 Profit Announcement document there were eleven separate mentions of higher “funding costs”. This compared with no use of that phrase in the 2007 profit announcement. Yet the net interest margin (NIM) for the 2007 financial year falling by 0.15% compared with a 0.1% fall in 2008.

So the margins have fallen both year…but only now is Commonwealth looking for a bigger handout from customers. All the four big banks have added an extra 0.5% to mortgage rates over and above the RBA’s official rate adjustments.

Yet margins are contracting. Despite the margin contraction, though, the bank still saw its net interest income increase in dollar terms. It rose by 12%. That was partly due to an increase in business lending of 22%. But its domestic deposit volume also increased by 23%.

And consider this, reader…CBA has the largest volume of retail accounts, many of which would be high margin transactional accounts. In other words, CBA pays next to no interest to customers for these deposits.

Honestly… of the four major banks, CBA probably has the least to worry about with its funding costs.

But the bank is making more loans for less money per loan. How long can it keep that up? We’re not sure.

As Al said yesterday…the crystal ball is rather cloudy in some sectors.

However, we do know one thing. Providing the banking system in general is able to weather the storm of increased funding costs, CBA would probably do well to not lay it on too thick with the “woe is us” act. Otherwise customers might be well justified in asking for some of their money back when (or if) the good times eventually return.

This Week’s Most Important Money Morning Story:

Earlier this week, the Reserve Bank of Australia told the world…wait for it…nothing new at all! But in true central banking fashion, it took 25,254 words to say so. We calculated: that’s the equivalent of one month’s worth of weekly Money Mornings (I know which I prefer to read). Fortunately Al was a little more succinct. Click here for the full story >>

Monday: Onesteel announced a 61% increase in half-year operating cash- flow earlier this year. It puts that down to the expanding business. Until steel makers are really starting to hurt, iron ore’s a buy. That’s not the case yet. Click here for the full story >>

Tuesday: It jumped from $1.77 to $2.25 in one week during 2007. And it kept rallying until recently. FMG’s year-high was $13.15 on June 25 this year. Basically, the stock rose by 643% in 15 months. Click here for the full story >>

Wednesday: It’s a little too early to be talking about stock market bottoms. But here’s our view…the best time to compare our own period with is the last real recession. Back in the early 1990s. Not the Tech Wreck. Click here for the full story >>

Thursday: As far as the bear market in equities goes, investors are certainly down on confidence. But they aren’t motivated by sheer terror just yet. That makes us think the market has more selling left in the tank. And more days like yesterday to come. Click here for the full story >>

Friday: This small-cap digger has discovered the third largest mine of its kind in the world. Not only that…but the mine just got bigger too. This company, though unpopular now, announced a huge new reserve figure last month. The ASX wasn’t ready for it. The stock added 25% in five days. It’s cutting a swathe through the gloomy market.

The RBA Tells You What You Already Know

The Reserve Bank released its Statement on Monetary Policy for August yesterday, reader. It took 25,254 words, 76 graphs and 17 tables for our monetary authority to tell you everything you already know about Australia’s economy and financial markets.

Only 28 of those words meant anything to anyone.

“On the assumption that the subdued demand conditions are likely to continue, scope to move to a less restrictive monetary policy stance in the period ahead is increasing.”

It all boils down to that. The RBA only really needed three words: “interest rate cut”. That would’ve done it.

The rest of the publication is a recap.

Fuel costs are high. Asset prices are falling. Economic growth is slowing everywhere. Inflation is high. The credit crunch isn’t over. Business conditions are deteriorating. Retail spending is falling.

So it looks as though we’ll be getting an interest rate cut. Money markets and analysts are taking it as a given now.

Then again, central bankers have resorted to threats and games before. We guess we’ll find out in a month.

But there was one optimistic point from the RBA’s letter. Australia’s terms of trade are increasing, thanks to coal and iron prices. Buy the ‘Out Economy’, we say.

Another Chance to Buy the ‘Out Economy’…at a 34% Discount

How can you do that? Well, here’s a thought. Iron companies have lost chunks of market value in the last two months.

Fortescue’s (ASX:FMG) down 34% from its high.

Murchison’s (ASX:MMX) off 43%.

Mount Gibson’s (ASX:MGX) 41% lower.

They could go lower.

But the iron business is still a gold rush in its own right, whatever the share prices are doing. Fortescue announced yesterday that plans to double its iron production are ahead of schedule. We asked Gabriel what he thought of the stock. He was pretty keen. Scroll down for the full story.

Meanwhile, fellow iron ore producer Mount Gibson announced a record net profit of AU$113 million. The market didn’t even glance up. The stock traded flat.

You buy when there’s blood in the streets. What about when there’s utter indifference in the streets? What about when the streets are flush with beige?

It’s uninspiring to see investors shun good results. It’s not like insiders anticipated this either. Mount Gibson has been trading lower for the last month. But markets change. It’s handy to get in before that happens.

A Correction in Bank Pain

The market isn’t entirely indifferent these days, though. It shrieks and leaps up on a chair every time another company confesses sub-prime blues.

But as we’ve said before, sub-prime losses aren’t the best measure of how Australian banks are travelling. It’s how much their funding costs rise.

And, as you can see from our Bank Pain Index to the right, funding costs are back to where they were this time last year.

Maybe it’s tempting to think that the credit whipping is over. Especially when Bendigo and Adelaide Bank (ASX:BEN) posts solid, 40% growth in annual profit.

Don’t be fooled though. This isn’t permanent. As we said above, money markets have factored in a rate cut. Probably a double-slash of about 50 basis points. That’s how the RBA usually kicks off the cutting party. It likes to loosen things up with a double-shot of financial liquidity.

But if the RBA makes its move and cuts…don’t expect money markets to follow the cash rate down any further. And that’ll leave banks with a big spread between the cash rate and their own funding costs. A big, nasty, expensive spread.

Or, the alternative…the RBA doesn’t cut rates and money markets skip back up to nosebleed highs. Someone hand ANZ a tissue.

Babcock, the Life of the Party

After looking at that Mount Gibson result, it seems like investors are bored with the share market, reader. And every time things get boring, Babcock and Brown (ASX:BNB) likes to step in and liven the place up a little. Like the attention-seeking guy at a party who loves to make a spectacle. Usually at his own expense.

Right on cue…Babcock’s tipping next half’s profit will be down 40%.

Investors’ lives suddenly became instantly interesting. They had purpose. They had a mission. Their mission was to sell the stock down 12% for the day.

Credit crunch? Not over.

Money Weekend editor Kris Sayce has been all over this story. Babcock’s paying for establishing a high-debt business model that doesn’t work when the cost of debt goes up. And the money markets continue to flog companies like Babcock into submission. It’s not over.

Gold Cheapens to US$828

Meanwhile, gold took a big fall last night reader. It’s gone all the way down below US$830. Gabriel’s trying to figure out whether traders will support it from here, reader. He’ll let you know tomorrow.

Remember…gold’s one of the best ways to sell the financial crisis. This is just a correction. And in a financial crisis this huge, there’s more to come. Watch for gold to move up again later this year.

“waiting for the banks to have a rights issue. I wonder if there is an economic cycle that started in 1990 and is starting again now’.

James this is a great question and much beyond the scope of a couple of paragraphs but let me try and in any case it is useful to talk about the banks as they are the source of so much misery and conjecture of late.

 have chosen ANZ to look at as it is representative of three of the major banks – except CBA which was still a government corporation back in the 80’s and to look at the 90’s technically we need some history.

Let’s look at a chart going back to the 80’s:

click chart for more detail

But I also want to look at the chart how it looked in the 90’s and this is the beauty of ProfitSource as it allows you to step back into history:

click chart for more detail

As you can see there was a wave four happening and eventually it did recover but you can see from the next chart that ANZ moved sideways for almost 15 years:

click chart for more detail

 not implying for one moment that the banks could range trade for the next 15 years but I do expect them to take some time to recover.

James I could not say we will see the banks do a rights issue and frankly it would have to be so well priced to win the confidence of shareholders and rights issues have their dangers too as they can force price down even further.

One thing I do note about banks is that all of the big four have had major first and second line management reshuffles – some unforeseen and the Instos are just a little wary about the banks ability to really inspire at a time when it is most needed.

Growing up in the UK, I remember the weekly visit of the “Rag & Bone” man. This Albert Steptoe-like character would roll past on his horse and cart each week shouting “Raaag ‘n booooone.”

Here in Australia it’s different. The local council asks us to put all our large item rubbish onto the nature strip a couple of times each year. After scavengers have picked over it, the council takes it all away for us.

It’s rubbish day in the financial markets too. The time is ripe - for the banks especially - to shovel out as much garbage as they possibly can. The bad news just keeps coming.

Not only that, but ANZ, Westpac and NAB (and St George) have or will soon have, reasonably new management teams. They’ll grab the opportunity to dump and lay blame on previous management decisions.

The banks are the most interesting story out of all the listed companies. ANZ Bank is clearly the worst performer out of the four majors, having fallen by 50% from its high. However CBA, Westpac and NAB haven’t done spectacularly well either having fallen by more than 20%, 20% and 40% respectively.

The size of NAB’s exposure to US-based CDO’s was extraordinary compared to the other three major banks. It just looks like the classic case of “smart” people being suckered into a product that was great when interest rates were low and people could service debt, but not so great when the reverse happened.

And if you still aren’t quite sure how a CDO works, well, you aren’t alone. Apparently NAB had no idea about the mechanics of a CDO either.

There are plenty of commentators out there declaring that the worst of it is over (even last week in this column we thought that the ‘vibe’ of the market had changed – excepting financials). But it still seems a little premature to dive in, boots and all. Let’s not forget that we’ve heard at least half a dozen times during the last six months that the “worst is over”, or that there is “light at the end of the tunnel.”

Yet the market still continues to wobble at these lower levels.

So what should the trader or investor do? Naturally we can’t give personal advice otherwise we’d get a slap across the chops from ASIC. But we’ll say thing. For the trader a volatile market should be a happy time providing they adjust their risk tolerance. For an investor, over the longer term, averaging in at these prices may not be the craziest thing in the world to do. Just don’t go thinking you’ve picked the bottom of the market.

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.