There are four key threats to the profits of Australia's banks: bad debt write-downs from imploding corporates, the well-documented rise in the cost of wholesale funding, losses from structured-finance holdings and the potential for mortgage defaults.
Unlike banks in the US - the smaller ones are dropping like flies - Australia's banks are relatively well-managed and well-capitalised. With every new problem exposure, however, the prospect of the banks moving to improve their capital buffers and the cost of funding via large equity issues increases.
The potential for mass mortgage defaults is the most remote of the challenges facing the banks at the moment. Home loan defaults have been rising but still comprise a negligible hit to profits. Australian households are as safe a bet as any asset class there is.
Moreover, falling interest rates are reducing the likelihood of red ink flowing in the big banks' mortgage books. The danger is unemployment. If, for instance, the commodity super-cycle were to end and Australia were to find itself in the grip of a global recession, this country's highly indebted households would begin to default in numbers. Such an outcome would pose a real threat to bank profitability.
At this point the crisis on Wall Street is yet to spill over into the Australian economy.
The rise in the cost of wholesale funding has already wreaked damage on bank profit margins. In the case of the Big Four however - NAB, CBA, Westpac and ANZ - their large depositor bases and a $10 billion a year fee clip serve as decent protection against the rise in wholesale funding costs.
The bancassurance group Suncorp and the second-tier players are not finding the going quite so easy, and non-bank lenders … well, look at Rams.
To the next threat: structured finance. Over the past three months ANZ and National Australia Bank have both taken large write-downs on their collateralised debt obligations (CDOs) and other fancy structured products. Banking analysts are increasingly tweaking their forecasts and their modelling for the prospect of further red ink from these investments.
CBA and Westpac have both admitted to exposures as well but these are widely regarded as less of a problem than for ANZ and NAB. UBS recently raised the spectre of $150 million up to $1.6billion in further structured finance write-downs for NAB.
For its part, ANZ has a large credit default swap (CDS) exposure and has been hit hard by its exposure to the stock lenders Opes Prime, Chimaera Financial Group and Tricom. This week brought another bout of bad news with a $US120billion ($U151 million) exposure to the bankrupt Lehman Brothers. They can't take a trick.
Which brings us to the "bad boys". The bad boys are the leveraged former heroes of the boom - the smartest guys in the boom you might say - who borrowed too much and whose share prices have been decimated.
The figures on the accompanying table are estimates of the bank exposures to these bad boys - and to the latest and greatest of the bad boys, Babcock & Brown. These estimates are gleaned from public admissions, corporate advisory and institutional sources, and should be regarded as a guide.
It is a worrying guide, particularly for ANZ and Suncorp; the former because of its exposure to B&B and the latter because it is smaller than the Big Four banks and can less afford the losses.
Most of the bad boys are not insolvent and still have the chance to trade out of their positions. Sadly, the rise in counterparty risk from the woes on Wall Street and the increasing prospect of damage to the real economy does not help the prospects of the bad boys. Most if not all are now in de facto "work-out" with their creditors - and likely to fail.
