By Greg Peel

Bank analysts figured it out a while back, but unfortunately the market has not, particularly foreign investors in the Australian market. It took the local bank analysts a while, mind you, so we can only hope the market catches on eventually. The funny thing is that if you listen to market commentary, you'd swear the market had caught on. Yet day to day whipsawing of Australian bank stock prices would tend to suggest otherwise.

What am I talking about? I'm talking about the fact Australian banks have reverted to being the "defensive" stocks they have been throughout nearly all of history with the exception of the period 2003-07. That period represented the runaway credit boom which took us to the GFC in 2008, and to the same GFC in a different form in 2011. In that period, Australian banks stopped being defensive and became high-beta, cyclical stocks, with stock prices driven by economic growth which was itself credit-fuelled. Since then, banks have remained cyclical in terms of stock index movements largely because of the F in GFC. What has been the source of all the trouble since 2008? Banks ? first US then European. So it stands to reason that Australian banks should also be sold off when things get volatile once more.

But actually it doesn't. The problem with Europe's banks at present is that they are undercapitalised vis a vis the level of toxic sovereign debt risk they are carrying on their balance sheets. If nature had been allowed to take its course, such that Greece would have defaulted long ago and possibly set off a cascade of defaults right through to Italy, then possibly all of Europe's banks would be bankrupt.

In 2008 the story was the same, except in that case it was US banks and toxic mortgage debt. The US banks have since been recapitalised by the public sector, and it would seem the same might be about to happen for the European banks. But what of the Australian banks?

Australia's big banks undertook extensive recapitalisation in 2009-10 via the private sector (albeit with a government deposit guarantee providing a safety net). In retrospect, given the fact Australia did not fall into recession, the extent of recapitalisation was probably over the top, and for the last two years Australian banks have been gradually bringing their unused provisions against potential bad debts back into their earnings pools. However they weren't to know this at the time, and given the collapse of global mortgage security markets they had to quickly find new loan book funding through expensive off-shore loans ? the last of which will roll off mid-2012. Australian banks did not have any great exposure to toxic US mortgage debt (NAB had some but nothing too destructive) and they don't have any exposure of note to European sovereign debt.

The only exposure Australian banks have is to a renewed increase in offshore funding cost and a renewed increase in local bad debts due to a recession (and one can argue Australian ex-resources is already in one). Yet herein lie offsets. Credit demand in Australia has plunged but that means less offshore funding is required. Deposit demand has soared which, again, means less need for offshore funding. What this means is that Australia's banks are well capitalised (and exceedingly so compared to US and European banks) and are able to maintain reasonable net interest margins (a bank's source of earnings) through a period of sluggish loan growth. Such margins means Australian bank payout ratios are quite safe, which in turn means dividend yields will remain very attractive until such time as stock prices rally strongly once more.

And this is where the contradiction lies between the "what I say" and "what I do" attitude of foreign investors. Almost every commentator appearing on US business television, and plenty of them on Australian business television, will tell you investing in quality dividend stocks is the way to play this market right now. Australian banks fall into that category, yet every time Europe sneezes again Australian banks are dumped from offshore.

Of course, such episodes do provide opportunities for local investors, if they are prepared to hang on for the wild ride.

The previous FNArena Australian bank report was published on August 23, which was a point at which Europe had reared its ugly head once more after we'd all just got over the US credit rating downgrade and the market had tried to rally again. On August 23, our bank table looked like this:

Between then and now markets have suffered all sorts of extreme volatility, and none more so than in the last week and even as I write. Today's version of the table is as follows, with closing prices reflecting the 3.6%% rally achieved yesterday:

Spot the difference? Well there are certainly differences, but not to any great extent. ANZ Bank ((ANZ)) has suffered one broker downgrade to Hold from Buy which has it slip to third place in the FNArena database consensus table thus shifting Westpac ((WBC)) into second. None of Westpac, National ((NAB)) or Commonwealth ((CBA)) has seen a rating change since August 23.

There has been a little bit of movement in closing prices, but not much. There has been virtually no movement in consensus broker target prices, meaning not a lot of change to that still extraordinary upside to valuation. And those fabulous yields, shown here before applying 100% franking, remain fairly similar.

In other words, despite all the turmoil in the ensuing period which seems to have brought Europe to the brink, Australian bank analysts have just not seen any reason to change their tunes.

Indeed, bank reports in the interim period have remained relatively positive, in least in terms of highlighting defensive qualities and attractive yields in a period of acknowledged slow growth ahead. Goldman Sachs, for example, has suggested bank "dividend yields look sustainable". Macquarie reiterates that the aforementioned offsets in operation mean income growth for the banks will "hover at or around the average level seen for the last 20 years".

It isn't all beer and skittles however, with a couple of old habits reappearing to make bank analysts a little nervous.

Having surveyed the banks' senior loan officers, UBS finds that in the current environment of slowing credit demand the response has been to once again ease lending standards. As we all know, it was lax lending which brought us up to the GFC in the first place. Obviously, Aussie banks are not suddenly writing "NINJA" mortgages, but they are easing off on previously tightened mortgage requirements in the face of easing house prices and mortgage demand.

They are also loosening requirements for large corporations, but at this stage they've left requirements for small and medium enterprises (SME) as they have been post-GFC. The agriculture sector, the services sector, and some industrials are enjoying better access to loans, but the offset is a further tightening for anyone in retail and manufacturing ? the two "dog" sectors of post-GFC Australia. In other words, banks are cherry-picking via their loan requirements as they let a bit more light in through the shutters. The conclusion drawn is that loan growth will improve over the next 12 months, but net interest margins will ease as a result.

UBS thus believes the Australian banks are "structurally challenged", and will need to focus on cost cutting and processing upgrades. However at current prices, UBS believes valuations are fair.

In the meantime however, when it comes to mortgages the Big Four banks are "writing almost every new loan," as research by RBS Australia has found. The Big Four currently hold 62% of the $1 trillion Australian mortgage market, with the balance spread across the smaller banks, foreign banks, credit unions etc and the (minimal) securitisation market. Prior to the GFC, the Big Four controlled 49% of mortgages.

It is perhaps not all that comforting, therefore, at a time when talk of a global recession is once again rife, to learn that Australian mortgage standards are being eased again in the face of falling demand. Nor is it all that comforting to find that the Big Four are once again discounting mortgages prices, as JP Morgan notes.

[As an aside ? two of the great misconceptions in Australia are that mortgage rates bear any relationship to the RBA cash rate, and Australian banks are some sort of non-competitive cartel.]

NAB started it all off with its "breaking up" campaign, which proved not only cleverly irreverent and a real slag off at stupid politicians but also a great success. NAB has picked up quite a slice of the mortgage market as a result, ANZ's gains have been modest, while the offset is Westpac's losses have been modest and CBA has been the big loser. Given the extent of Big Four dominance in the mortgage market, and given the Big Four are writing almost every new loan, as RBS notes, it's all as good as a zero sum game.

Yet within the zero sum game, as JP Morgan has found, competition has led to mortgage discounting ? again. But rather than competition being based in the standard variable rate (SVR) market as it usually has been, competition has hotted up in the fixed rate market. Fixed rates are now being offered below SVRs. How can that be?

Well, it's all about the first point I made above, being that multiple-year mortgage rates have nothing to do with the RBA overnight cash rate, as well they shouldn't given the duration gap. The average duration of loans on a bank's books sit around the 4-5 year mark, and the Australian yield curve has "slumped" of late given high demand for term deposits and expectations of an RBA rate cut. This allows the banks to lock in cheaper funding and thus offer cheaper fixed rate loans without the usual level of risk associated with not being able to move rates up and down with the RBA.

It's all good news for the home buyer, but for the bank stock investor it means greater pressure on those important net interest rate margins, which are what translate into earnings and dividends. JP Morgan thus concludes that earnings risk is now to the downside for banks, meaning the "slow" rate of earnings growth for Australian banks previously assumed will be even slower.

On that basis, we can conclude that while Australian banks have become "defensive" once more, despite still being the plaything of fickle foreign investors, they are not quite as defensive as, say, a utility or a telco, or even a supermarket. But then that is why Australian bank yields are currently at such historically high levels (even before we talk 100% franking). Nobody said there was no risk at all.